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October 19, 2011 at 02:31 PM
For those near or in retirement, losses matter a lot. Investors nearing retirement who suffer significant losses risk not being able to retire or being forced to reduce their lifestyle in retirement significantly.
Retirees taking income from their portfolios—especially those early in retirement—are susceptible to “sequence risk,” the key aspect of which is that losses early in retirement while taking portfolio distributions increase the failure rate of retirement income plans dramatically.
However, those whose investment horizons are much longer than the retirees and near-retirees described above have little reason to fear near-term losses when they have a solid investment plan in place. Indeed, times of market tumult provide opportunities to buy assets on sale.
For these investors, the problem is having the psychological strength to do so, particularly since there is so little evidence that the market can be timed successfully by the typical investor—few professionals have persistent success at it.
That we typically aren’t psychologically strong is reflected by the numerous studies (most prominently the annual QAIB from Dalbar) that show us underperforming the markets by a lot generally because we buy high (because greed gets the best of us), sell low (because fear gets the best of us) and trading excessively (because ego gets the best of us).
As a practical matter, then, how can we control our emotions and thus make better decisions? The best answer seems to be that because we cannot really control our emotions, we should try to avoid putting ourselves in situations where our emotions can get the better of us.
In his classic Fooled by Randomness, Nassim Taleb describes a hypothetical portfolio with a 15% average annual excess return and 10% volatility. Assuming a standard distribution, 93% of years would result in positive aggregate return. We should be so lucky!
However, when we narrow the timeframes, something interesting happens.
While 93% of years would provide positive returns, quarters would only be positive 77% of the time and months would be positive only 67% of the time. On a day-to-day basis, we’d only see positive returns 54% of the time and on a minute-to-minute basis, we’d see positive returns only 50.17% of the time.
That means the more frequently we look at the performance of our portfolios, the more likely we are to feel the psychological pain of loss. And the more pain we feel, the harder it will be to “stay the course” with one’s investment plan.
