Following The Stock Market Is Bad For Your Returns

Following The Stock Market Is Bad For Your Returns




by Urban Carmel, The Fat Pitch

Summary:  The irony of equity investing is this: if you knew nothing about the stock market and did not follow any financial news, you have probably made a very handsome return on your investment, but if you tried to be a little bit smarter and read any commentary from experienced managers, you probably performed poorly.

The human mind has a tendency to assess risk based on prominent events that are easily remembered. The 1987 crash, the tech bubble, the financial crisis and the flash crash in 2010 are all events that are easily recalled. The mind automatically assigns a high probability to prominent (but rare) events. It ignores the more important "base rate" probability that better informs decisions. The fact that the stock market rises in 76% of all years, that it gains an average of 7.5% per year and that annual falls greater than 20% occur less than 5% of the time, are ignored in decision making. The mind interprets every 10% correction as the beginning of something much worse, even though a 10% fall is a typical, annual occurrence during bull markets.

Bearish market commentary that highlight risk conjure gravitas. Bullish commentary often seems shallow. But remember, in the absence of relevant data, the "base rate" probability is your best guide. Conflating prominent, but rare, events with high probability is an ongoing impediment to better investment returns. Recognizing this inherent deficiency in our decision making is perhaps the biggest potential source for improvement for most investors.
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In the past 12 months, the S&P has returned 22%. In the 3 years since the end of QE3, the total return is 37%. In the past 5 years, returns are over 100%.

Yet, throughout this period, investors with even a passing interest in financial news have regularly seen commentary from experienced managers that the stock market is highly likely to plunge now (from Daniel Miller). Enlarge any chart by clicking on it.


The irony of equity investing is this: if you knew nothing about the stock market and did not follow any financial news, you have probably made a very handsome return on your investment, but if you tried to be a little bit smarter and read any commentary from experienced managers, you probably performed poorly.

That fact is apparent in the statistics, where the average investor earns a return that is less than 1/3 of what they would have earned if they knew nothing and blindly invested in the stock market (next 3 charts from JPM).

These statistics are not the product of the recent and ongoing bull market either. Since 1950, the lowest return from the S&P was a mere -3% but the highest return was +28% on a rolling 5 year basis. Risk has clearly been to the upside.

Since 1980, the S&P has closed higher 76% of the time and suffered an annual loss of less than 3% an overwhelming 84% of the time.

In the past 193 years, US equities have suffered an annual loss greater than 20% just 9 times, a "base rate" of 4.7%. The "base rate" is the probability you would assign to an outcome if you knew nothing other than how often it was statistically likely to happen (from basehitinvesting.com).

All of this came into focus again last week when the S&P celebrated the 30th anniversary of the 1987 crash. Those working at the time can attest to the affect the crash had on investor confidence. In one day, the S&P fell 21%. Over 10 days, the index fell 32%, worse than even the darkest period of 2008, the largest financial crisis in 4 generations.

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