Stocks

What Makes Stock Investing Hard Is The Poor Feedback Mechanism On Allocation Choices

I’ve been trying to lose weight most of my life. I discovered the secret when I was diagnosed with diabetes. I have to check my blood sugar levels each day. The number that comes back tells me with precision whether I followed a proper diet the day before. If I cheat and put sour cream on a baked potato, that shows up in the number. I of course try to rationalize away the little bits of cheating just as I always did in the days when I did not have those numbers available to me. But it is hard to rationalize when you can see in black and white the effect of the decisions you have made.

Feedback Mechanism
rawpixel / Pixabay

People without diabetes have feedback mechanisms available to them too. It’s usually a scale. People make efforts to cut back on the calories and the scale tells them whether they are succeeding in their efforts or not. The trouble with a scale is that it takes several weeks before a change in an eating habit shows up in a reduced number on the scale. Humans respond much better to prompt feedback than they do to delayed feedback.

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Everything is like that. Most of us can save a few hundred dollars to have extra spending money on a vacation if we begin the effort to do so a month or two in advance. But we all struggle to save at age 30 for a retirement slated to begin at age 65. Distant goals are hard-to-achieve goals. We like to see a payoff for our efforts in a short amount of time. When we see a quick payoff, it energizes our efforts to change our behavior.

Buy-and-Hold offers lots of quick payoffs. The average long-term return on stocks is 6.5 percent real. So the likelihood is strong that an investor who adopts a Buy-and-Hold strategy is going to see a payoff for doing so within a few years. There have been time-periods when stocks did not provide positive returns for a number of years. But an asset class that offers an average long-term return of 6.5 percent real has to provide positive numbers in most years. So the odds are strong that the investor who elects to follow a Buy-and-Hold strategy is going to be pleased with it by the time that a few years have passed.

And, once a number of good return years are in the books, it doesn’t hurt the investor too much to see a negative return year pop up. I point out in my writings all the time that the annual annualized return on stocks from 2000 forward has been only 3.5 percent real. That’s a return a good bit below the average return of 6.5 percent for a good number of years. Earning that low of a return for nearly 19 years running has left a lot of investors a good bit short of their retirement planning goals. But rarely do Buy-and-Hold investors complain about the sub-par returns that we have seen since the turn of the century. The picture looks a lot different when returns for the last four years of the old century are included in the calculation. From January 1996 forward, the annualized real return has been 6.6 percent real. Most investors do not know the precise numbers, but they know the general story. Most are generally pleased with how Buy-and-Hold strategies have performed on an overall basis even though they would of course be even happier if not for the return shortfall of the past 19 years.

The only thing that makes Buy-and-Hold look bad is a prolonged bear market. Shiller’s research suggests that we will see a price crash of 50 percent or more within the next year or two or three. If we see a 50 percent crash, investors will become dissatisfied. They will see their retirement dreams slipping away. They will begin asking questions about Buy-and-Hold that they have never asked before.

But prolonged bear markets do not take place often. We have good records of stock prices going back to 1870. That’s 148 years. Stock valuations have always played out in a hill-and-valley pattern, with perhaps 20 years of gradually rising valuation levels followed by perhaps 15 years of gradually falling valuation levels. So an investor sees the completion of one full pattern only after he has been investing for 35 years. Someone who started investing in stocks in 1982 would not have personally witnessed the bottom of a secular bear market to this day, 36 years later (this bull/bear cycle has taken longer than any earlier one to play out). That’s a slow, slow, slow feedback mechanism, the kind that the human mind has a hard time processing and learning from.

The only way to appreciate the importance of the hill-and-valley pattern that governs stock performance is to step out of your own personal circumstances and take a look at a graphic that shows the history of the market that you were not able to participate in personally. I remember seeing a graphic showing the hill-and-valley pattern that was presented in the early pages of Robert Shiller’s book Irrational Exuberance and being blown away with the clarity and the significance of the message being conveyed. “That’s it!”, I thought to myself. “That’s the missing piece of the puzzle. That’s how it really works.”

The job of the investment advisor is to help the investor understand how the slow feedback mechanism tricks us into thinking that we don’t need to take valuations into consideration when setting our stock allocation when in reality it is important that we do that if we want to keep our risk profiles constant over time.

Rob’s bio is here.