Tuesday, October 14, 2008

Half of Last Week’s Losses Erased

If last week’s stock performance was a “meltdown,” then Monday saw an “explosion” that erased half of last week’s losses as measured by the S&P 500 index. With Canadian markets closed on Monday, it will be interesting to see how they react in today’s opening.

For some reason, the 11.6% recovery in the S&P 500 has not generated much excitement. Even if the rest of this week sees stocks prices fully recover from last week’s losses, it seems that many investors will still feel the stinging pain of loss.

We’re wired to feel losses more strongly than gains. Our instincts often do not serve us very well when it comes to making investment decisions. We’re prone to being overly confident during good times and overly fearful during bad times like we’ve had lately.

Do you really believe that our financial system and our way of life will crumble away? It’s time to tune out the hysterical ranting on pseudo-news channels and think for ourselves.

5 comments:

  1. Not that I'll lend any credence to what I hear on CNBC but one trader explained last week that a lot of the fall was due to hedge funds which were forced to liquidate for two reasons: (1) They were hit with massive redemptions and (2) Many were forced to sell due to margin calls. So much for making money in any type of market!

    ReplyDelete
  2. CC: I guess that redemptions at times like this contribute greatly to the fact that funds have higher returns while they're small and lower returns after they swell.

    As you say, there is no shortage of people who claim to be able to help investors make money in any type of market. I'm very skeptical of such claims, but I do think it's possible to lose money in any type of market :-)

    ReplyDelete
  3. Have your read "Influence" by Robert Cialdini? He talks a lot about all the psychological traps humans are susceptible to. Charlie Munger highly recommends the book. He even gave the author a BRK-A share.

    Anyway, I think he mentions loss aversion in the book, where test subjects are given $30, say. They are then offered a wager to get a total of $50 if they win a coin flip, or get a total of $20 if they lose the coin flip. Most turn down the offer, since they are afraid to lose $10, vs winning $20.

    Part of the key is the setup of the test. Since they are given the $30 first, they feel the need to avoid losing any of it, so they forego a bet with good odds (a 50% chance of $20 gain vs a 50% chance of a $10 loss.

    If a test subject is instead offered the chance to win $50 for a head, or $20 for a tail, or offered the choice to not play and just get $30, most take the bet on the coin flip. When posed this way, the problem removes the loss aversion from the situation.

    Now that I think of it, I'm not sure if this example was in "Influence". I'm almost certain it was in "The Warren Buffett Portfolio" by Robert Hagstrom, but he may have lifted it from "Influence".

    At any rate, you're probably aware of this test. You seem to have an interest in these psychological issues.

    ReplyDelete
  4. Gene: I liked Cialdini's "Influence: The Psychology of Persuasion" so much that I've recommended it to friends and family many times since I first read it several years ago. My copy is currently on loan to someone, but I've lost track of who. I can't remember for sure, but it seems plausible that it contains the experiment you described. I agree that a loss is only felt strongly if the person feels ownership before the loss occurs. So, investors during the high-tech bubble felt cheated out of the money they came to believe they deserved before the crash. But, if someone who moved to an isolated island through the run-up and fall and only learnt what happened after the fact would not have felt the loss nearly as strongly.

    ReplyDelete
  5. Your person returning from a desert island to check his portfolio sounds like a great sequel to the Tom Hanks movie "Cast Away". Cast Away 2 - Return of Capital :-) How about Capital Punishment? Ah well, I'll send you the script when I'm done writing it.

    However, I prefer that episode of Futurama where Fry goes to check his bank balance after 1000 years in a cryogenic chamber to find he's a billionaire due to the compounding interest: Season 1 - Episode 6 - A Fishful of Dollars

    ReplyDelete