UPDATE: How bear markets attack your mind as well as your money
By Mark Hulbert, MarketWatch
New investors who take a big stock-portfolio hit can be scarred for years
A bear market is one of the most cruel fates that can happen to investors. This is why it's so important, before you risk a penny in the market, to understand the distribution of stock market returns -- the range of return in a given year.
Unlucky investors who do not appreciate that distribution, and who experience a bear market out of the starting gate, may suffer lingering effects for years that significantly reduce their lifetime profits.
This is just one of the insights afforded by the new field of neuroeconomics, an interdisciplinary field of study borne of advances in everything from computational biology and neuroscience to psychology and mathematical economics.
The benefits of this interdisciplinary approach have been recognized quickly. For example, the Federal Reserve Bank of Philadelphia recently hosted a conference entitled, "Neuroeconomics and Financial Decision Making: Foundations and Applications in New Domains (https://www.philadelphiafed.org/consumer-finance-institute/events/2019/neuroeconomics-and-financial-decision-making)."
To be sure, even before neuroeconomics, research showed that it makes a big difference to our long-term portfolio return when bear markets occur -- what economists refer to as "sequence risk." But sequence risk is a purely mathematical phenomenon. Neuroeconomics focuses on what an early-stage bear market does to our psyches.
The picture isn't pretty, according to Camelia M. Kuhnen, a finance professor at the University of North Carolina's Ken-Flagler School of Business, and one of the speakers at the Philadelphia Fed's conference. She has found from her research that investors actually learn differently (assimilate information and draw conclusions) when they experience a loss rather than a gain. Because of this asymmetry, she told me in an interview, investors have what she calls a "pessimism bias" -- an overly pessimistic view about investments.
This bias has lasting effects. Investors who harbor excessive pessimism are likely to systematically invest less in risky assets such as stocks. This will tend to cause them to fall further behind other investors who were not scarred by an early-stage bear market, which in turn will reinforce their pessimism bias. It can be hard to break out of this vicious cycle.
To be sure, a bear market is traumatic to any investor, no matter where in their investment lives it occurs. But it has less of an impact on investors who have experienced better years first, who can be more objective about the distribution of stock-market returns.
Ideally, however, according to Kuhnen, we should be studying that distribution before we have our money on the line in the stock market, when we can be the most objective in putting losses into a long-term perspective. This is why she says it is so important to teach financial literacy in college and high school -- before most people begin investing.
The distribution of stock market returns
What is the distribution of stock market returns? The chart below reflects calendar-year price-only returns for the Dow Jones Industrial Average since its creation in the late 1800s. Notice the bell curve with fat tails -- extending from years in which the Dow lost more than 50% (1931) to those in which it gained more than 50% (1915 and 1933).
The average of the Dow's calendar-year price-only returns is 7.5%, with a standard deviation of 21.2%. Using some simplifying statistical assumptions, and assuming that the future will be like the past, 95% of future annual returns will fall within a range of two standard deviations above or below that average -- from minus 34.8% to plus 49.9%.
That's a very wide range. Even the 2007-09 Financial Crisis, for example, fell within that distribution. The Dow's loss in the worst calendar year during that crisis --2008 -- was minus 33.8%
You can readily appreciate how difficult it can be to accept that something as traumatic as the 2007-09 bear market is nothing more than random fluctuation. That's why we need a solid grounding in financial literacy in order to give our intellects a fighting chance in battling our emotions and any nascent bias towards pessimism.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. Hulbert can be reached at email@example.com (mailto:firstname.lastname@example.org)
Read: Here's what it takes to weather a major bear market and then buy stocks on the cheap (http://www.marketwatch.com/story/heres-what-it-takes-to-weather-a-major-bear-market-and-then-buy-stocks-on-the-cheap-2019-07-30)
More: A few simple steps for millennials who want to start investing (http://www.marketwatch.com/story/a-few-simple-steps-for-millennials-that-want-to-start-investing-2019-07-31)
-Mark Hulbert; 415-439-6400; AskNewswires@dowjones.com
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August 14, 2019 05:21 ET (09:21 GMT)
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