INSIGHTS

On August 28, 2012

Opportunity Cost: Emotions

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Emotions May Be Keeping your Clients in Cash, Putting their Long-Term Goals at Risk.



Taking a snapshot of headlines and it is not hard to discern where investors’ predispositions lay. 

“World’s Economic Problems Face Monetary Leaders” Owen Ullman, AP


“Should the U.S. Return to the Gold Standard?” Lewis E. Lehrman & Henry S. Reuss, Christian Science Monitor


“Is Federal Reserve to Blame for Economic Problems?” John Cunniff, AP


“Economic Troubles Mount in Japan” Ralph de Toledano, Sunday Union


“Europe A Continent Facing Uncertain Future” AP / Boca Raton News

To be fair, investors are barraged with headlines akin to a lawyer leading a witness, but the base psyche of the investor is already conditioned to be more wary during certain times as compared to others.  We have discussed at length the Recency Bias and its strong influence on sentiment, consumption and ultimately asset allocations.  However, understanding that subtle subconscious recognition also has an impact on decision making.  A study done by Hershleifer and Shumway in 2003 found that sunshine in the morning had a higher likelihood of higher equity returns as measured over 26 various international equity exchanges.   Somehow it doesn’t seem hard to imagine a new subsidy for skylights from the U.S. government for those who designate day trading as their vocation.



In managing investments, dealing with emotions is given quite a bit of lip service, but little in recognition during actual decision making.  The relationship between deliberative contemplation and emotional reaction is a science that is similar to trying to putt a golf ball into a moving hole.  Just when the conclusions about these relationships begin to get quantifiable, a macro shock is thrown in to shake up the fabric of the base premises.  




Consider that one of the trickier aspects to investing is the reflexive component.  Simply put, the reflexive component states that as a participant, one cannot discern cause and effect because of the mere participation in the event.  As such, an investor is trapped inside a coagulation of emotions, and actions,  as well as both external and internal stimuli that seems to give reason to the definition of insanity given to us by Albert Einstein:  “Insanity is doing the same thing over and over again and expecting different results.”  As such, the consistent underperformance of the average retail investor without any advisory component becomes more painfully obvious.  Numerous studies have been done about the underperformance of investors who are left to their decision making inside a vacuum without counterweights.  Inside a vacuum with no other stimuli but what one allows in, which almost surely leads to emotion being a larger influence. 



Currently, we see more reasons for past historical emotional patterns repeating themselves.  Consider what has happened with Treasury purchases by households and their corresponding yields recently as compared to the last 50 years.

When rates are at or near all-time lows, we find the largest holdings of Treasuries in households and nonprofits, according to the Federal Reserve’s Flow of Funds report.  At the end of 2008, smack dab in the middle of the recession, holdings totaled $256 billion.  At the end of the first quarter of 2012 (most recent release), the total was $1.308 trillion or an increase of 400%.  When yields were consistently above 10% for 5 years, holdings only increased anemically.  Today, there would be a long line of investors who would like to go back in time and invest in Treasuries yielding north of 12%. 



It appears now that the reasons for paralysis are as long as they are deep.  A few include, but are not limited to, the upcoming presidential election and the uncertainty that arises from it, the broader coverage of more remote economic developments and the media headlines that follow, Europe’s lack of leadership in light of the severity of the economic challenges, China’s economic slowdown, global geopolitical events, and last, but not least, the Fed’s involvement in more Quantitative Easing (QE) or more creative and distinct action.  I apologize to all my former grammar professors and teachers about the last sentence; however, its construction and length seem fitting to the thoughts that investors experience.  The barrage of information that is attempted to be digested daily is like one long run-on sentence full of economic and market uncertain terms. 



While this is the first of a four part series on opportunity cost in certain markets, it could be argued that emotions are the one component that has always hindered and hurt investors over the last century.  History is riddled with the recurring theme of the herd chasing many assets at the wrong time and running away from the assets that would perform better if emotion could be minimized.  Now to those who might have missed the dates on the headlines we led the article with, would anyone be surprised to find out that those headlines all occurred in 1981 and 1982?  Do a search today and you will find very similar headlines.  For the next 20 years (1982 -2001), the S&P 500 had a total return of 1103% (annualized at 14.18%).  We wouldn’t forecast similar returns, but would a return significantly above the average of the last 13 years (annualized 2.72% total return) be surprising?  We think so.  As evidence, just look at this year.  We have dealt with an escalating European concern with increasing chances of unexpected returns, an election in the United States that is pivotal to the future economic growth and China’s “recessionary growth” (said tongue in cheek) and yet the total return of the S&P 500 has a total return of 13.75%.  The economic and market patterns keep repeating themselves in spite of the consistent mantra of “it’s different this time.”  It is always different this time mainly in that the veracity of the argument with which investors believe that is. 

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the disclosures webpage for additional risk information. For additional commentary or financial resources, please visit www.aamlive.com/blog.
CRN: 2012-0802-3303R

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.