Our apologies for the second article relating to the eruption of Eyjafjallajökull this week. It lies heavy on our minds because we are a team that splits time between our European offices and the Chicago headquarters. As we wrap up an unexpected second week at the London office and realise how woefully unprepared we (and our clothing supplies) were for this interruption, we have made an effort to glean investing lessons from the massive ash cloud that has blanketed much of Europe and left thousands of travellers stranded across the globe.
Time Horizon
In a day and age when many investors' time horizon has crept into "sometime before lunch" territory, a volcanic eruption in Iceland has served as a useful benchmark with which to scale our sense of time and history. The last time that Eyjafjallajökull erupted, between 1821 and 1823, Milton Wright and Susan Catherine Koerner--parents to the fathers of flight, Orville and Wilbur Wright--hadn't even been born. The Amsterdam Stock Exchange--widely considered to be the world's first--was formed by the Dutch East India Company in 1602--10 years before Eyjafjallajökull's second most recent recorded eruption.
So how does this help in thinking about an investment horizon? In a world of 10-second news bites and ever-present mobile internet access, it has become increasingly difficult to keep time in its proper perspective. We have long advocated a buy, hold, and re-balance investment discipline with a vision fixed on the long-term. However, the long-term for stocks can sometimes be several decades, or more. After the crash of 1973-74, the FTSE 30 (a precursor to the FTSE 100) did not recover all its inflation-adjusted losses until May 1987. In the US, it took until August 1993 for the stock market to reach the same inflation-adjusted level as in January 1973, a wait of two decades! After the crash of 1929 and the Great Depression, stock markets did not fully recover until the mid-1950s.
These events are rare, and we are naturally inclined to discount the chance of them wiping out our portfolio at exactly the wrong time. But major crashes, just like earthquakes and volcanoes, happen. As your time horizon to retirement and future spending becomes shorter, review your asset allocation and shift toward a safer portfolio with more fixed-income. It’s always tempting to take on the extra equity risk and reach for greater gains, but remember just how long the time scale of the Earth and the markets is. Think about whether you can hold out for a decade or two without dipping into your portfolio’s equity stakes.
Overconfidence
Overconfidence is one of the most common behavioural pitfalls in investing. This behaviour can manifest itself in countless ways: overconfidence in financial forecasts, forecast ranges that prove too narrow, extrapolating recent trends into the future, blind dependence on financial models, and many others. If history, and a massive cloud of volcanic ash, can teach investors anything, it is to always expect the unexpected. Overconfidence can lead investors to ignore evidence that could potentially disconfirm their investment theses, and often leads them to instead latch onto the body of evidence that confirms their own opinions and forecasts. This can leave one blind to the potential for "fat tail" or "Black Swan" events that can have serious investment implications--or shut down air travel across Europe for days.
Try to question all the assumptions going into your portfolio, from the returns you expect to the diversification benefits of different stock investments. Don’t just look at the past decade of history (though after 2008-2009, this may be a good decade to review), but read about the great crashes of yesteryear and think about what those possible market disruptions could mean for your savings. You may find yourself adding a couple of insurance-like investments to your portfolio, and a few more socks to your suitcase each time you travel.
Loss Aversion
Studies by behavioural economists have shown that people feel much more pain from losing money than they experience pleasure from a similarly-sized financial windfall. These studies demonstrate a natural aversion to the risk of loss amongst many investors. Similarly, many stranded travellers stuck paying for involuntarily extended holidays are now finding themselves in the truly unusual position of bemoaning an extra week in Thailand. If people were completely rational, they should be fairly indifferent between an extended holiday or coming home to a fat cheque at the end of their planned voyage. Instead, the former seems tragic when viewed as an unplanned loss of work or home time, while the latter would undoubtedly be a welcome bonus anytime. This volcanic interruption will no doubt leave many thinking twice before booking their next plane trip, but risk and reward tend to be proportionately sized. Investors who assume more risk will have higher expected returns--all else equal--and should ignore the urge to overemphasise their losses relative to gains.
This psychological phenomenon helps explain why so many investors time their market purchases poorly. As stocks fall in a bear market, they often see the losses mounting from their portfolio’s peak and feel compelled to do something, anything to stop the pain. Same with a rising market, where the gains experienced by everyone else may feel like losses to someone who missed the bull run, leading them to pour in money near the top of the market. A strict rebalancing plan helps avoid these common errors through determining all portfolio actions in advance, regardless of the investor’s feelings about losses or gains.
In other investments, not driven by the core portfolio allocation and rebalancing, investors should simply avoid thinking about their position in terms of gains or losses. Try to wear blinders, only look at today and the future. What is the price of the investment? What are its future prospects? How over- or under-valued does it look? Those questions should provide nearly all the information you need as to whether the investment should be kept or sold, regardless of the past performance.
Patience
Patience is critical whether you are waiting to get home or investing. Ultimately there is little that a stranded traveller or an investor can do to influence their outcomes. The key is to focus on those factors that are within the realm of control and realise which are not. Investors can control their time horizon and realise that a longer perspective on the market can make "volcanic" market events--like the most recent meltdown--seem somewhat less dramatic (think of how much ground most major market indices have reclaimed since their nadir). Furthermore, by studying common behavioural biases that have led many astray in the past, investors can better recognise when they might be falling into common traps. If there is any silver lining here, it is that these lessons will probably continue to serve investors well until the next time Eyjafjallajökull blows its top--here's to hoping that’s not for another 200 years or so.
Bradley Kay contributed to this article.
