Stocks Look Less Scary This Way

By: Michael Ashton | Wed, Jun 10, 2015
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Here is a quick follow-up on yesterday's column, along with an administrative note (at the end). Yesterday, I noted there that momentum investors will begin to lose interest in being long equities as the year-over-year price return goes towards zero. I thought of another way to illustrate the same point, which maybe gets to something more like the average investor thinks.

The average "retail" investor wants big returns, but has a very non-linear response to losses. The reason that individual investors as a whole tend to under-perform institutional investors is that the former tend to exaggerate the effect of losses while underestimating the probability of losses. So, what tends to happen is that individual investors are perennially surprised by negative equity returns (don't feel bad - financial media is set up to reinforce this bias), and react harshly to mildly negative returns - but not harshly enough to significantly negative returns.

So, the chart below shows a simple calculation of the probability of an equity loss over the next twelve months assuming that the expected return is just the return of the last 12 months, and the standard deviation of the return is the VIX (and assuming distributions are normal...just to complete the list of improbable assumptions). This doesn't seem unreasonable with respect to assessing a typical investor's expectations: returns should continue, and volatility is forward-looking.

Probability of Loss assuming T12 S&P return and VIX std dev

Maybe it's just me, but in these terms it seems more amazing. For much of the last few years, the trailing 12 month return was so high that it would take around a one-standard-deviation loss (16% chance) to experience a negative year - if, that is, we use prior returns to forecast future returns. In general, that's a very bad idea. However, I can't argue that this naïve approach has failed over the last few years!

What is the trigger that makes investors want to get out? After years of gains are investors going to act like they are "playing with house money" and wait until they get actual losses before they get jittery? Or will a 30-40% subjective chance of loss be enough for them to scale back? I think that this way of looking at the same picture we had yesterday seems much more promising for bulls. But, again, this is only true if valuation doesn't matter. Stocks look less scary this way...but this is probably not the right way to look at it!

**Administrative Note - I have just agreed to write a book for a terrific publisher. The working title is "What's Wrong with Money?: The Biggest Bubble of All - and How to Invest with it in Mind." I am very excited about the project, but it is a lot of work to turn the manuscript out by late August for publication in the fall. My posts here had already been more sporadic than they used to be, but now I actually have an excuse! If you would like to be on the notification list for when the book is published, simply send an email to WWWM@enduringinvestments.com and I will put you on the list!

 


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Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA
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Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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