• 4 hours Alberta’s Unlikely Alliance With The Nuclear Industry
  • 22 hours The True Cost Of Opportunity In America
  • 1 day Why Investors Shouldn't Ignore Gold Stocks
  • 2 days Facebook Scrubs Over 2 Billion Fake Accounts
  • 2 days Dow Scrambles To Avoid Fifth Straight Weekly Loss
  • 3 days Is This The World’s First Truly Democratic Stock Exchange?
  • 3 days India’s Wealthiest Set To Hold $23 Trillion By 2028
  • 3 days First Quarter Profits Slip For World's Top Oil Companies
  • 3 days The Yuan May Be China's Biggest Weakness
  • 4 days Hedge Funds Having A Banner Year
  • 4 days Disney Heiress Asks “Is There Such A Thing As Too Much?”
  • 4 days BHP Turns Bullish On EVs
  • 4 days Investors Turn Bullish On America’s Nuclear Decommissioning Business
  • 5 days The $90M Inflatable Rabbit Redefining Modern Art
  • 5 days Huawei’s Fate In The Air
  • 5 days Tesla Slashes Prices Again
  • 5 days The Modern History Of Financial Entropy
  • 6 days Italy’s Central Bank Embraces Sustainable Investing
  • 6 days Trump Lifts Metals Tariffs To Cool Simmering Trade War
  • 6 days Researchers Push To Limit Space Mining
Market Sentiment At Its Lowest In 10 Months

Market Sentiment At Its Lowest In 10 Months

Stocks sold off last week…

Strong U.S. Dollar Weighs On Blue Chip Earnings

Strong U.S. Dollar Weighs On Blue Chip Earnings

Earnings season is well underway,…

How Millennials Are Reshaping Real Estate

How Millennials Are Reshaping Real Estate

The real estate market is…

  1. Home
  2. Markets
  3. Other

Stocks Look Less Scary This Way

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!

 


You can follow me @inflation_guy!

Enduring Investments is a registered investment adviser that specializes in solving inflation-related problems. Fill out the contact form at http://www.EnduringInvestments.com/contact and we will send you our latest Quarterly Inflation Outlook. And if you make sure to put your physical mailing address in the "comment" section of the contact form, we will also send you a copy of Michael Ashton's book "Maestro, My Ass!"

 

Back to homepage

Leave a comment

Leave a comment