Blog

September 30, 2011 - Market Commentary

Posted by: STEVE ARNETT

Posted on: October 7, 2011

Dalbar, Inc., a provider of financial services, just completed a study entitled “Quantitative Analysis of Investor Behavior” that examines how the individual investor has performed over different periods of time. For the 20 year period ending 12/31/2010, the S&P 500 and Barclays Aggregate Bond indexes had average annual returns of 9.14% and 6.89%, respectively. For the same period, the average securities investor and bond investor saw average annual returns of only 3.83% and 1.01%, respectively. What caused these average investors to perform so poorly compared to the associated indexes?

Behavioral Finance is a rapidly growing field of study that seeks to explain how and why people, and markets, sometime behave irrationally or unpredictably, creating distortions in their performance. Below are some of the concepts that Dalbar identified as potential roadblocks to investors’ good decision making:

• Loss Aversion: expecting high returns with low risks
• Narrow Framing: making decisions without considering all implications
• Anchoring: relating to familiar experiences even when it is inappropriate
• Optimism: believing that good things happen to me and bad things happen to others
• Herding: copying the behavior of others even in the face of unfavorable outcomes
• Media Response: reacting to news without reasonable explanation

Each of these behaviors can affect an investor’s psyche when investing in the market and can yield disappointing returns (even in a bull market), thus becoming self-fulfilling prophesies.

“Herding” and “Media Response” are probably the most significant contributors to investors’ poor decisions. As John Naisbitt once said,

We are drowning in information and starved for knowledge. Rather than attempt to sip selectively from a fire hydrant, we inevitably defer to consolidators and aggregators – the financial media – in at least some of our consumption of supposedly relevant ‘news.’ Handing over our editorial filter to others can lead to some awkward tensions between a complex world and somebody else’s interpretation of reality.

Hallelujah!

Many of these investors aren’t getting the counsel of professional advisors who can help them avoid making these impulsive mistakes.

It is amazing how much more volatile the stock market is today compared to 20 or 30 years ago. Each decade had its own unique facts and circumstances that affected the market’s performance. Below is a table that demonstrates by decade (give or take a year or two) how many days the S&P 500 index rose or fell by more than 3% from the prior day’s close.

Period	3%+ Days	Best	Worst
1/1/62 - 12/31/69	4	4.65%	(6.17%)
1/1/70 - 12/31/79	4	4.90%	(2.84%)
1/1/80 - 12/31/89	22	9.10%	(20.47%)
1/1/90 - 12/31/99	19	5.12%	(6.87%)
1/1/01 - 12/31/09	98	10.79%	(8.72%)
1/1/10 - 9/23/11	15	4.67%	(6.59%)

Just looking at the numbers, it might appear that there wasn’t much going on in the ‘70s, but it had its share of significant events. We were coming out of the Vietnam War. Nixon moved us off the gold standard. We saw OPEC’s oil embargo, wage and price controls, and the Iran hostage situation. It was not a calm decade by most measures but it only had four days in which the S&P index rose or fell by more than 3% -- and all of these swings were positive.

In the first nine years of the new century there were 98 such days of 3+% swings over the prior day’s close, both positive and negative. The period contained two of the worst bear markets in recent history, preceded by the tech bubble and financial crisis, respectively, and which accounted for 30 days and 50 days of the 98-day total, respectively. What caused all of this volatility? Many believe it was likely attributable to high frequency trading.

The more recent turmoil in the market began to bubble up in late July 2011 and later exploded on August 5th  after Standard & Poor’s downgraded the US from a AAA to AA+ credit rating. From its April 2011 high, the market (i.e., S&P 500) fell to its 2011 low in August, representing a decline of almost 18% -- just shy of the 20% mark that would define a bear market. August alone experienced seven 3% +/- days. The ensuing European saga, with the near default of Greece and the fear its default would bleed over into Ireland, Portugal or Italy, fueled a panic in the global market. Where did its investors go for safety? Not to the other AAA rated countries but to that AA+ rated country: the US. With the demand for safety, the 10 year Treasury moved from a yield of 2.71% all the way down to 1.72%, reaching levels not seen in more than 50 years. The money leaving US Domestic funds continues to flow at full force; August’s $35 billion withdrawal was the second largest, behind only the $47 billion withdrawal in October 2008. Since the beginning of 2007, more than $409 billion has been moved out of US domestic funds. Not surprisingly, consumer confidence hit a three decade low. When you reach these extremes, you can count on having a pretty good rally.

For the first nine months of 2011, returns for the S&P 500, NASDAQ, Russell 2000, MCSI EAFE and Lehman Brothers Aggregate Bond indexes were <8.68%>, <8.30%>,<17.02%>,<14.98%>, and 6.65%, respectively. For the same period, our Stock, Aggressive Stock, Balanced and Fixed portfolio returns were <13.86%>, <15.51%>, <6.37%> and 1.12%, respectively.