Past trauma blinds in­vestors to present dan­ger

The Pak Banker - - OPINION - Barry Ritholtz

THE CFA In­sti­tute pub­lished its an­nual sen­ti­ment re­port this week. It sur­veys in­di­vid­ual and in­sti­tu­tional in­vestors to de­ter­mine what they are anx­ious about. You might be sur­prised to learn that about one-in-three is greatly con­cerned about an­other 2008-09 type fi­nan­cial cri­sis: In­vestors re­vealed a grow­ing anx­i­ety about the state of global fi­nance. Al­most one-third of in­vestors feel that an­other fi­nan­cial cri­sis is likely within the next three years (33 per­cent of retail in­vestors/29 per­cent of in­sti­tu­tional in­vestors). In some coun­tries, such as In­dia (59 per­cent) and France (46 per­cent), the fear fac­tor was even greater. Just as ev­ery gen­eral fights the last war, in­vestors, too, fear what just hap­pened. Rarely (if ever) are they con­cerned about the unknowns that might be ahead. We even dis­cussed this last year in "what just hap­pened ver­sus what hap­pens next." It is sim­ply part of in­vestor psy­chol­ogy.

Why is this? The "Re­cency Ef­fect" af­fects in­vestors even more than it does gen­er­als and oth­ers. Loss aver­sion is based upon how much more painfully and deeply in­vestors ex­pe­ri­ence a fi­nan­cial de­cline ver­sus the more mod­est im­pact of the pos­i­tive emo­tions as­so­ci­ated with a gain. As we learned from Daniel Kah­ne­man and Amos Tver­sky, it's not that we don't like to make money in the mar­kets -- of course, we do -- it's just that the pain of loss is twice as strong as the plea­sure of gains. As noted pre­vi­ously, "Trauma may be the key to un­der­stand­ing in­vest­ment-re­lated re­cency ef­fects. In in­vest­ing, it isn't just the most re­cent events that stand out; it's events of greater psy­cho­log­i­cal or emo­tional weight that leave the more last­ing mark."

In­vestors re­call in­tense mem­o­ries more than run-of-the-mill rec­ol­lec­tions, be­cause, well, it's a good sur­vival fea­ture. An ex­pe­ri­ence that put your life at risk -- and that you were for­tu­nate enough to sur­vive -- is go­ing to leave a mark. Hence, an or­di­nary Tues­day has al­most no res­o­nance to your fu­ture in­vest­ing self, but a mar­ket crash, a fi­nan­cial cri­sis, deep bear mar­ket or hyper­in­fla­tion stay with in­vestors for a long time. When you look at the typ­i­cal doom­say­ers -- those who cap­ture the me­dia at­ten­tion -- they are not fore­cast­ing some­thing unique: They are prog­nos­ti­cat­ing a re­peat of a prior catas­tro­phe. (A vari­a­tion of this is the folks who in­sist that the last cri­sis never ended). That sort of fear-mon­ger­ing has much more res­o­nance than warn­ings about some­thing that hasn't hap­pened be­fore. Per­haps this helps ex­plain why warn­ings about sub­prime and de­riv­a­tives were mostly ig­nored in 2005-07. How re­al­is­tic are fears of a "do-over?" How of­ten do we have re­peats of re­cent crises? The dou­ble-dip re­ces­sion of 1980 and 1982 are an OK ex­am­ple, but not a great one. In­fla­tion, a 16-year bear mar­ket and thedeath of eq­ui­ties led to price/earn­ings ra­tios in the sin­gle dig­its by the time those con­trac­tions came along. In­ci­den­tally, that was a fab­u­lous time to start buy­ing stocks. Hence, we end up with an un­der­stand­able but some­what ir­ra­tional fear of what al­ready oc­curred and not what might come in the fu­ture. Long-Term Cap­i­tal Man­age­ment's catas­tro­phe -- a highly lever­aged hedge fund trad­ing illiq­uid se­cu­ri­ties -- was a fore­warn­ing about risk man­age­ment and ramp­ing up cap­i­tal 40-to-1 times. But it hardly was a pre­scient warn­ing about se­cu­ri­tized sub­prime loans and de­riv­a­tives. I bet you can guess most of the peo­ple be­hind the fol­low­ing im­mi­nent anx­i­ety-in­duc­ing claims: Au­to­mo­bile credit as the new sub­prime. 1987-like crash. col­lapse of the dol­lar. .Sec­u­lar stag­na­tion The CFA In­sti­tute found that retail in­vestors were most fear­ful of an­other fi­nan­cial cri­sis -- but they just barely edged out in­sti­tu­tional in­vestors (33 per­cent to 29 per­cent). It seems that any­one with a psy­che is sub­ject to ir­ra­tional fears of a re­peat of re­cent events. In­vestors should be look­ing for­ward, but too of­ten are not. What is it you are afraid of? If you are go­ing to be fear­ful, at least be afraid of the right things.

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