Fear, Greed and Knowledge

Fear, Greed and Knowledge

Fear, Greed and Knowledge

On a recent television news show appearance, Yale University Psychiatry Professor Rajita Sinha -- who serves as director of the Yale Interdisciplinary Stress Center -- stated there are three factors that can make fear spiral out of control. These include our conclusion that a situation is unpredictable, uncontrollable and persistent.1

All three exist with the Coronavirus and have always existed in the market. They have resulted in sellers of securities in this current market. We go to extremes sometimes to try to control these fear factors, such as selling the entire investment and going to cash.

But for every seller there must be a buyer who has concluded at the current price those three factors are acceptable to them and, from the current price, they have expectations of earning a positive average return over an appropriate holding period (given the uncertainty of those current situations and those future returns).

Please remember that the objective of a free-market is to set fair prices so buyers will be risk-appropriately rewarded for the uncertainty of returns that exist at the moment of purchase. However, this also means sellers get a fair price given the current uncertainties, and therefore, the buyers are not positioned to get an unusually high return.

So buyers should not let the emotions of greed lead them into thinking there are greater expected returns available given the risks of the securities they own. Buyers need to remember there is a reason prices are where they are and that reason is the uncertainties of future returns.

All that being said, buyers should expect a fair return from fair prices and that the uncertainty of that fair return is embedded in the current price, where the price is inversely proportionate to the uncertainty.

So the current price of any stock or bond reflects the risk and expected return of that security. The expected return is determined by utilizing factor models for stocks and bonds and the uncertainties of that expected return.

Such an important statement includes two financial ideas that are intertwined and rely on each other, and combined, these are known in academic circles as the joint hypothesis. These include the Efficient Market Hypothesis and Asset Pricing Models, both of which were the thoroughly researched ideas behind Eugene Fama's Nobel Prize in 2013.

In other words, the joint hypothesis says that risk and return are related because prices are fair.

Knowledge and information can contribute to fear reduction as well as more rational and disciplined choices. With that in mind, the data and graphics provided below might prove helpful to you. It might improve the quality of your choices, because fear without knowledge can make us think the situation is more dangerous than it is.

Researchers at Dimensional Fund Advisors looked at past market declines through 2019, starting at any day since 1926. They wanted to see what average returns were after those declines in one-, three- and five-year periods. The results should contribute to reducing your fears of current market volatility.

Below are tables created by Dimensional's analysts breaking down returns after observed downturns of 10%, 20% and 30% for the Fama French US Total Market Index going back to 1926. Also shown are results for subsequent one-, three- and five-year periods. Notice that across each percentage decline, the average total return generated double-digit gains in the subsequent periods. Note, too, that not every subsequent period showed positive returns.  

10% Market Declines
Peak First Date from Peak that Decline of 10% Occurs Subsequent Total Return 1Yr Subsequent Total Return 3Yr Subsequent Total Return 5Yr
5/14/1928 6/12/1928 37.59% -25.59% -29.97%
9/3/1929 10/19/1929 -39.40% -69.86% -57.67%
5/29/1946 8/27/1946 -8.41% 2.12% 75.79%
6/12/1950 7/12/1950 38.41% 67.02% 208.64%
3/19/1953 9/14/1953 44.21% 126.93% 157.62%
8/2/1956 2/11/1957 0.65% 46.97% 101.07%
7/15/1957 9/20/1957 18.20% 40.41% 60.61%
1/5/1960 3/8/1960 24.19% 33.54% 87.06%
12/12/1961 5/9/1962 11.50% 50.41% 73.66%
2/9/1966 5/17/1966 18.05% 47.22% 45.92%
11/29/1968 6/18/1969 -21.81% 20.02% -3.31%
4/28/1971 11/1/1971 23.26% -19.40% 23.68%
1/11/1973 3/21/1973 -10.26% 0.35% 4.59%
9/12/1978 10/24/1978 10.31% 51.06% 133.34%
10/5/1979 10/22/1979 42.97% 67.39% 118.58%
2/13/1980 3/10/1980 31.87% 74.78% 120.24%
8/11/1981 9/4/1981 6.33% 55.96% 159.17%
6/22/1983 2/9/1984 22.59% 96.67% 118.48%
8/25/1987 10/15/1987 -4.01% 6.41% 59.08%
10/9/1989 1/29/1990 4.74% 52.76% 71.37%
7/16/1990 8/16/1990 21.52% 56.42% 103.85%
7/17/1998 8/4/1998 21.19% 17.39% 1.76%
7/16/1999 8/10/1999 19.04% -23.91% -4.34%
3/24/2000 4/13/2000 -18.34% -36.44% -8.35%
10/9/2007 1/8/2008 -32.09% 2.36% 21.10%
4/2/2012 6/1/2012 31.82% 78.04% 112.90%
6/23/2015 8/24/2015 16.06% 63.61%  
9/20/2018 10/24/2018 14.23%    
Average Total Return   11.59% 32.69% 67.49%
 
20% Market Declines
Peak First Date from Peak that Decline of 20% Occurs Subsequent Total Return 1Yr Subsequent Total Return 3Yr Subsequent Total Return 5Yr
9/3/1929 10/28/1929 -22.93% -64.69% -49.40%
5/29/1946 9/9/1946 1.64% 16.62% 104.95%
7/15/1957 10/21/1957 37.72% 55.90% 71.04%
12/12/1961 5/28/1962 29.94% 72.94% 98.47%
2/9/1966 10/7/1966 43.37% 46.69% 65.76%
11/29/1968 1/30/1970 13.90% 42.42% -3.66%
1/11/1973 11/26/1973 -25.76% 21.18% 32.35%
8/11/1981 8/12/1982 71.01% 110.20% 275.76%
8/25/1987 10/19/1987 22.61% 38.99% 105.25%
7/16/1990 10/11/1990 37.66% 83.01% 138.26%
7/17/1998 8/31/1998 39.75% 24.60% 19.39%
3/24/2000 12/20/2000 -7.50% -4.81% 16.07%
10/9/2007 7/15/2008 -20.25% 19.67% 59.52%
9/20/2018 12/24/2018 39.24%    
Average Total Return   18.60% 35.60% 71.83%
 
30% Market Declines
Peak First Date from Peak that Decline of 30%
Occurs
Subsequent Total Return 1Yr Subsequent Total Return 3Yr Subsequent Total Return 5Yr
9/3/1929 10/29/1929 -13.57% -60.34% -42.77%
11/29/1968 5/14/1970 41.56% 45.81% 35.37%
1/11/1973 6/28/1974 18.14% 40.46% 69.44%
8/25/1987 10/26/1987 29.58% 42.20% 116.11%
3/24/2000 3/21/2001 6.31% 9.83% 35.53%
10/9/2007 10/6/2008 4.49% 20.65% 87.04%
Average Total Return   14.42% 16.43% 50.12%
Past performance is no guarantee of future results. Short term performance results should be considered in connection with longer term performance results. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. A peak is a new all-time high prior to a downturn. Downturns are defined as periods in which the cumulative return from a peak is –10% (-20%) or lower. Returns are calculated for the 1-, 3-, and 5-year look ahead periods beginning the day after the respective downturn threshold of –10% (-20%) is exceeded. For the 10% (20%) threshold, there are 28 (14) observations for the 1-year look ahead, 27 (13) observations for the 3-year look ahead, and 26 (13) observations for the 5-year look ahead. For the 30% threshold there are 6 observations for the 1, 3, and 5 year look ahead periods. Peaks and downturns are patterns that are developed by the price action experienced by all securities.  Data provided by Fama/French. Eugene Fama and Ken French are members of the Board of Directors of the general partner of, and provide consulting services to, Dimensional Fund Advisors LP.

The takeway here is that stepping back to consider a broader set of data can help your perspective on investing to be driven less by fear and greed and more by knowledge.    

Along those lines, we urge you in times of increased volatility to re-examine your risk capacity. You can click here to re-take (or try for the first time) our Risk Capacity Survey.      

Footnote:

1.) CBS News, interview on "CBS Sunday Morning" television broadcast, March 22, 2020. 


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