Showing posts with label hype. Show all posts
Showing posts with label hype. Show all posts

Dec 25, 2008

Price of Greed and Fear

Despite of all our knowledge, training and experience we sometimes decide to follow our heart instead of our head.
What's wrong with that?

Nothing, as long as your decisions are not based on greed and fear

Illustration: We all know.....

I. How to advice on getting a better reward/risk ratio.
Modern Portfolio management (MPT) helps us.

Risk/return trade-off between bonds and stocks1980-2004 (AAII)
Bonds: 60% 5-year Treasury Notes+40% LT Treasury Bonds
Stocks:(S&P 500)


II. The performance/time model of stocks

Correct Outlook

III. Asset allocation is key behind portfolio returns
So it's not about Market Timing!

Moreover Market Timing is a dangerous game as research firm DALBAR showed.

Although the S&P 500® 1988-2007 Index had an annualized return of 12%, the average equity fund investor (in equity mutual funds) only generated a 5% return and market timers, who tried to outsmart the market by timing their inflows and outflows, generated an annualized loss of 1%.

Market Strong ... Investors Wrong

Chart: Market Strong ... Investors Wrong
*Measures returns of investors in equity mutual funds. Source: Bureau of Labor Statistics, DALBAR

Greed and Fear
When the asset strategy has been chosen and implemented, it comes down to strong nerves, to hold this strategy.

But nothing human is strange to us. Who can resist the pressure of shareholders, advisors or analysts to question the current strategy after 2 or 3 years of extremely high (or low) stock returns?

In straightening out and defending your policy, stakeholders and advisors will often argue that you're a rearview mirror actuary or board member. They'll stress that the actual situation is not comparable with any situation in the past.

However, always keep in mind the words of Sir John Templeton (1912-2008) :
The four most expensive words in the English language are
'This time it's different'

So how successful are you, in cashing in on your emotions an withstanding pressure?

Still, if you nevertheless give in and are going to change your bond/stock ratio based on fear, greed or hype, all bets are off.


As is clear form the example above, when your strategy is vulnerable to heart cries, you'll end up in the famous Pork Cycle , which - in this case - leads to a return level beneath that of risk free assets. The price of Greed and Fear!

When you've set your assets according your chosen asset strategy, only change this strategy when the underlying long term asset-modeling parameters substantially change. In every other case, don't decide on basis of 'heart over head'.

Define and allocate equity (as security) for an 'up front' defined period of time in wich you're willing to except lower or even a defined maximum negative performance. Agree this strategy up front with the supervisory board and national Supervisors.

Sources: MyMoneyBlog , Schwab, DALBAR