Managing Risk, Not Chasing Returns: Lessons from History and Human Nature

Benjamin Graham is credited with the quote …“The essence of investment  management is the management of risks, not the management of returns.”

In the last edition of our newsletter, we discussed the tendency of individual investors to let their risk tolerance drift higher when the stock market has long periods of strong returns.  It is human nature to take our most recent experiences and extrapolate them to be our forever future, forgetting it was a few short years ago the market was down over 20 percent.  Compounding the pain of this error, the math works against you when you understand a portfolio or security down 20% will need a 25% positive return to get back to breakeven.

In November 2023, Victor Haghani and James White ran an experiment with 118  young adults trained in finance (you can read the entire experiment on SSRN.com, search “Haghani).  The experiment was called “The Crystal Ball Challenge.” Each participant was given $50 and the opportunity to invest their stake trading in the S&P 500 index and 30-year US Treasury bond futures with the added advantage of seeing the front page of the Wall Street Journal in advance of their trading day (but with stock and bond price data blacked out).  For example, a Wednesday paper was reviewed for placing trades the preceding Monday, and the positions closed out on Tuesday, i.e, the players were seeing information, then going back in time two days to place their trades.  The game was played for 15 days, one day for each year from 2008 to 2022, with the newspaper dates randomly selected from a universe of days in the top half ranked by overall market volatility, further screened to be days where one-third of them are days of employment reports, one-third from days of Fed announcements, and the other third purely random.

The players in this experiment did not do well, despite having the front page of the newspaper ahead of time. About half of them lost money, and one in six went bust. The average payout was just $51.62 (a gain of just 3.2%).  The key takeaways? (1)  News does not equal market predictability;  (2) Risk sizing matters more than foresight; (3)  “False precision”, participants assumed front page news was a clear directional signal leading to overconfidence and herd behavior; (4) It is misleading to listen to the talking heads stories that justify prices rather than data; and (5) ignoring the history lessons from prior periods is detrimental to your portfolio.

Research has shown that as humans we are prone to various cognitive biases that can lead to irrational decision-making. We aim to mitigate this by building a framework centered around your specific goals, risk tolerance, and risk capacity. By leveraging our asset allocation software and extensive experience, we strive to help you avoid the pitfalls of human instinct and bring a rational, disciplined process to the portfolios we build for you.

-Dave & Drew