Jim O’Shaughnessy included the following insightful story in his recent market commentary:
In the study, originally reported in a Wall Street Journal article entitled “Lessons from the Brain-Damaged Investor” and led by researcher Baba Shiv of Stanford University, a group of 41 participants played an investment game where each was given $20 to start and asked to make 20 rounds of one dollar investment decisions based on a coin toss. They would choose either “invest” or “don’t invest.” If they chose “don’t invest,” they kept their dollar. If they chose “invest,” the researcher took the one dollar and flipped a coin. If it came up heads, the dollar was lost but if it came up tails, the investor was rewarded with $2.50. Clearly the most profitable strategy would be to play every round, as the expected value of each one dollar “invested” is $1.25 The twist in the study was that one group of participants had suffered brain damage which affected key emotional centers in the brain such as the orbitofrontal cortex, the amygdala, or the insula. The other participants had either no brain damage at all or brain damage that affected non-emotional centers of the brain.
Those without any emotional brain damage invested just 58 percent of the time ended with $22.80 on average. Those participants with brain damage outperformed their healthy counterparts by 14.5 percent investing 84 percent of the time and ending with an average of $25.70. The main reason participants with normal brains did so poorly was because of their behavior after a loss. Instead of recognizing the very simple positive expected value of choosing “invest”, the normal group was scared of losing twice in a row and as a result invested just 41% of the time after a loss. The damaged group maintained their overall percentage after a loss, investing 85% of the time. This study illustrates that fear, loss, and risk avoidance act as a tax on our portfolios if we do not take action to circumvent their influence.
Real life investors have even better odds of winning than the participants in the study. A coin toss is 50/50, but the stock market goes up 72 percent of the time (based on U.S. market data since the founding of the U.S. stock exchange.)
(The bold is our emphasis.)
At times like now, many people probably read the story above and say to themselves, “Yea, but this market is going to drop another 50% from here.” Maybe, but based on history, probably not. (I would not use this logic to advocate avoiding any risk management techniques.)
However, it is common practice for investors to dedicate a portion of their overall allocation to always being in the market. Such exposure may even come in the form of a position in a flexible (not risk-free) strategy, like our Global Macro portfolio. Perhaps that is 20 percent of the overall portfolio for some investors-maybe it is 80 percent for others. For that portion of an investors’ portfolio dedicated to being in the market, the story above absolutely applies. Choosing to quit playing every time a correction in the portfolio occurs will lead to selling low and buying high, ultimately achieving very poor investment results over time.
