When Would You Rather Outperform?
Source: The Decision Lab
In a recent blog post, Ben Carlson surveyed his listeners and found that roughly 2/3rds would instead outperform during a bear market while the rest would rather outperform in a bull market. I haven’t run the numbers myself, but I suspect we’d probably get a similar result if I surveyed our clients.
Psychologically, this outcome makes sense. People hate losses, and this particular cognitive bias even goes by the official name of “Loss Aversion.” To quote The Decision Lab:
“Loss aversion is a cognitive bias that describes why, for individuals, the pain of losing is psychologically twice as powerful as the pleasure of gaining. The loss felt from money or any other valuable object can feel worse than gaining that same thing.”
From an investment standpoint, however, the investor preference to outperform in a bear market doesn’t make sense at all. On average, bull markets last about 6.6 years with an average cumulative return of roughly 339%, whereas the average bear market has lasted only 1.3 years with a cumulative loss of 38%. In other words, as this chart from First Trust points out (going from 1926 – 2019), 2/3rds of investors would prefer to sacrifice outperformance for 78 of the bull market years if it meant outperforming during the 15 bear market years.
Why Is This Important?
Human nature is to be a flawed investor. We often get so scared of temporary declines that we sacrifice the long-term power of compounding. Retirees end up overallocated to things that appear safe (cash, CDs, Treasuries) and under-allocated to the equities most capable of helping them maintain their spending power throughout a multi-decade retirement.
Here Come The Important Caveats.
Consistently outperforming to the upside is notoriously tricky, whereas outperforming on the downside is much easier. Add an extra cash buffer to your stock allocation, and you will beat the index when it declines. Add some high-flying equity positions when the market is going up, and it may or may not work out. My goal was not to focus on achieving outperformance. There are no facts about the future, and past performance is not indicative of future returns. However, the world rarely ends, and being overly conservative is likely one of the most significant long-term risks an investor can take.