Got to Know When to Hold ‘emSubmitted by WWA Planning & Investments on August 28th, 2019
Kenny Rogers made Don Schlitz’ song The Gambler famous back in the late 1970’s. If you recall the lyrics, the old gambler tells the young one that you have to know when to hold your cards and also when to fold them.
Economists have a name for just about every aspect of the financial world and one known as The Gambler’s Fallacy is at work in many card games. It’s the belief that if something has happened less frequently than usual for a while it will become more frequent soon (and vice versa). For a poker player who’s had poor hands all night long, it’s the hope that a good hand must be coming pretty soon – that it’s worth staying in the game. In the world of investments, it’s owning a poorly performing security and holding on until its price bounces back. Selling an investment at a loss can be difficult for anyone because you’re admitting that you made a mistake – even if only to yourself.
We think the best way to look at any investment is to ask this question: ‘Would I buy it today at its current price?’. If the answer is no, it should probably be sold regardless of the gain or loss. As professional investors, we often make these decisions for our clients and I assure you that we’re just as tempted to hold onto a losing position as anyone. Having a clearly delineated process and believing in it helps us face each decision with reasonable confidence.
I’ve said before that when considering a new investment for our clients we’re more likely to look to last year’s losers than its winners. We are very aware of the gambler’s fallacy and try avoid acting on it but we do act on the concept of mean reversion. It is the understanding that a large enough group of stocks is likely to ‘revert to the mean’, to move from a level of undervalued to overvalued (and vice versa). This is the heart of portfolio rebalancing. However, it’s a strategy we use somewhat sparingly – only when the allocation of assets has moved quite far from our target proportions. Nobel prize winner Eugene Fama once said: ‘Investing is like a bar of soap: the more you handle it the smaller it gets’.
On the other hand, knowing when to hold ‘em may be even more important – at least for investors. When markets are strong, everyone believes that she or he is in for the long-haul and would never sell in a panic. Unfortunately, statistics don’t support that assertion. According to the research firm Dalbar, over the past 30 years the S&P 500 (the 500 companies in the US of most interest to investors) gained 9.97% annually. Over that same period, the average investor gained only 4.09%. What’s the source of the underperformance? Selling investments at the wrong time – when they are down – instead of just riding out the storm.
I’ve mentioned our friend Carl Richards before, a planner from Denver. He coined a term to describe this difference between people’s intentions and their outcomes: the Behavior Gap. Here’s a sketch he uses to illustrate it:
If investors know that their need is likely to be long term, why do they ‘fold ‘em’ at the wrong time? There are lots of reasons described in the literature but I think the simplest to understand might be a term I’ve coined: Headline Overload. Simply, it’s very difficult to ignore media attention to the latest market activity, especially to the downside.
With that in mind, here’s some interesting data compiled by investment firm First Trust Advisors:
You can see that even in difficult years like 2002 & 2008 (which had significant declines during the year), markets rebounded from their lows. Because the penalty for selling at the wrong time – folding – is so great, it’s something we try to guard against in our practice and encourage others to do too.
Kudos to Kenny Rogers for providing an important key to investment success: knowing when to hold ‘em and when to fold ‘em. That’s something we help our clients with every day.