Author Topic: Avoid the Consequences of Being Wrong  (Read 6081 times)

AdrianC

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Avoid the Consequences of Being Wrong
« on: September 26, 2016, 09:56:06 AM »
A Bill Bernstein interview I thought was worth a read:

http://www.aaii.com/journal/article/investing-to-avoid-the-consequences-of-being-wrong.mobile

The conclusion:
For most people, over the long term it probably is optimal to be 100% in stocks, but almost nobody can execute that optimal strategy. So, a suboptimal strategy that you can execute is better than an optimal one you can’t. For most people, the best path is one that involves owning a large amount of bonds so they can sleep at night during the bad times.

We've been 100% stocks until recently. Since we have "won the game" it seemed prudent to take some off the table, and I don't want a repeat of 2008/09 when we had no dry powder to take advantage of cheap prices.


Seppia

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Avoid the Consequences of Being Wrong
« Reply #1 on: September 26, 2016, 10:32:43 AM »
I don't know where the markets will go tomorrow, but sure as hell i'm not going to hold any bonds under any circumstance at today's valuations.
Yield is close to zero, the potential upside is minimal, but the potential downside is huge.

AdrianC

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Re: Avoid the Consequences of Being Wrong
« Reply #2 on: September 27, 2016, 05:17:22 AM »
I don't know where the markets will go tomorrow, but sure as hell i'm not going to hold any bonds under any circumstance at today's valuations.
Yield is close to zero, the potential upside is minimal, but the potential downside is huge.

Huge?

https://personal.vanguard.com/us/insights/article/barrickman-itv-bonds-042016

Here's an example: Take an intermediate-term, investment-grade bond fund with a duration of 5.5 years and an initial yield of 2.25%. Assume rates rose by a quarter percentage point every January and July from 2016 through 2019, ending at 4.25%. As you can see in the chart, the cumulative total return would be negative through the first quarter of 2018, but by the end of the second quarter of 2023, it would be higher than if rates hadn't changed.

Stocks have the potential to drop 30-40-50% (and they will during your investing lifetime).

A total bond market fund has the potential to drop a few percent.

ender

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Re: Avoid the Consequences of Being Wrong
« Reply #3 on: September 27, 2016, 07:04:44 AM »
I've been considering that paying my mortgage is sort of like a bond fund.

DrF

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Re: Avoid the Consequences of Being Wrong
« Reply #4 on: September 27, 2016, 09:03:48 AM »
I've been considering that paying my mortgage is sort of like a bond fund.

Only if you use the home equity to rebalance your AA yearly or so. But, if you're mortgage is 3+%, then that's a pretty good guaranteed return for a "stable interest bearing fund".

AdrianC

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Re: Avoid the Consequences of Being Wrong
« Reply #5 on: September 27, 2016, 11:22:23 AM »
I've been considering that paying my mortgage is sort of like a bond fund.

I considered our stocks, plus large cash emergency fund, plus a paid off house as a reasonable allocation. We got through 2008/09 like that, but I was also still working like a fiend and pulling in money. We bought what we could on sale. Not having a ton of dry powder was frustrating, though.

As I glide into FIRE, and, I admit, as I see stocks as richly valued, I've thought it prudent to reduce our stocks allocation somewhat. This coincided with a Bogle-inspired epiphany causing me to pull funds from a couple of active managers we had been with for a long time and from some individual stocks. Those funds I have put into BSV (Vanguard Short-Term Bond ETF) as I decide what to do. I'm still not sure that I need bonds long term.

marty998

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Re: Avoid the Consequences of Being Wrong
« Reply #6 on: September 27, 2016, 04:00:59 PM »
For most of us we will be a long time retired.... 40+ years potentially.

Think where stocks were 40 years ago and the compound growth since then to now. Extrapolate it out and the mind boggles.

I've been considering that paying my mortgage is sort of like a bond fund.

Yes, I see this too... comes with a guaranteed return of 4.19% and the principal reduction further reduces my monthly interest expense for my real estate investments, and frees up capacity for future purchases.

MustacheAndaHalf

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Re: Avoid the Consequences of Being Wrong
« Reply #7 on: September 27, 2016, 05:44:37 PM »
I don't know where the markets will go tomorrow, but sure as hell i'm not going to hold any bonds under any circumstance at today's valuations.
Yield is close to zero, the potential upside is minimal, but the potential downside is huge.

You might have missed this paragraph from the article:
"A hundred and fifty years ago, Walter Bagehot was the editor of the The Economist and wrote a very, very prescient sentence. He said that John Bull can stand many things but he can’t stand 2%. What he was talking about were the falling interest rates that were seen during the middle and latter part of the 19th century when you could get 4% on Consols (consolidated British annuities), which was a real yield; there was no inflation back then to speak of because they were on a gold standard. Yields went down to 2% and people couldn’t live on 2%, so they began investing in speculative assets and invariably got their fingers burned."

Bumperpuff

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Re: Avoid the Consequences of Being Wrong
« Reply #8 on: September 27, 2016, 06:57:28 PM »
There's also bonds beyond Municipal and US treasury.  Emerging market bond funds pay pretty well and can provide some buffer when/if the $US falls.  There's also Junk bonds, and corporate bonds.  Of course, they  also carry a much higher risk.

Scandium

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Re: Avoid the Consequences of Being Wrong
« Reply #9 on: September 28, 2016, 07:58:42 AM »
A Bill Bernstein interview I thought was worth a read:

http://www.aaii.com/journal/article/investing-to-avoid-the-consequences-of-being-wrong.mobile

The conclusion:
For most people, over the long term it probably is optimal to be 100% in stocks, but almost nobody can execute that optimal strategy. So, a suboptimal strategy that you can execute is better than an optimal one you can’t. For most people, the best path is one that involves owning a large amount of bonds so they can sleep at night during the bad times.

We've been 100% stocks until recently. Since we have "won the game" it seemed prudent to take some off the table, and I don't want a repeat of 2008/09 when we had no dry powder to take advantage of cheap prices.

I find this unconvincing. So he's admitting that bonds are only a security blanked, to keep people from "panicking" and presumably sell. But if there are losses wouldn't such an irrational creature sell anyway? What is the limit?

Per Portfolio visualizer the max drawdowns are:
100% stocks: 40%
60/40: 22%

So how does one know that 40% drop is too much, but 22% is ok and allow you to sleep? This seems so arbitrary. Someone sitting with a $1MM portfolio would freak out and sell everything if they lost $400,000, but be perfectly fine and remain calm if they only lost $220,000? Wouldn't someone who behave irrationally sell everything in both situations?!

And personally I think irrational behavior is best combated with reason, understanding and research, not applying safety blankets and covering up the fundamental problem. We don't still sacrifice to the rain gods, we accept how the weather works and deal with it. And I think of my wife in this situation. She can barely remember the login to her 401k. The market could drop 50% tomorrow and she wouldn't know about it, or care. I don't see why she'd need bonds.

AdrianC

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Re: Avoid the Consequences of Being Wrong
« Reply #10 on: September 28, 2016, 09:47:49 AM »
Per Portfolio visualizer the max drawdowns are:
100% stocks: 40%
60/40: 22%

IIRC, the S&P500 was down 52% during the financial crisis. It was a nerve-wracking time. How did you feel?

Scandium

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Re: Avoid the Consequences of Being Wrong
« Reply #11 on: September 28, 2016, 09:56:13 AM »
Per Portfolio visualizer the max drawdowns are:
100% stocks: 40%
60/40: 22%

IIRC, the S&P500 was down 52% during the financial crisis. It was a nerve-wracking time. How did you feel?

I just pulled the number from portfolio visualizer. That was total US stocks.

I was i college in 2008 so didn't have anything invested so I don't know. I've only seen 10-20% drops, on small amounts. But it never seemed to me that "sell everything" would be the best course of action. If I've already lost 52% how much worse can it get? What does selling get me? What's the logic in that? And if I'm the kind of person who think that's a good idea, would I not think the same with a 25% loss?

UnleashHell

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Re: Avoid the Consequences of Being Wrong
« Reply #12 on: September 28, 2016, 10:26:48 AM »
you only lose 52% if you'd saved all that in cash and invested it at the high point and sold at the low.
which makes you a market timer/ trader / moron. take your pick.


what if you'd invested from 1998 to 2008, regularly. and then didn't sell when it went down 52%.
 
how would you be doing now?

what if you'd carried on investing on the same basis until 2011? Then how you doing?

This argument is like saying that you bought a house for cash in 2008 and sold it in 2011. you lost loads so you shouldn't ever invest in houses again. Especially now because next time the price crashs you won't have learnt a bloody thing from history and you'll sell when it goes down.

Classical_Liberal

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Re: Avoid the Consequences of Being Wrong
« Reply #13 on: September 28, 2016, 11:03:51 AM »
There is more to a diversified portfolio than "being able to sleep at night".  Yes, it helps those prone to panic to not sell at the worst possible times.  It also helps decrease one of the biggest possible risks to portfolio failure, sequence of returns.

Once a portfolio is in drawdown a person is essentially forced to sell no motter market performance for cash flow.  A person 100% VTI, in a 40-50 percent down turn has to sell assets at the worst possible time.  If this downturn persists for more than a couple of years, a portfolio of 100% equities will be in deep trouble. Of course one could pick up part time work, or reduce expenses, etc.  However, these are fixes outside of the portfolio.  The sequence risk is reduced when a portfolio has other (not stock)non correlated assets.  The hope is that at least one of the other asset classes is holding or increasing value with diminished capital in the equity markets.

Some diversity to a portfolio, particularly in the beginning of a long draw down, will increase success rates of portfolio survivability.  The cost is a lesser chance of building higher (but totally unnecessary) levels of wealth later in the lifecycle of the portfolio. This is a trade I'm willing to make, but it all depends on goals.

AdrianC

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Re: Avoid the Consequences of Being Wrong
« Reply #14 on: September 28, 2016, 11:44:13 AM »
what if you'd invested from 1998 to 2008, regularly. and then didn't sell when it went down 52%.

I did and didn't sell. Our total net worth was down 40% at point.

Quote
how would you be doing now?

Fantastic!

Quote
This argument is like saying that you bought a house for cash in 2008 and sold it in 2011. you lost loads so you shouldn't ever invest in houses again. Especially now because next time the price crashs you won't have learnt a bloody thing from history and you'll sell when it goes down.

Did you read the same article?

Bernstein again:
For most people, over the long term it probably is optimal to be 100% in stocks, but almost nobody can execute that optimal strategy.

If you can execute the optimal strategy you're a winner over the long term, congratulations.

I wonder why Bernstein, a professional financial advisor, thinks that "almost nobody can execute that optimal strategy"?

AdrianC

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Re: Avoid the Consequences of Being Wrong
« Reply #15 on: September 28, 2016, 11:50:18 AM »
I was i college in 2008 so didn't have anything invested so I don't know. I've only seen 10-20% drops, on small amounts. But it never seemed to me that "sell everything" would be the best course of action. If I've already lost 52% how much worse can it get? What does selling get me? What's the logic in that? And if I'm the kind of person who think that's a good idea, would I not think the same with a 25% loss?

People sell after a 52% loss because 48% is better than 30%, 15%, or zero. They are in panic mode.

A vicious, 50% dropping bear market is just what you want.

AdrianC

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Re: Avoid the Consequences of Being Wrong
« Reply #16 on: September 28, 2016, 11:51:30 AM »
There is more to a diversified portfolio than "being able to sleep at night".  Yes, it helps those prone to panic to not sell at the worst possible times.  It also helps decrease one of the biggest possible risks to portfolio failure, sequence of returns.

Like!

Wish we could recommend or like posts here.

Bumperpuff

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Re: Avoid the Consequences of Being Wrong
« Reply #17 on: September 28, 2016, 02:17:38 PM »
A Bill Bernstein interview I thought was worth a read:

http://www.aaii.com/journal/article/investing-to-avoid-the-consequences-of-being-wrong.mobile

The conclusion:
For most people, over the long term it probably is optimal to be 100% in stocks, but almost nobody can execute that optimal strategy. So, a suboptimal strategy that you can execute is better than an optimal one you can’t. For most people, the best path is one that involves owning a large amount of bonds so they can sleep at night during the bad times.

We've been 100% stocks until recently. Since we have "won the game" it seemed prudent to take some off the table, and I don't want a repeat of 2008/09 when we had no dry powder to take advantage of cheap prices.

I find this unconvincing. So he's admitting that bonds are only a security blanked, to keep people from "panicking" and presumably sell. But if there are losses wouldn't such an irrational creature sell anyway? What is the limit?

Per Portfolio visualizer the max drawdowns are:
100% stocks: 40%
60/40: 22%

So how does one know that 40% drop is too much, but 22% is ok and allow you to sleep? This seems so arbitrary. Someone sitting with a $1MM portfolio would freak out and sell everything if they lost $400,000, but be perfectly fine and remain calm if they only lost $220,000? Wouldn't someone who behave irrationally sell everything in both situations?!

And personally I think irrational behavior is best combated with reason, understanding and research, not applying safety blankets and covering up the fundamental problem. We don't still sacrifice to the rain gods, we accept how the weather works and deal with it. And I think of my wife in this situation. She can barely remember the login to her 401k. The market could drop 50% tomorrow and she wouldn't know about it, or care. I don't see why she'd need bonds.

I'm aiming for 90% stock, 10% bonds.  That lets me re-balance to take advantage of market downturns.  If the market tanks while I'm in my draw-down stage I'll be able to live off bonds for 1-3 years (depending on if I take advantage of the fire-sale).  I sleep well at night with 100% stock, but having a small percentage of bonds will provide a bit of flexibility in band times and won't create too much drag in the good.

Rubic

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Re: Avoid the Consequences of Being Wrong
« Reply #18 on: September 29, 2016, 07:34:21 AM »
If I've already lost 52% how much worse can it get? What does selling get me? What's the logic in that?

You'd be surprised, but we probably shouldn't be. People aren't rational when
these kind of events occur.

I had a relative who was 100% invested into the S&P 500 and sold everything
in 2009 at the worst possible time -- for a 50% loss.  I tried to change his mind
otherwise, but he was convinced he would "lose everything".  This was someone
with a full pension, social security, full medical coverage, no debt, cash in the bank,
and a paid-off house.  If someone with all of this going for him could panic, I guess
almost anyone can.

Retire-Canada

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Re: Avoid the Consequences of Being Wrong
« Reply #19 on: September 29, 2016, 08:02:13 AM »
I had a relative who was 100% invested into the S&P 500 and sold everything
in 2009 at the worst possible time -- for a 50% loss. 

Do you think having more bonds in his portfolio would have changed that outcome?

Rubic

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Re: Avoid the Consequences of Being Wrong
« Reply #20 on: September 29, 2016, 08:52:08 AM »
I had a relative who was 100% invested into the S&P 500 and sold everything
in 2009 at the worst possible time -- for a 50% loss. 

Do you think having more bonds in his portfolio would have changed that outcome?

I actually suggested this several years before the financial storm -- to no effect.  He didn't
want to give up potential market gains (greed) and was convinced that he could weather
any financial downturn in the market (fear).  I was surprised that he sold all his equities
at the worst possible time (I was buying), and it bolsters Bernstein's argument that many
people won't act rationally when push comes to shove.  My relative never invested back
into the stock market, and probably never will.

Again, I was really surprised because we'd had many discussions about the volatility
of the stock market and the need to be diversified. He was conservatively invested in
the S&P 500.  We'd discussed John Bogle, Jeremy Seigel, Warren Buffett. This was
not an uneducated man.  I think it's worth mentioning in this thread because even if
you can keep your head about you, you can expect friends and relatives to panic
and make dumb decisions.

To quote Charlie Mungerr:

"In fact, you can argue that if you're not willing to react with equanimity to a market
price decline of 50% two or three times a century you're not fit to be a common
shareholder, and you deserve the mediocre result you're going to get compared
to the people who do have the temperament, who can be more philosophical about
these market fluctuations."



Retire-Canada

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Re: Avoid the Consequences of Being Wrong
« Reply #21 on: September 29, 2016, 10:22:49 AM »
To quote Charlie Mungerr:

"In fact, you can argue that if you're not willing to react with equanimity to a market
price decline of 50% two or three times a century you're not fit to be a common
shareholder, and you deserve the mediocre result you're going to get compared
to the people who do have the temperament, who can be more philosophical about
these market fluctuations."


Although I didn't enjoy the tech bubble nor the 2008 and I didn't take advantage of the opportunity they presented either....looking back they taught me some valuable lessons about my own reactions to these types of events. I despite a poor understanding of how the markets worked I didn't panic and didn't pull my money out. What I also didn't do was buy a bunch more equities when they were cheap, but that's something I understand now and will put into action when the next "big one" happens.

Bummer about your relative, but what can you do?

Rubic

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Re: Avoid the Consequences of Being Wrong
« Reply #22 on: September 29, 2016, 11:23:10 AM »
Bummer about your relative, but what can you do?

Acknowledging the question is rhetorical, however ...

What I'm doing is using this example for my nieces and nephews in the hope
that the lesson will pass into the family lore of a common investing mistake to
avoid in the future. 

Who knows, eh?

AdrianC

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Re: Avoid the Consequences of Being Wrong
« Reply #23 on: September 29, 2016, 11:41:30 AM »
I had a relative who was 100% invested into the S&P 500 and sold everything
in 2009 at the worst possible time -- for a 50% loss. 

Do you think having more bonds in his portfolio would have changed that outcome?

He might still have sold all his stock, but it wouldn't have been a 50% of portfolio loss.

Or maybe not. If a 60/40 was down 22% (from earlier in the thread) would that be enough to cause panic? Don't know.

In my own case I've put some in bonds due to valuation concerns. I will have some dry powder next time. If that makes me a market-timer, so be it. I've already won the game.

Scandium

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Re: Avoid the Consequences of Being Wrong
« Reply #24 on: September 29, 2016, 11:59:05 AM »
I had a relative who was 100% invested into the S&P 500 and sold everything
in 2009 at the worst possible time -- for a 50% loss. 

Do you think having more bonds in his portfolio would have changed that outcome?

He might still have sold all his stock, but it wouldn't have been a 50% of portfolio loss.

Or maybe not. If a 60/40 was down 22% (from earlier in the thread) would that be enough to cause panic? Don't know.

In my own case I've put some in bonds due to valuation concerns. I will have some dry powder next time. If that makes me a market-timer, so be it. I've already won the game.

But from the description of the person who sold, it wasn't the fact that his account had dropped x%. It was that he thought he would loose everything. He thought it could go to zero. Would having some bonds have stopped him from thinking that? Wouldn't he instead just have sold all his stocks and maybe kept the bonds. I guess that's a smaller loss, but not for the sleep-at-night reason.

Classical_Liberal

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Re: Avoid the Consequences of Being Wrong
« Reply #25 on: September 29, 2016, 12:22:46 PM »
I believe, there is definitely a behavioral/psychological component to the markets that doesn't necessary follow EMH.  In totality, human behavior is not always rational.  We accept this in every other discipline from medicine to sociology, humans dont always act with their best interests in mind even with all available information.  I don't know why anyone would consider financial markets any different.

That being said, I think we can improve our odds of acting rationally by conditioning the emotional part of our brain.  Some stoic mental exercises of "what if I lost 50% of NW today".  Maybe repeatedly running the numbers on Cfiresim and monte carlos to shove it into our brains just how robust the plan is in the face of worst case scenarios. Having a documented IPS and safety net plans outside of portfolio management. These types of exercises will provide some emotional relief if and when we are faced with a big bad bear.

Still, considering it's always possible we could potentially be sitting in a historically worst case or that the future can be worse than the past (I dont personally believe this to be the case).  I think being well versed on assets outside of equities and choosing a more balanced portfolio at beginning drawdown is well advised, unless someone is particularly concerned with a large legacy.

Rubic

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Re: Avoid the Consequences of Being Wrong
« Reply #26 on: September 29, 2016, 02:40:53 PM »
But from the description of the person who sold, it wasn't the fact that his account had dropped x%. It was that he thought he would loose everything. He thought it could go to zero. Would having some bonds have stopped him from thinking that? Wouldn't he instead just have sold all his stocks and maybe kept the bonds. I guess that's a smaller loss, but not for the sleep-at-night reason.

Who knows?

It's a valid question.  It's possible, but here's another scenario:  Let's assume
he starts with a conservative 50/50 allocation. In 2008, during the early part of
the crash he decides to reallocate all his bonds to stocks.  However, the market
still continues to crater well into 2009.  And he now really panics and sells
all his stocks, thus locking in a permanent loss.  It's a smaller loss than if
he'd started 2007 with 100% stocks, but emotionally he's probably gone through
the same gymnastics.  Keep in mind that it was going to take a long time for
him to withdraw these funds for living expenses -- possibly decades -- even if
the market had never recovered.  In the meanwhile, he had income (military
pension, social security) and other safety nets in place.

Again, I mention this because many people on the MMM forums are probably outliers
in terms of acting rationally.  However, financial advisors have to deal with this
behavior from their clients all the time.


Classical_Liberal

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Re: Avoid the Consequences of Being Wrong
« Reply #27 on: September 29, 2016, 03:47:50 PM »
But from the description of the person who sold, it wasn't the fact that his account had dropped x%. It was that he thought he would loose everything. He thought it could go to zero. Would having some bonds have stopped him from thinking that? Wouldn't he instead just have sold all his stocks and maybe kept the bonds. I guess that's a smaller loss, but not for the sleep-at-night reason.

Who knows?

It's a valid question.  It's possible, but here's another scenario:  Let's assume
he starts with a conservative 50/50 allocation. In 2008, during the early part of
the crash he decides to reallocate all his bonds to stocks.  However, the market
still continues to crater well into 2009.  And he now really panics and sells
all his stocks, thus locking in a permanent loss.  It's a smaller loss than if
he'd started 2007 with 100% stocks, but emotionally he's probably gone through
the same gymnastics.  Keep in mind that it was going to take a long time for
him to withdraw these funds for living expenses -- possibly decades -- even if
the market had never recovered.  In the meanwhile, he had income (military
pension, social security) and other safety nets in place.

Again, I mention this because many people on the MMM forums are probably outliers
in terms of acting rationally.  However, financial advisors have to deal with this
behavior from their clients all the time.

This is very true and why it's so important people are honest enough with themselves about risk tolerances and AA.  In this specific case, it sounds like risk was addressed, but what he "thought" was very different than reality when it happened. 

There is no way to know for sure his reaction, but a 50/50 portfolio of something like 50% S&P and 25% LTT and 25% STT probably wouldn't have seen much more than a 20 percent drop in 2008/9 (I'd have to backtest, this is only a quick estimate).  Forget rebalancing for him, that would have felt like doubling down on a hard 16 at the time, but would he have felt safe enough to just not act and draw from his growing bond allocation for a few years?  Who knows...

This should be a concern for many who are stock heavy in accumulation.  IMHO, it's gonna be a different mental ball game when you're in drawdown.


AdrianC

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Re: Avoid the Consequences of Being Wrong
« Reply #28 on: September 30, 2016, 06:49:36 AM »
I read this last night:

Like all of life's rich emotional experiences, the full flavor of losing important money cannot be conveyed by literature. Art cannot convey to an inexperienced girl what it is truly like to be a wife and mother. There are certain things that cannot be explained to a virgin either by words or pictures. Nor can any description that I might offer here even approximate what it feels like to lose a real chunk of money that you used to own.  - Fred Schwed, “Where are the Customer's Yachts”.

Probably more relevant to the threads like "Should I buy stocks on margin?" or "Should I day trade?", where loss can be permanent. The successful index fund buy and holder has to have faith that any loss is temporary.

“Where are the Customer's Yachts” is a great book, BTW. Written in 1940 and still totally on-point. Funny too.

triangle

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Re: Avoid the Consequences of Being Wrong
« Reply #29 on: September 30, 2016, 04:38:39 PM »
I think how the financial news is reported plays a small part in driving emotions. The news favors the Dow Jones Index which is fairly narrow and price weighted which often exaggerates moves in overall stock market.  Driving home from work and listening to the evening news report, one often hears 100+ point moves which can sound large in the abstract, when it is the percentage move that is more relevant but much less reported.  Even a 10 point drop might sound big to the causal listener if one thinks about the average stock price being a double digit or low triple digit value.

In the financial crisis of 2009 there was report after report of the Dow dropping with predictions that it would drop back to some level N.  While I cannot remember N it was a historical or psychological level not much lower than it reached. It wasn't until some later report highlighted that the 5+ lower priced members of the Dow could all go bankrupt and the index would not drop to that level that some people's emotions started to calm. When the nightly news opening news story is about the market tanking, that is the time to look away and not sell.