Fear and Loathing in the Markets

Who’s afraid of the big, bad market?

Doré illustration from Paradise Lost. Public Domain. Source: Wikipedia

We fear losing a lot more than we value winning. That’s why money-back guarantees are so effective in getting us to try something new, even though it’s usually a real hassle getting our money back. We don’t want to get stuck with something we don’t want, and that guarantee sounds pretty good.

Three centuries ago, a mathematician figured this out by looking at the lottery. He suggested that if a peasant found a lottery ticket with a 50% chance of winning 20 thousand ducats, he would probably be willing to sell it for 9 thousand ducats. The certainty of having smaller amount in his pocket would outweigh the potential for a much bigger win. This notion has been validated by numerous experiments. The value we put on winning and losing is asymmetric.

Source: Kahnemann & Tversky, “Choices, Values, Frames

We call this asymmetric behavior “loss aversion.” We worry about potential losses in the market even though gains are much more typical. It’s why investors overpay for safety when they buy bonds. Right now, high quality corporate bonds are priced as if they have a 7% chance of default. That’s about twice their historic average.

This gives rational investors an advantage. If people overpay for safety, we can take prudent risks and earn a little bit extra. By contrast, when everyone acts as if there’s no risk, that’s when things get overpriced. The market is a weighing machine, examining costs, benefits, risk, and uncertainty. It swings from fear to greed and back again.

And when everyone says they’re not afraid, that’s the time to get worried.

Douglas R. Tengdin, CFA

Charter Trust Company

“The Best Trust Company in New England”

By |2018-06-06T06:19:41+00:00June 6th, 2018|Global Market Update|0 Comments

About the Author:

Mr. Tengdin is the Chief Investment Officer at Charter Trust Company and author of “The Global Market Update”. The audio version of each post can be heard on radio stations throughout New England every weekday. Mr. Tengdin graduated from Dartmouth College, Magna Cum Laude. He received his Master of Arts from Trinity Divinity School, Magna Cum Laude and received his Chartered Financial Analyst (CFA) designation in 1992. Mr. Tengdin has been managing investment portfolios for over 30 years, working for Bank of Boston, State Street Global Advisors, Citibank – Tunisia, and Banknorth Group. Throughout his career, Mr. Tengdin has emphasized helping clients manage their financial risks in difficult environments where they can profit from investing in diverse assets in diverse settings. - Leave a comment if you have any questions—I read them all! - And Follow me on Twitter @GlobalMarketUpd

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