The S&P 500 and Emotional Pitfalls

As part of the investment committee for our firm, I often have conversations with clients and our advisor team about all kinds of investment related topics.  We discuss proper allocation, RMD strategies, tax related matters, risk-adjusted return, the merits of diversification, comfortable rates of distribution, the psychology of investing, and the list goes on, and on, and on.  However, as advisors we don’t talk to clients often enough about the mistakes that can be made when it comes to comparisons in the market or investment mistakes made on an emotional level that can hurt the long term performance of their accounts.

This month, I wanted to highlight one specific misconception and then a couple of emotional pitfalls that investors fall victim to.  This is not as much about pointing out common mistakes, but rather to have you consider how emotion can affect our actions.

First, a common misconception about the S&P 500 and why it may not always tell us the full story.

I’m not sure how many of you read Barron’s, but they published an interesting article last month about the S&P.   I wanted to point it out since I’m not sure how many folks truly understand the S&P and what it represents.  Obviously, most of you probably know that the S&P index does in fact represent 500 stocks in the domestic, or U.S., market.  These companies are all different sizes of market capitalization and represent all different sectors as well.  What most may not know is that the S&P is market cap weighted, meaning the larger the company the larger percentage of the S&P index it represents.  For example, even though there are 500 stocks in the S&P index, the largest 20–yes just 20 stocks– represent over 30% of the weighting.  That percentage gets much larger when you look at the largest 50 or 100 stocks.  The paradox creates a situation where the index is heavily influenced by its largest valued companies.  What does that mean for today in current markets?  It certainly explains the divergence in index performance vs. average stock performance.   Investor sentiment has been shifting toward the larger mega-cap stocks within the index, while their middle and smaller-cap brethren have fallen out of favor for now.  For example, although the S&P 500 has set a number of record highs in 2014, the average return of the stocks within the index as a whole is down 7.2% YTD. This analysis demonstrates that the largest 20 stocks of the S&P 500 index, which account for 30% of the index’s weighting, are leading the S&P 500 forward, while the lower-weighted stocks have experienced larger declines from their 52-week highs.

Why do I mention all this?  Because I feel it is important to educate with facts, and remind everyone that what you hear or see is not always the full story.  To compare a well-diversified allocation to an index that is market cap weighted can greatly distort the real picture.

Secondly, I wanted to mention a few pitfalls to consider before making investment decisions.

In the past we have mentioned that emotions can make us do some pretty unusual things.  Markets are unpredictable, and people are emotional by nature.  Mixing the two can lead to flawed decision making and regret, as the temptation to buy stocks when they’re high and sell when they’re low overwhelms common sense.  Our own human nature is often our investing downfall.  Here are 3 common investing pitfalls.  If we can recognize these pitfalls, we can hopefully try to avoid them.

  1. Incorrectly predicting your future emotions: Too many investors are confident they will be greedy when others are fearful. None assume they will be the fearful ones, even though somebody has to be, by definition. The vast majority of people overestimate their willingness to take risk. Fear is a strong emotion and often plays a much greater role in decision making than logic.  Past behavior may be the best way to judge risk tolerance. If you panicked and sold stocks in 2008, you probably have a lower risk tolerance, regardless of what you think today. If you went headfirst into technology stocks in 1999, you are probably susceptible to future bubbles, regardless of how contrarian you think you are now.
  2. Failing to realize how common volatility is: Napoleon was said to define a military genius as a man who can do the average thing when all those around him are going crazy. One key to keeping a cool head during market drops is realizing how common they are. If you don’t understand how normal big market moves really are, you are more likely to think a pullback is something unusual that requires attention and action. It often doesn’t.   From 1900 to 2013, a broad index of U.S. stocks returned an annualized 6.5 percent.   Yet chaos in any given year is normal: The spread between an average year’s highest and lowest close was 23 percentage points. Investors regularly want explanations for why the market is dropping. The honest answer — that is just what stocks do.  The bright side is history shows us stocks move higher more than they move lower, and patience is rewarded.
  3. Trying to forecast what stocks will do next: The inability to forecast hasn’t prevented the desire to keep forecasting. No matter how bad forecasts are, investors come back for more. In 2005, investment bank Dresdner Kleinwort published a study of aggregate professional forecasts such as stock prices, interest rates, and gross domestic product growth.  As a group, the predictions were terrible. But the researchers found a fascinating trend: an almost perfect lag between predicted and actual results.  Don’t bet too much on forecasts because it might be an expensive guess.  You have no control over what the market will do next. You do, however, have complete control over how you react.

I note these three because it is much easier to avoid an emotional reaction if you have given thought to the issue before you’re presented with it.  If this topic has piqued your interest, I encourage you to read our blog, “Behavioral Finance – Part I”.