Behavioral Portfolio Management: How successful investors master their emotions and build superior portfolios by C. Thomas Howard

Author:C. Thomas Howard [Howard, C. Thomas]
Language: eng
Format: epub
ISBN: 9780857193254
Publisher: Harriman House
Published: 2014-03-17T00:00:00+00:00

The return histogram advantage

Histograms are a well-known statistical tool for representing random variables, such as investment returns. A histogram for the 462 monthly S&P 500 returns – those used to create the mountain chart in Figure 7.1 – is displayed in Figure 7.2. It displays a much different picture than does the mountain chart.

Figure 7.2: Monthly S&P 500 returns, January 1975 to June 2013

What stories flow from this representation of market returns?

The first is the average monthly return is positive and, in addition, a majority (63%) of the monthly returns are positive. Thus you were able to tilt the odds in your favor by investing in the stock market during this time period. Successful long-term investing is about tilting the odds in your favor, not generating consistent returns over time. Cash equivalents are the only investments yielding consistent returns over time and we all know how good they are for building long-horizon wealth.

The second story is that the matching positive returns on the right side of the distribution are larger than the matching negative returns on the left side. The matching positive returns more than offset the negative market returns. I will demonstrate this in the next section. Naturally, we would like to eliminate the negative returns, but since there is a 63% chance next month’s return will be positive, you must correctly forecast at least 63% of the months in order to increase your return relative to buying and holding. Research shows such accuracy in forecasting is very difficult to achieve. The fact that the matching positive return more than offsets the negative return provides a further argument against short-term market timing. [33]

Many will object to viewing market returns as a histogram rather than as the traditional mountain chart. This is largely driven by our desire to be able to tell a story about what has happened and the belief that much of what happens in the stock market is driven by concurrent events. However the truth is the path followed by the market, as represented in Figure 7.1, is one of millions of possible paths. We know that the return in any month is largely driven by the collective emotions existing in the market that month, thus different collective emotions produce a different return. So the actual sequence of returns is, surprise, surprise, random.

Consequently, a histogram provides the most accurate representation of market returns. The mountain chart is an emotionally driven, random representation of market returns. This means that the many stories based on the mountain chart are themselves largely random. Histogram trumps mountain chart when discussing investment performance with clients.

Download

Copyright Disclaimer:
This site does not store any files on its server. We only index and link to content provided by other sites. Please contact the content providers to delete copyright contents if any and email us, we'll remove relevant links or contents immediately.