Perception of Equity Risk

I looked out the doorway of my hangar on a hot Saturday afternoon, watching another Regional Jet depart as I did some cleaning. I knew from years of experience that those summer thermals were creating a turbulent ride for the passengers in that plane, yet as I watched from the ground the flight looked as smooth as glass. As always, I found myself wishing I was in the air, while on that hot day I was certain many of the passengers experiencing the turbulence in that plane were wishing they were on the ground. From where I stood the flight looked smooth and controlled. For the passengers if would have felt unstable and even frightening. Perception can be so different based on your point of view.
 
During the first ten years of this century the investment world went through what became known as the “Lost Decade.” Lost, because many of the major market indexes ended the decade about where they started. During that time there was a money manager who ran a fund that defied all odds and turned in an annual rate of return slightly above 17%. The manager was heralded for his brilliance in the face of enormous odds, and was highlighted on talk shows, in newspapers, and national magazines. His returns would have been great even in good years, but they were miraculous during bad ones. And of course, investors nationwide wished they could have been invested in his amazing fund – or did they?
 
Behind the phenomenal returns lay a dark reality. In a study conducted by Morningstar®, they calculated that despite the funds 17% annual return over 10 years, the average investor in this particular fund actually lost 11% per year. The surprising conclusion was that investors in the fund were behaving like nervous passengers on a bumpy airplane. The rough economy of that decade created a turbulent ride for investors who would jump out of the fund whenever they perceived danger, and then back in when things calmed down. This led to a continual “Buy high, Sell low” cycle. As the fund headed for a record-breaking decade, the perception of danger kept most investors from enjoying it.
 
It’s a good thing airplanes don’t offer parachutes to passengers, otherwise they might be landing with a lot of empty seats. Many passengers perceive far more danger in turbulence than actually exists. Investors likewise constantly talk of volatile, uncertain and crazy markets as if today’s movements are unique.  Unlike airplane passengers however, investors do have “investment” parachutes, and they often use them to abandon an otherwise sound financial plan(e).
 
There are real risks in investing, but one of the greatest is the human aspect that often perceives danger and acts on it, and in so doing might create an even greater risk. Think carefully before deciding to use that investment parachute. You may be departing a sound financial aircraft while at the same time jumping to a new uncertainty below.