|12-26-2013, 04:19 PM||#1|
Worst-Case Scenarios Can Distort Investment Decisions
Study after study has shown that most investors tend to make exactly the wrong investment decision at precisely the worst time. They sell when the stock market bottoms out and return once it’s peaked. Recent evidence has confirmed this trend once again, with investors in equities having sat out most of the current rebound before moving back into the stock market. That’s one of the most compelling arguments for bringing in an objective investment professional.
A popular method of determining an investment’s risk level is to evaluate “worst case scenarios” based on historical peak-to-trough changes in an asset’s value over a fixed period. But, as is so often the case, it’s not that simple, and such a dip can often obscure the true risk reality.
The problem with peaks and troughs
The problem with relying on peak-to-trough changes is that they assume that your time horizon begins right at the market peak and terminates at its nadir. If you determine your risk tolerance based solely on your maximum potential loss, you likely will under-allocate risk assets relative to your long-term objectives.The bottom line
An alternative way of evaluating downside scenarios is to look to rolling-period returns. Rather than just focusing on the maximum historical loss, rolling returns speak to benefits that investors receive from the tendency of financial markets to normalize after major dislocations or shocks.
For example, during the two major market declines in the last 25 years, the rolling three-year return was less severe than the maximum peak-to-trough loss experienced during those downturns.
Furthermore, rolling three-year returns are likely to be positive in most cases for investors who are patient and maintain a long-term outlook during times of severe stress. As evidence, rolling three-year returns were positive from 1988 to 2002, from 2004 to 2008, and from 2011 to the present for the 80/20 investor. This represents roughly 80 percent of the last 25-year measurement period.
Basing investment allocation decisions on worst-case scenarios accentuates negative outcomes and can distort an investor’s risk profile. Unless the market makes new highs every day, there will technically always be a peak-to-trough loss. That’s why rolling-period returns are more informative for investors with objectives designed to grow wealth in excess of inflation over a longer-term horizon.
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