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Some might see an economic downturn as reason to panic as the results over the next few years will almost certainly be down, as will the share price. But some might use an economic downturn and its falling share prices as a reason to buy in, as the price paid for that share could be very low given what that company can and will do in an economic recovery. All of us think of ourselves as rational beings even in times of crisis, applying the laws of probability in a calculated fashion. We like to believe we are above average in skills, intelligence and experience. Who admits to being an incompetent driver or a stupid investor? In Against the Gods : The Remarkable Story of Risk, Peter Bernstein wrote a remarkable book about the nature of risk, going back centuries. Along the way he demonstrates that understanding risk underlies everything from game theory to bridge-building to winemaking. Among the concepts explained by Bernstein that mean most to investors, two stand out. The first is loss aversion. The second, reversion to the mean. Bernstein cites the studies that were done to show how reluctant we are to accept a loss, because to do so proves we are inept and doesn’t fit our self perperception. In research, doctors would completely change their recommended treatment for a specific disease depending on how the information was presented. If the researcher said: Taking this course of action, you will lose 50% of your patients, the doctor was less likely to use that treatment. If the researcher said: Taking this course of action, you will save 50% of your patients, the doctor was more likely to use the treatment, although the other facts were all the same as in the first instance. This might explain why so many investors are prepared to see a major part of their wealth disappear in fees, but cannot stand the sight of their portfolio declining 5% in one year, when that loss might be temporary and a fraction of the erosion through costs over time. Reversion is another issue which we have written about before. Once again, Bernstein quotes research that shows that all actions – whether your investment returns or your sports team’s results – have an average to which they revert. If your team plays much better than you are used to seeing it, they will probably play worse the next game, to return to the average performance that the talent within that team can attain. The implication on investments – whether property or shares – is huge, and yet how often do you see long term charts in a newspaper that shows you where the prices are in relation with their average? The veteran investors are very aware of these long term trends and how prices sit against their benchmarks, because they have been around long enough to have seen a season or two.
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