Have you ever heard of the term Gambler’s Fallacy?
Gambler’s Fallacy is the false belief that if an event has occurred multiple times before, it will happen less often in the future. For example, if a dice roll has turned a six in the last three rolls, the mistaken belief is that a six is less likely to show up on the next roll. The truth is, the odds are still 1:6 that a six turns up.
Investors suffer from a form of Gambler’s Fallacy where if the market has suffered consistent losses through a certain period, the chances of it going much lower are slim. For example, it’s been treacherous waters for the Dow since the beginning of the year – down nearly 12% and trading showing extreme volatility.
Source: Google Finance
The Gamblers’ Fallacy from the average investor’s standpoint in the current situation is that because the Dow has suffered multiple days of losses already this year, further losses are less likely than gains. If you’ve been watching the news, that may not be the case.
According to a recent CNBC survey of CFOs from top corporations and organizations, the majority (68%) responding to the survey said a recession will occur during the first half of 2023.
Here are some other sobering results from this survey:
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Amid high inflation that has become the No. 1 business risk, not a single chief financial officer surveyed by CNBC thinks a recession can be avoided. Additionally, 46% believe that the Fed won’t ultimately be able to control inflation.
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The macroeconomic view of CFOs informs a bearish stock market outlook, with most expecting the Dow Jones Industrial Average to fall to 30,000 before reaching a new high, which would represent a decline of 9% from its current level and an 18% decline from its 2022 high.
It’s clear from the nation’s financial elite that a recession is not only possible but inevitable, which means more pain in store for retail investors.
Keeping with the gambling theme, here are a few lines from the classic Kenny Rogers’ country song “The Gambler” that investors should remember as the year wears on.
You’ve got to know when to hold ’em.
Know when to fold ’em.
Know when to walk away.
And know when to run.
I’m going to make the case that now’s probably a good time to fold ’em and run. Why?
If you’ve already suffered investment losses this year, in my opinion, those losses will only keep piling up. And as losses pile up, the hole you have to dig out of and the road to recovery only becomes steeper. That’s because of another fallacy.
A common fallacy is that if your portfolio suffers, say – 30% in losses, it only needs to gain 30% back to get you back to where you originally were. The math says otherwise. That’s because you lose 30%; you have less to work with from which to dig yourself out of the hole.
Check out the following chart:
This chart gives you a sliding scale of what your portfolio is required to gain to get back to ground zero, given a certain percentage of loss. What stands out the most is that as your losses deepen, the road back becomes exponentially steeper. For example, a 20% loss requires a 25% gain to return to normal. A 30% loss requires a 43% gain to snap back to normal.
The difference in gain required between a 20% loss and a 30% loss is 18% (43%-25%). Now, look at the jump in gain required between a 30% loss and a 40% loss. That difference is now 24% (67%-43%). The steeper the losses, the steeper the climb to get out.
The task of recovering from investment losses becomes even more daunting if you need to dip into your portfolio to compensate for the loss of income or buying power, etc.
Source: franklintempleton.com
This chart says that if you take out an average of 5% a year in distributions over five years, the path to normalcy is exponentially worse than when not taking withdrawals. So, a 20% loss that required 43% in gains to get back to normal now requires a nearly impossible 82% in gains to return to normal if withdrawals are made.
I doubt there is a single pundit predicting normalcy for the economy or the stock market. Smart investors are prepared because they avoid them rather than taking losses and trying to climb out of them. How?
By insulating their portfolios with assets uncorrelated to the broader markets. By leveraging their portfolios with private alternatives like real estate and private equity, smart investors insulate their portfolios from inflation, recession, and mob behavior.
To savvy investors, avoiding losses is much better than recovering from them.
