A long-time friend and I were discussing the bottom line of the famous Daniel Kahneman Noble Prize-winning conclusion (that he made along with his friend Amos Tversky). I’m paraphrasing here, but we (humans) hate losing more than we like winning. That’s a bit broad, but the essence of Prospect Theory is that investors feel a greater emotional impact from a loss than we do of a gain of the same size.
This will be a short but useful tip today…
My friend and I had very different reactions to the pullback the market is experiencing now. Look at what we’ve seen so far, through Friday morning, near the low of the current move:
That does look like a pretty big pullback until you look at it as a drawdown (charts from Charlie Bilello’s blog):
A five percent drawdown is not that big at all. And even though it’s the worst of the year since March, we’d have to say that most any account should be built to survive that.
In fact, historically, this is a very mild pullback year. Again, from Bilello at Creative Planning, here are the returns per year and biggest end-of-day drawdowns since 1928:
The median close of the day, intra-year drawdown is -13%. And as you can see from this data, six of the last 11 years have had single-digit drawdowns. This has been a strong bull indeed, and it would certainly not be out of the ordinary if we didn’t have a much deeper drawdown this year, especially with a seasonally strong period coming up in the fall.
So why has this pullback seemed so ugly?
We’ve had a very strong year with double-digit gains in in the broader indexes. And because they a) followed an ugly 2022 market year, b) followed a really strong rally reaching multi-year highs in some indexes, and c) fed many perma-bear expectations, this pullback has had felt particularly rough for many people.
But let’s get back to Kahneman and Tversky. This 5% drop has hit people just when some were starting to claim the “end of inflation worries” (I don’t buy into that) and also buying into a soft landing (I may be persuaded into that camp if we can get to Thanksgiving relatively unscathed).
But here’s the real kicker. Had we run up another 5%, I don’t think there would have been so much howling.
Lastly, I’ve often worn my heart on my sleeve here at VTI, and my dad had to be hospitalized over the weekend. I’ve been with him since last Friday and took a break to write a VTI article and do some TV on Thursday (Varney & Co at 11 AM EDT).
Your prayers are appreciated as we figure out the next steps…
Please send your thoughts on Prospect Theory, hating to lose and any other comments to drbarton “at” vantharp.com
Great Trading and God bless you,
D. R.