Whipsaw Risk and Investing in Stocks
How do you think recent investors in GE are feeling about their decision?
Would you hold on after a monthly drop of 30% in the stock price?
Interesting read from the Capital Speculator here about how investors can be influenced to act impulsively in the early years (I think it could be days) of a new investment. As someone who can speak from experience, there is nothing worse than seeing a recent investment go negative soon after your purchase. The bubble thoughts that start floating around include..."Will it keep going down?" "When should I start to think about selling this dog of a stock?" to "How could I be so stupid? It's even cheaper now!."
Notice how none of these thought bubbles included such rational queries such as "Have the company fundamentals changed in a meaningful way that has reduced the value of the company?" or "Looking out 3-5 years, do I still like the prospects of this company and how it can deliver a decent return to investors?" Thankfully, I have largely given up my urge to pick individual stocks, but the elation and disappointment that I felt following the purchase of individual stocks is not easily forgotten.
Here's a few key insights from this article:
- Importance of early impressions from an investment: "The probability of getting whipsawed is high, in other words, soon after you deploy capital anew to a mutual fund, ETF or portfolio strategy. Therein lies the biggest risk that an investor will abandon a strategy in wake of steep short-term losses — or assume that unsustainably high performance early on is the norm. Either way, early impressions can be and probably will be misleading, which can lay the groundwork for trouble later on in the crucial task of managing expectations."
- We shouldn't be surprised by volatility in first few months of an investment; it's just math!: The pattern of high volatility in the early months of a new investment isn’t surprising. Simple math tells us why. When your holding period is short, any one or two months can unleash a big impact on the trailing return, for good or ill. Eventually, the influence of any one month – or six – has minimal influence on the annualized performance for the full trailing period. The main point is that at some point the performance you were expecting (assuming it was a reasonable forecast) is likely to prevail, give or take.
- How do deal with this uncertainty? Plan for it! "Fortunately, managing this type of behavioral risk is easy — if you’re prepared for it. It starts with modeling the range of paths for a strategy to develop perspective on what may be coming."
Want to see whipsaw risk in action? Have your students play our new investing game STAX and try to beat the computer and their classmates. The securities that they can buy to beat the computer include individual stocks, an index fund, gold and commodities which can all be quite volatile. Since the game only provides monthly price updates, players will see sharp rises and falls every 5-6 seconds (now that's whiplash!). The game also provides updates on their profits too so they can see their gains jump or their losses mount in a very short period of time.
Here's a great question to ask them after the play the game:
How many times did you sell a security soon after you bought it because the immediate price action was negative?
This will likely be their first experience with whiplash risk and now they will know how they might react when they make that first investment.
About the Author
Tim's saving habits started at seven when a neighbor with a broken hip gave him a dog walking job. Her recovery, which took almost a year, resulted in Tim getting to know the bank tellers quite well (and accumulating a savings account balance of over $300!). His recent entrepreneurial adventures have included driving a shredding truck, analyzing executive compensation packages for Fortune 500 companies and helping families make better college financing decisions. After volunteering in 2010 to create and teach a personal finance program at Eastside College Prep in East Palo Alto, Tim saw firsthand the impact of an engaging and activity-based curriculum, which inspired him to start a new non-profit, Next Gen Personal Finance.
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