So Goes January, So Goes the Year?

 

Focusing on an arbitrary time frame is called “reference dependence.” It regards the comparative nature of human perception. It also concerns the tendency of people to compare things to some reference point. Perception of an outcome depends on the reference point that a person chooses. The reference point or time frame is arbitrary and is based on random choice or personal whim.

The idea of reference dependence reminds me of when I watched Arkansas play Virginia Tech in the Belk Bowl last week.

After the first quarter, Arkansas was beating Virgina Tech 17-0. If we judged the game at that reference point, the score was so one-sided that it seemed like Arkansas was going to decimate Virginia Tech.

arkansas-virginia-tech-first-halfSource: http://secsports.go.com/scores/football/arkansas-razorbacks

By halftime, the score was 24-0. Arkansas was ahead by three touchdowns and a field goal. The momentum was evident. The game appeared to be a terrible mismatch. If we placed bets, it would have been for Arkansas to win the game. At that point, this outcome was most probable.

When a game is close, fans “watch it closely.” However, when the score broadened to 24- 0, many fans probably stopped paying attention and expected Arkansas to be the winner.

Yet football has four quarters, not just two.

Three touchdowns and a field goal are a tough lead to overcome. It would require Virginia Tech first to play very well with their defense so as to prevent Arkansas from scoring more points against them. Then, they would need their offense to score many touchdowns and field goals just to catch up.

In the third quarter, that’s exactly what they did.

arkansas-virginia-tech-final-score

By the end of the third quarter, Virginia Tech had scored 21 points to make the score 21–24. In the final and fourth quarter, they scored another 14 points to take the lead 35–24. They scored 35 points, and their defense held Arkansas to zero in the second half. It was a high-volatility game – swinging from one extreme in one period to another extreme in the next.

Now, look at it from the perspective of a Virginia Tech fan. By halftime, they were losing 0–24. All hope was gone. They may have stopped watching. If they were at the game, they might have left at halftime.

The end of the game was the only time frame that mattered.

Global markets operate in the same way. Our perception is just the result of our reference point – the time frame we choose. Below is the S&P 500 stock index over 18 months from January 2015 to June 2016. Overall, it was non-trending and volatile.

non-trending-stock-market-period

It wasn’t just U.S. stocks. Developed countries and Emerging Markets countries declined even more as they trended in wider swings.

global-market-trends-returns-asymmetric

 

You can probably see why very few people invest all their money all the time in the stock market. It doesn’t matter how much the return is if the risk is so high that you reach your uncle point before it’s achieved. At some point, investors decide to look, and when they do, their perceptions depend on the reference point they choose. For this reason, global markets require risk management, and investors need behavioral management. If the swings of 10% to 25% observed over the past two years aren’t enough to shake out every investor, the declines of -50% or more that we’ve seen the past fifteen years probably are.

Much like the Belk Bowl, the stock index was down and out for most of the period but ended the year positively in the final quarter.

last-quarter-spy

 

As investors, our most important reference point is, ultimately, our full investment time horizon. For most people, that means their entire lifespan. For those who establish trusts, foundations, or endowments with their money, their reference point goes beyond their own lives. Investment management is different from football in that the score compounds for as long as you have money invested. It is not just one season, or one quarter, or a single game.

The end is the only time frame that matters. Everything in between is just you deciding to compare one reference to another.

I titled this observation, “So Goes January, So Goes the Year.”

You can probably see how arbitrary it is to say that.

By the way, you can see on the chart that the stock market dropped sharply last January, but it ended positively for the year.

“So Goes January, So Goes the Year”?

Not always.

The end is the only time frame that really matters.

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