Category: Market Research Page 2 of 11

Know Yourself: The Four Investment Temperaments

I recently read “The Four Temperaments” by Rev. Conrad Hock, AngelusPress.org.  In it the author describes in detail the good and bad traits of each of the four temperaments: choleric, sanguine, melancholic and phlegmatic.  Everyone has a dominant temperament, and, in the book, you can take a simple test to find your own temperament.  There are also many online sites that allow you to take a test to determine your temperament.  Unlike personality, your temperament never changes with time!

The fact of the matter is we are all emotional.  But we all react in different ways when presented with unintended consequences, surprises, conflict, decision-making etc. (both good and bad).  I started working with clients and their investments back in the early 90’s.  It amazed me how clients reacted differently to the same 20% move higher or the same 20% move lower in the market, even when they had the same risk tolerance.  Most of these reactions were based on perceived expectations correlated directly with their investment temperament.

The chart below shows the emotional rollercoaster ride millions of investors go through from time to time, which may influence investment decision-making.  In many cases the decisions investors make can be quite irrational and detrimental to their long-term portfolio goals.  Many investors don’t have the expertise and certainly not the time or focus needed to make proper investment decisions.

September 2015 edition of ICICIdirect Money Manager Magazine.  Source: Credit Suisse

Behavioral Finance is an amazing topic.  There have been numerous books written and any Economics/Finance major has taken at least one course on this subject.  I won’t turn this into a 50-page thesis, but I would like to explain four investment temperaments I have coined over the last 25 years.  These observations include clients, prospects, family, friends and strangers.

  • Risk Seeker This type of investor wants to make as much money as possible, regardless of risk. This type wants to make make at least as much as the general stock market going up.  On the way down they aren’t happy, but they won’t sell, knowing they will make back their portfolio losses and then some in the future.  They are extremely confident individuals.  A spin-off of the risk seeker is one that has the same objective, however their reaction during large drawdowns is different.  They start to panic, even though they came in with a long-term game plan. They know the risks involved with investing aggressively, but eventually they will sell everything at the worst possible time.
  • Controlled Risk-Taker This type of investor wants to make all the money when the general market goes up but wants to lose very little during drawdowns. Much of their investment portfolio is in equity positions.  These investors are typically well informed on what the general market is doing.  Buy and hold won’t work during periods of large drawdowns, so they employ active management in bad times.  They will quickly reduce portfolio equity exposure at early signs of emotional pain.
  • Preservationist This type of investor wants to make money with much less risk than the stock market. They feel safer with bonds because they aren’t as volatile.  Many investors with this mentality either fear they will run out of money in their retirement years or they want to give it all to their children/grandchildren.  They simply want to be reassured that their principal is still there.  Any growth is a positive.
  • Balancer This type of investor wants to make money in line with stock market returns, but they want downside protection. They know stocks are riskier than bonds and the next bear market will eventually come. They like being in a diversified stock/bond/alternative portfolio.

In late October the S&P 500 gave up all its gains for the year in just a few weeks (see chart below). From the close on October 3rd to the close on October 29th, the S&P 500 fell 9.71%. The Nasdaq 100 Index fell 12.09%, led by one of its largest components, Amazon (AMZN), which fell 21.19%.

Created with StockCharts.com.  © StockCharts.com, Inc.  All Rights Reserved.

The most common reactions I heard at the end of October were:

“Everything is fine, it’s time to buy more at a discount.”

“Ouch, that hurt. I don’t know if I should sell or hold here.”

“This doesn’t feel good, but at least my exposure was reduced, and I had a diversified portfolio, including bonds.”

“Is this the start of the next Bear market?!?! Is my money safe???”

“We’re still in a Bull market. I’m diversified and this bump in the road is OK.”

“I’ve enjoyed this Bull market, but this is the second time this year I’ve seen a 10% drop.  I think it’s time to be a little more defensive, unless the market has a good rally.”

As stated before, you can see many different reactions to the same 10%+- move in the market.  All these reactions are normal, depending on your temperament.  At Spectrum Financial one of the first things we talk to prospects about is their risk/reward profile.  Investors must be honest with themselves when asked questions like:

  • What is the biggest drawdown you could handle?
  • What are your long-term goals? How long are you willing to invest with us to meet them?
  • What Index(s) will you compare your portfolio to?
  • Is your outlook generally optimistic or pessimistic concerning investing?
  • Do you feel you are an aggressive, moderate or conservative investor?

I tell prospects and clients all the time that there are no wrong answers to the above questions.  If these questions are answered honestly, it’s much easier to customize a client portfolio based on his/her temperament so that expectations are met.  Once allocated, we know we are doing a good job when we see a drawdown in the market like we saw this October and our clients are happy with their return based on their risk/reward expectations.  If a client calls disgruntled, in many cases they aren’t as aggressive/conservative as they thought they were.  We can easily adjust portfolios accordingly.

What type of investment temperament do you have?  Call our office and let us explain our unique investment products and how they can be a great fit for your investment portfolio.

Sentiment

Sentiment is defined within the investment community as investor attitude toward a broad market or asset class.  Following sentiment can be a useful endeavor as a component of risk assessment.  Growing bullishness can help investments rise but overly optimistic attitudes often occur near market peaks.  On the opposite side, bearish attitudes can pressure markets lower, but overly pessimistic or fearful actions can wash out those sellers to set the stage for a recovery.

Sentiment can be measured a number of ways, but most fall under the categories of investor perception surveys or detection of their actual actions.  Surveys can be verbal or online and generally reflect what responders think of the market in an upcoming time frame.  Responders may or may not have acted on their beliefs.

Above is an example of a survey by the American Association of Individual Investors (AAII).  The scale to the right of the survey (lower pane), displays the percentage of the responders with a bullish outlook for the S&P 500 Index over the subsequent six months.   Notice the survey number tends to track the movements of the stock market.  Human nature is such that what is happening now tends to heavily influence perceptions of the future – if it’s bad now, then it will be bad or worse in the future.

Herd mentality can provide the fuel to a rally or sell-off as people’s actions are a natural by-product of their thoughts.

At extremes, the intensity tends to mark turning zones.  Therefore, assessing sentiment can be useful as a contrary indicator but only after determining what qualifies as an extreme.  In the chart above, zones of Excessive Optimism and Excessive Pessimism have been marked.  Excessive optimism has been a worthwhile warning prior to major and minor peaks or at least stagnation.  Excessive pessimism tends to be seen near lows.  Not all market peaks and bottoms are accompanied by sentiment extremes using the AAII survey but when extremes show up, this information may play a role in portfolio adjustment.

As noted, surveys convey investor perceptions but as the saying goes, “actions speak louder than words”.  There are numerous ways to detect sentiment derived from actions taken by investors.  The options market often attracts speculators looking to leverage their ideas of bullish outlooks by way of buying call options or bearish outlooks with buying put options.

Created with TradeStation. © TradeStation Technologies, Inc. All rights reserved.

Put/Call ratios display the number of puts versus the number of calls traded.  A ratio of 1.0 means an equal number of puts and calls are being purchased but that sort of balance is not the norm.  The stock market and investor perception generally have a positive longer-term leaning which tends to have average Put/Call readings around 0.9 or nine puts purchased for every ten calls.  In the chart above, the raw Put/Call is displayed but the zig-zagging raw readings can be too short-term to be useful for most investors.  In the middle pane, a 10-day moving average has been applied to better illustrate the ebb and flow of sentiment.

Sentiment analysis can come from various sources and deal with multiple time frames.  Surveys tend to be longer term while option related sentiment measures tend to be shorter-term.  In mid to late October, weakness in the stock market had survey readings decline but without excessively pessimistic readings.  Fearful or bearish speculators rushed to put options with more intensity than bullish buyers of call options.  That set up overly bearish extremes prior to the early to mid-November rebound.  Keeping tabs on sentiment can assist in keeping emotions in check.  If opinions of market match overly optimistic or pessimistic sentiment readings, then re-evaluation may be in order.  Investors would be wise to not use this information in a vacuum but as a part of a more comprehensive plan.

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