If there was a 50/50 chance of losing money, would you take the bet?
The uncertainty of the outcome can excite some and frighten others.
We all assess risk differently.
However, human nature being what it is, means we tend to gather around a middle marker.
In 1979, psychologists Amos Tversky and Daniel Kahneman developed the Prospect theory…how people choose between probable alternatives that involve risk where the outcomes are uncertain.
The result of their studies identified that collectively, we have a bias towards loss aversion.
The following chart — from the Prospect theory research paper — indicates the emotional response to losses is twice as powerful as it is to gains:
Aversion to losses was evaluated based on exercises where the outcomes were uncertain.
This finding should be ringing ALARM BELLS…but it’s not.
Because in the main, investors are NOT displaying any signs of loss aversion.
I’ve just released research on four investment classes where this is particularly the case.
But lack of loss aversion is an Everything Bubble-wide problem.
Take the all-time high US stock market.
Investors believe the Fed has all but guaranteed a certainty of outcome…the market is always going to rise.
Therefore, why be concerned about any lasting financial harm?
The greatest risk always exists when people discount risk out of the equation.
Complacency and careless dismissal of historical precedents are two traits typically associated with the later stages of a booming market.
The giddy pleasure of gain is what makes us oblivious to the pain that awaits.
(If you’d like to hear some investing strategies that can help you avoid this pain, click here.)
The pain for some will be excruciating
Successful investing, according to the investment industry, is about time in the market. Staying the distance increases the odds of long-term capital appreciation.
That’s certainly been the case since the early 1980s…for both property and shares.
There has been a number of setbacks (market corrections and recessions) that have temporarily derailed capital growth. But normal transmission resumes and markets (eventually) go to higher highs.
The industry message of ‘time in the market’ is designed to remove the uncertainty (our inherent bias towards loss aversion) involved in the investment process.
But what if the investment ‘certainty’ — created from market activity over the past (almost) 40 years — has actually taken us to a point of greater uncertainty?
Meaning the potential — and pain — of loss could be more powerful than that identified in the Prospect theory.
What if the US is on the cusp of wiping out US$44 trillion of net worth…the equivalent of two years of economic activity?
I can appreciate how the mere prospect of this happening pushes the boundaries on credibility.
But does it?
This chart — dating back to 1950 — shows US household net worth as a percentage of disposable net income:
Source: Federal Reserve Economic Data
During the post-Second World War period when the US was great, household net worth to disposable income stayed steady…in and around the 550% mark.
Then the secular bear market hit in the mid-1960s.
This might seem hard to fathom, but the US share market went nowhere (other than up and down on the spot) for more than 15 years.
With asset prices stagnating and disposable incomes rising (due to inflation), the ratio fell.
After 1980, as the US share market recovered, the ratio moved back above the 500%-plus level.
At the peak of the dotcom boom, for the first time in history, the ratio snuck over 600%.
The ‘tech wreck’ drew it back into that 550–560% zone. Not too much damage done.
The US housing bubble had the same uplifting effect…the ratio soared past the dotcom-high mark…nudging 670%.
Then came the corrective forces of the GFC. Asset price fell. Where did the reversion process come to rest?
Yep, you got it…back into that 550–560% zone.
And here we are today, within a whisker of 800%.
This next chart puts a dollar amount on US household net worth.
In dollar terms, the fall from 620% to 550% in 2000 to 2003 flatlined household net worth.
The impact of the GFC caused far more pain.
US household net worth shrank from US$70 trillion to US$59 trillion…wiping out US$11 trillion (which, at that time, equated to 80% of GDP).
Destruction of wealth on this scale was (in 2009) considered to be the worst economic downturn since the Great Depression.
Here’s the really scary bit folks…
If the next reversion to the mean succumbs to the same gravitational pull that appears to exist around the 550–560% mark, then, in dollar terms, that requires US$44 TRILLION of asset values — shares, property, bonds, and cryptos — to be shredded.
Let me repeat…this amount is equivalent to 200% of US GDP.
Source: Federal Reserve Economic Data
Should that, or anywhere near that happen, it’ll make the GFC look like a Sunday school picnic.
The pain will be beyond bearable for many who believed in the certainty of ever-appreciating asset values.
The scenario outlined above is not fanciful.
The trends of markets past — from the Fed’s very own data sources — are on show for all to see — or at least, for all who want to see.
Time to think rationally, not irrationally
The reason why wealth levels (asset values) are drawn to the average is simple…household income (money spent in the economy) can only afford to price assets at a reasonable multiple of that income.
That multiple can be stretched during periods of excessive exuberance, low interest rates, and abundant liquidity…but these periods prove to be temporary.
The gravitational pull — associated with ‘mean reversion’ — is evident in the two previous asset bubbles. Asset prices (shares and property) after a period of deviation are deflated back towards the long-term average.
The ‘time in the market’ mantra — designed to massage away fears of uncertainty — has gained traction during a period that’s unique in history…a period that is unlikely to be repeated anytime soon.
The dynamics that enabled central banks to blow three bubbles of increasing size are losing potency.
The capacity to exponentially expand debt levels is reaching its limit. The capacity to take interest rates lower — making debt cheaper — is all but exhausted.
And more importantly, due to the emotional trauma associated with loss aversion, the public are unlikely to (once again) be co-opted into the central banks’ ‘grand growth experiment’…at least not in the numbers required to reflate asset levels beyond the Everything Bubble marker.
The only certainty with this market is the certainty of loss.
When that’ll happen, I don’t know.
But what I do know from physics and market history is this: the higher it goes, the harder it falls.
The return to the 70-year trend line on net worth to disposable income promises to be one very long and painful descent.
The time to think rationally is before — not after the event.
Editor, The Rum Rebellion
PS: The Rum Rebellion is a fantastic place to start your investment journey. We talk about the big trends driving the Australian Economy. Learn all about it here.