4th Quarter 2012

Posted on January 25, 2013 · Posted in Newsletters

“If it bleeds, it leads,” – Unknown

Evolution in Information Processing

Hundreds and hundreds of thousands of years ago while gathering food on the plains of Africa, our ancestors may have received two simultaneous pieces of information.  First, there were an abundance of nuts and berries all around them.  Second, stalking in the grass nearby was a pride of lions.  If they focused on the good news, natural selection may have ensured that they did not survive to hunt and gather another day.

At Schwab Institutional’s annual conference in November, we had the opportunity to attend a talk by Peter Diamandis, author of Abundance – Why the Future is Better than You Think, where he elaborated on this type of information processing.  Apparently we are wired for bad news.  Our senses bring in far more data than we can possibly process, and, survival is the most important driving factor in our evolution.  All of this data is fed through a small section in the temporal lobe called the amygdala.  The amygdalae are our early-warning detectors, sorting through data to see what might harm us.  It is therefore entirely explicable that we preferentially look at negative news, and almost as obvious that profit-driven media outlets would capitalize on this instinct.

This explanation is supported by research.  Prospect theory, developed by Amos Tversky and Daniel Kahneman in papers written in 1979 and 1991, is a theory of choice under uncertainty which includes a feature called loss aversion.  Simply put, people care more strongly about a loss in utility than they do about a gain of equal magnitude. Prospect theory helps explain why there are differential reactions to negative and positive news creating an asymmetry in information processing.  Further, consider the “fight or flight” reaction to negative events, which leads to heightened heart rate, blood pressure and perspiration, and prepares any organism for either fighting or fleeing (Cannon 1932). This striking reaction to negative information also has no positive equivalent.  Why are we hardwired in this way?  Again, it seems very likely that evolution favors animals that exhibit a combination of mildly optimistic but intensely loss-averse behavior.  You have to be willing to try new food sources, but if your friend gets eaten while you’re there, you need to be the animal that never goes back.

Implications for Investing

The fourth quarter and much of 2012 were characterized by an abundance of negative news stories concerning the European debt crisis, the economic slowdown in China and the impending ‘fiscal cliff’.  How did individual investors react to the constant stream to awful news?  They sold stocks.  According to the Investment Company Institute, investors purged themselves of more than $150 billion worth of stock mutual funds and ETFs.  This massive sale of stocks follows the sale of more than $150 billion of stock mutual funds and ETFs in both 2011 and 2010.  With investors selling for three consecutive years, the returns on stocks must be bad news as well.  Actually, there is a bit of good news.  The table below displays the returns on the

Index 1 Year 3 Years
S&P 500 (Domestic) 15.6% 35.5%
MSCI AC Ex. US (International) 17.4% 13.6%

S&P 500 and MSCI All Country Excluding the US indices for the past one and three years.  The individual investors who have been selling over the past three years have missed out on a nice rally in equity markets.

Is there any good news?  Actually, there were a number of positive trends in 2012.  One was America’s growing energy independence.  The International Energy Agency (IEA) published its annual report stating that the US may be energy independent by 2020.  They also expect the US to produce more oil than Saudi Arabia by then.  Additionally, the US added 1.8 million jobs in 2012 on top of a similar number in 2011.  While not robust, the economy is headed in the right direction.  Some believe that the United States could be experiencing a manufacturing renaissance as a result of cheap energy and rising labor costs outside the US (including China).  These trends make it cost effective for companies to locate new factories within our borders.  Though it may be harder to find and buried deeper in the news, there are positive and uplifting stories occurring every day.

Looking forward, we remain cautiously optimistic concerning equity markets and somewhat defensive with regard to fixed income markets (please see our intra-quarterly newsletter – if you would like another copy, please call our office or go to our website).  Earnings continue to grow at companies and valuations remain reasonable.