The Buckingham Report

Eight months ago I wrote in The Prudent Speculator about how emotions are investors' worst enemy, a truism confirmed in studies that show that for most people, the pain of a financial loss is more than twice as intense as the pleasure of an equivalent gain. I discussed a coin-toss game in which the dealer gives twenty $1 bills and asks the player to make twenty investment decisions based on the toss of a coin. In each round, the player can choose not to play and keep the dollar. If he does play, he will receive nothing if the coin comes up heads, but will get $2.50 if it comes up tails. If he doesn't play at all, he will still have $20. However, assuming an equal number of heads and tails, the most predictable outcome given the 50/50 chance of the flip, he who plays every single round would end up with $25.

I know that Prudent Speculator readers would choose to play every round! However, that is not the way most people act. After a few painful losses they are likely to stop playing rather than stay in the game and let the odds work in their favor. In “Investment Behavior and Negative Side of Emotion,” published last June in Psychological Science, researchers studied ‘normal’ participants and individuals with lesions in the region of the brain that controls emotions. In the coin toss game, the brain-damaged players made better investment decisions - they chose to play more often. Having weaker emotional function, they performed more rationally than investors with normal emotions!

Controlling one’s emotions is also the key to success with the TV game show Deal or No Deal in which contestants slowly reveal the contents of up to 26 cases containing amounts ranging from a penny to a million dollars. From the official TV show web site, “The rules are simple. Choose a briefcase. Then as each round progresses, you must either stay with your original briefcase choice or make a ‘deal’ with the bank to accept its cash offer in exchange for whatever dollar amount is in your chosen case.”

Given the fairly high Nielsen ratings (it was #10 last week), I suspect that many have seen the show, playing along at home. And, believe it or not, I think that watching Deal or No Deal might make you a better investor as the show provides an entertaining lesson in probability theory. Better yet, play the online version of the game a few times at: http://www.nbc.com/Deal_or_No_Deal/game/

Statistical analyses are a bit tricky when there are still 15 or 20 cases to open. But as the number of cases left grows smaller, it becomes easier to apply probability theory. Consider a scenario where 5 cases remain containing $10, $100, $1,000, $100,000 and $1 million. The odds of getting each amount are equal, meaning that there is a one in five chance of ending up with $1 million, a one in five chance of ending up with $100,000, and so on. If the banker offered $150,000 in exchange for your case, would you take it? I suspect that many folks would accept the certainty of the guaranteed payout, even though the unemotional player would say ‘no deal’ to anything less than $200,000, which is the economic value (there is a one in five chance) of just the $1 million possibility.

Disciplining emotions when one invests is a major factor in achieving long-term success, especially when we are constantly bombarded by seemingly intelligent research that suggests equities are excessively risky for the long-term investor. For example, I came across a column by a well known market watcher suggesting that one is not justified in betting that the stock market will beat a savings account when investing for a five-year period. His rationale was that stocks had only beaten the risk-free return 74% of the time, a number that in his mind did not equate to statistical significance. Certainly, I agree that there are no guarantees as stocks could turn in sub-par or even negative returns over the next five years, but I would argue that based on the historical evidence the odds are clearly in the favor of the equity investor.

And the longer one holds stock, the greater the probability of outperforming. Looking at data from Jeremy Siegel's Stocks for the Long Run, for the period 1802 - 2001, equities outperformed Treasury bills 61.5% of the time for 1 year; 65.3% of the time for 2 years; 74.0% of the time for 5 years; 80.1% of the time for 10 years and 94.5% of the time for 20 years.

In fact, if one has a 20-year time horizon, the data presented below from Ibbotson Associates (slide #15 of my recent Florida MoneyShow presentation) might suggest that equities are less risky than bonds. Yes, over that span, stocks have, as one would expect, blown away bonds in the best of times, but the downside in the worst 20-year period has been better (less worse) as well! Talk about statistical significance!

To be fair, the pundit's major point was that many folks do not invest with a long-term time horizon or that they may be long-term oriented in theory, but fail in practice as their emotions or other circumstances force them out of equities at inopportune times. Paying attention to what has worked historically and playing the percentages has helped us maintain an unwavering discipline throughout the inevitable ups and downs of the market, propelling The Prudent Speculator to a #1 ranking for total return performance over the past 10, 15 & 25 years, according to the Hulbert Financial Digest!

For us, the Deal or No Deal banker (i.e. risk-free Treasury bonds) will have to make us one heck of an offer (something north of 10% per year) before we will ever consider changing our No Deal response to the question of bailing out of equities!

--------------------------------------------------------------------------
The information contained herein is believed to be reliable. However, such information has not been verified by us and we do not make any representations as to its accuracy or completeness.

Past Performance is no guarantee of future results.

Opinions expressed are those of John Buckingham, which are subject to change without notice and are not intended to be a forecast of future events, a guarantee of future results, nor investment advice.

Total Return Rankings of The Hulbert Financial Digest are calculated using proprietary and undisclosed methods of the publication's editor.  A newsletter’s Hulbert Financial Digest’s Ranking is based on an average of its several portfolios in the event it recommends more than one (and includes portfolios that the letters have discontinued). As of  2/28/06, The Prudent Speculator is ranked #1 out of 82, 57 and 14 newsletters monitored for the 10, 15 and 25 year periods and #2 out of 32 newsletters monitored for the 20 year period, respectively. Hulbert currently monitors in excess of 160 newsletters. For more information about The Hulbert Financial Digest call 866-428-6568.

--------------------------------------------------------------------------
About Al Frank Asset Management

Al Frank Asset Management, Inc. (AFAMI) is an Investment Adviser, registered with the Securities & Exchange Commission, is editor of The Prudent Speculator (TPS) newsletter, editor and publisher of The Prudent Speculator TechValue Report (TVR) newsletter, and is the Investment Adviser to two value oriented no-load proprietary mutual funds and individually managed accounts.

Al Frank Asset Management, Inc. is committed to assisting our customers build wealth. We are a leading resource for value-based investor information in the financial community, where we combine our simple, proven philosophy of buying under valued securities for their long-term appreciation with our experience, hard work, and intensive research to give you actionable investment information that can be used on a daily basis.

For information on separate account management, please call us toll free at (888) 994-6827. Or, visit us at www.alfrank.com.