The “zoom theory” and market gyrations

Posted by on July 21, 2010 @ 8:52 am in investing

As we sat around after a recent family cookout, talk turned to the stock market’s recent gyrations.

The older folks (I am, of course, in that camp) were grumbling about the spring slump in stocks. After listening to his middle-aged relatives talk about the damage to their retirement portfolios and their varied views on the market, my 20-something nephew, Rob, confidently said he saw no reason to fret.

“I just keep the zoom theory in mind,” he said.

“Zoom theory?” we asked. “What’s the zoom theory?”

He borrowed a pen, grabbed a paper plate, and drew a graph. Here’s a close replica:

Rob's Zoom Theory

Rob said that when you focus on the stock market’s recent performance—in effect, “zooming in” on the near-term—the market’s zigs and zags seem really significant. But if you zoom out and look over a longer horizon, the market’s short-term gains don’t seem quite so impressive and the short-term declines don’t seem so scary.

“What you have to do is zoom out, not focus in,” he advised.

It’s not a bad idea. Students of behavioral finance have long noted that human beings are naturally susceptible to “recency bias”—the tendency to overweight recent experiences when forming your view of the future. In up markets, this bias can cause investors (or home buyers or mortgage lenders) to be overly optimistic and to take on more risk. In down markets, recency bias can lead an investor to assume that returns will continue to be terrible.

Of course, an investor’s time horizon can affect how easy or difficult it is to “zoom out” and take a long-term perspective. When you’re 20-something and your retirement plan balance is still relatively modest, it should be easier to react with equanimity to a market downturn. For younger adults, human capital (the earnings potential over their working lifetime) is likely to be far larger than their financial capital. For a 50-something investor, for whom retirement is five or ten years away, the situation is likely to be very different.

The key, obviously, is to set your portfolio mix of stocks, bonds, and cash to try to manage how much zooming and diving you feel you can withstand—both emotionally and financially.

Personally, I expect to encounter ups and downs in the markets and my portfolio balance. But the most thrilling roller coasters—I’ll leave those to Rob.

Note: All investments are subject to risk. Investments in bond funds are subject to interest rate, credit, and inflation risk.

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