Afraid of Market Risk? Stop. Be Afraid of Bias.

Afraid of Market Risk? Stop. Be Afraid of Bias.

October 12, 2014 Behavioral Finance
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(Last Updated On: March 15, 2015)

Stock markets have been sucking wind recently.





When I listen to the nightly news or indulge in 30 seconds of CNBC during the day, it seems as though the world is coming apart at the seams.

Perhaps a correction is on the horizon, and with a long enough horizon there is a 100% probability the market will blow up (e.g., the sun becomes a Red Giant and the Earth is liquidated).

But when consuming information we must always worry about availability bias, which causes our minds to overweight the probability of events that trigger primal instincts such as fear and greed.


Some headlines:

But just how big a deal is a 5% loss in the stock market?

The table below highlights the top 40 worst drawdowns from 1927 to 2013–all of them are worse than 5%.

We include the S&P 500 total return index (Large cap) and the Equal-weight CRSP total return index (small-cap).

One thing is clear:



Rank Date Start Date End SP500 EW_CRSP
1 8/30/1929 5/31/1932 -84.59% -85.86%
2 2/27/1937 3/31/1938 -51.27% -61.18%
3 10/31/2007 2/28/2009 -50.21% -55.19%
4 8/31/2000 9/30/2002 -44.41% -23.78%
5 12/31/1972 9/30/1974 -42.73% -49.86%
6 8/31/1932 2/28/1933 -30.38% -38.68%
7 9/30/1939 4/30/1942 -29.81% -21.00%
8 8/31/1987 11/30/1987 -29.58% -32.02%
9 11/30/1968 6/30/1970 -29.23% -48.32%
10 12/31/1961 6/30/1962 -22.33% -23.03%
11 5/31/1946 11/30/1946 -22.17% -28.13%
12 1/31/1934 3/30/1935 -21.89% -23.08%
13 8/31/1933 10/31/1933 -19.76% -24.17%
14 12/31/1938 4/29/1939 -17.01% -20.28%
15 11/30/1980 7/31/1982 -16.53% -12.82%
16 4/30/2011 9/30/2011 -16.26% -22.15%
17 1/31/1966 9/30/1966 -15.79% -15.70%
18 6/30/1998 8/31/1998 -15.18% -23.70%
19 7/31/1957 12/31/1957 -15.13% -18.37%
20 5/31/1990 10/31/1990 -14.82% -24.33%
21 12/31/1976 2/28/1978 -14.46% 25.53%
22 4/30/2010 6/30/2010 -12.93% -13.54%
23 7/31/1956 2/28/1957 -9.90% -3.90%
24 2/29/1980 3/31/1980 -9.75% -16.50%
25 8/31/1978 10/31/1978 -9.43% -17.22%
26 12/31/1952 8/31/1953 -9.01% -5.88%
27 6/30/1943 11/30/1943 -8.81% -11.80%
28 12/31/1959 4/30/1960 -8.42% -7.38%
29 8/31/1986 9/30/1986 -8.32% -5.91%
30 4/30/1971 10/31/1971 -7.87% -13.65%
31 3/31/1936 4/30/1936 -7.78% -12.30%
32 11/30/1983 5/31/1984 -7.21% -12.44%
33 1/31/1994 3/31/1994 -6.95% -5.55%
34 12/31/1989 1/31/1990 -6.77% -4.64%
35 12/31/1967 2/29/1968 -6.77% -3.36%
36 3/31/2012 5/31/2012 -6.60% -7.69%
37 9/30/1979 10/31/1979 -6.56% -9.79%
38 1/31/1946 2/28/1946 -6.54% -6.69%
39 6/30/1999 9/30/1999 -6.22% -3.75%
40 3/31/1956 5/31/1956 -5.90% -3.63%

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Knowledge is power and knowing the facts regarding the risks associated with stock market investing can help you put the current market movements in context. Does losing 5%+ stink? Of course.

But is the movement worthy of stirring behavioral emotions (e.g. fear or greed) that will almost certainly cause you to make a bad decision? Not even close!

  • Stay calm.
  • Stick to your program.
  • Never associate more activity with increased value.
  • Focus on evidence, not on stories.
  • Avoid television, which is systematically designed to trigger emotions that cause you to “react.”
  • Avoid advisors who recommend off-the-cuff “tactical changes.” These tactical changes justify an overpriced existence, but rarely equate to systematic value-add.
  • Avoid the stock market if you cannot take risk!

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Please remember that past performance is not an indicator of future results. Please read our full disclaimer. The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Alpha Architect, its affiliates or its employees. This material has been provided to you solely for information and educational purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed by the author and Alpha Architect to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from Alpha Architect.

Definitions of common statistics used in our analysis are available here (towards the bottom)

About the Author

Wesley R. Gray, Ph.D.

After serving as a Captain in the United States Marine Corps, Dr. Gray received a PhD, and was a finance professor at Drexel University. Dr. Gray’s interest in entrepreneurship and behavioral finance led him to found Alpha Architect. Dr. Gray has published three books: EMBEDDED: A Marine Corps Adviser Inside the Iraqi Army, QUANTITATIVE VALUE: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors, and DIY FINANCIAL ADVISOR: A Simple Solution to Build and Protect Your Wealth. His numerous published works has been highlighted on CBNC, CNN, NPR, Motley Fool, WSJ Market Watch, CFA Institute, Institutional Investor, and CBS News. Dr. Gray earned an MBA and a PhD in finance from the University of Chicago and graduated magna cum laude with a BS from The Wharton School of the University of Pennsylvania.

  • Steve

    (Need to amend Rank 21, EW_CRSP result to a negative).

    Initially I was surprised that there are “only” (looking at EW-CRSP) 28 draw downs >10% over 86 years, and “only” 18 >20% over the period.
    Still, I guess that shows (if they were evenly distributed, which of course they are not), there is a 20%+ draw down once every 5 years and a 10%+ draw down every 3 years – which is kinda scary for many investors.
    Everyone’s different I guess…for me it’s the 30%+ that make me go, “ouch,” that 86% draw down just makes me feel ill!

  • Hey Steve,
    There can be some serious pain in the market.
    Amazingly, those figures for ew are actually correct. SP=col 1, EW = Col 2
    Raw data below

  • posted pic

  • Steve

    Crikey! Thanks for that Wes…that is an amazing difference!

  • pretty insane. Not sure what was going on internal to the market. I guess this year you have an opposite effect: large is whooping small in a big way!

  • Michael Milburn

    re: “stick to your program”

    I wonder how many systems have behavior predicated on the market’s 200 MA, and the implication of that? My process uses 3% below a 240MA on S&P as a bearish indicator and it prevents me from taking new long positions – so at least from that standpoint the direction from here is quite interesting for me right now.

    As I was building my system I wondered how many others were using something similar, and what that might mean for the markets?