Here’s A Better Way to Think About Investing

Ser Jing - Here's A Better Way to Think About Investing (pic)I’ve got two stock ideas for you. Let’s see how you feel about those ideas after reading brief descriptions of them.

Here’s the first stock idea: This stock has already taken a 7% haircut in the past month, even though investors are still sitting on gains of 11% over the past year. Despite historical earnings growth of 7.5%, its outlook is poorer with long-term projected earnings growth of just 6%.

Here’s the second idea: This stock has clocked strong gains of 11% over the past 12 months in spite of a 7% fall from a month ago. Earnings growth is expected to come in around 6%, just a smidge lower than its steady historical growth rate that has averaged around 7.5%

If I were to hazard a guess, I’ll think the second idea would be the popular choice. But, as it turns out, both stock ideas were a description of the experience that investors had in the SPDR Straits Times Index ETF (SGX: ES3) (an exchange traded fund that closely replicates the Straits Times Index’s (SGX: ^STI) movement) according to data compiled from Yahoo Finance and Morningstar.

For those who found it disconcerting about how different conclusions can be made on the same subject based on the way information’s provided – welcome to the world of framing.

In Jason Zweig’s book, Your Money and Your Brain, he quoted University of Oregon psychologist Paul Slovic describing framing as such: “Equivalent ways of describing something should lead to equivalent judgements and decisions. But it’s not true. People’s judgements about risk are very moveable and subjective.”

The “moveable and subjective” nature of our assessment of risks is probably why focusing on the short-term movements of the stock market makes it seem a lot more risky than what historical precedents suggest.

Consider this. For investors checking the returns of the STI at the start of every year since 1988, they would have seen the index face annual declines of more than 10% in 7 out of 25 one-year periods (yes, one year is considered short-term!). That does seem risky, doesn’t it, seeing an investment lose more than 10% twenty eight percent of the time?

But, if the same group of investors had focused on checking rolling 5-year returns for the STI at the start of every year starting from 1993, they would have seen declines exceeding 10% in only 4 out of 21 five-year periods (that’s a larger-than-10% decline happening nineteen percent of the time). The outlook for the risk of loss suddenly diminishes when we stretch out our time-horizon.

The phenomenon of diminished risks when juxtaposing a long-term ‘frame‘ as opposed to a short-term ‘frame‘ does not just apply to the broader share market.

According to Yahoo Finance, shares of instant beverage manufacturer Super Group (SGX: S10) and health care provider Raffles Medical Group (SGX: R01) had declined by 13% and 9% in just the past month. Investors in them would probably not be too happy with the sliding prices of those shares.

But, long-term investors would have enjoyed returns of 402% and 128% for Super Group and RMG respectively over the past five years and should be very satisfied with such results, even after the past month’s fall.

Foolish Bottom Line

Framing our thoughts about investing using a short time horizon will likely lead to a perception of high-risks due to the daily – and largely unexplainable – short-term wiggles. But, once we lengthen our time-horizons in the way we frame our thinking about the stock market, we find that history’s largely on our side.

And, if nothing else, focusing on long-term returns will likely make us happier investors who are less prone to making rash, emotional, and financially harmful decisions because of the higher statistical odds of seeing better results over the long-term.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chong Ser Jing doesn’t own shares in any companies mentioned.