Before I begin this week’s commentary, I want to briefly discuss the recent decline in stock prices. Volatility increased with blazing speed; the six-month trading range for the S&P 500 index jumped from 4.44% as of August 13 to 14.09% as of Tuesday’s close. China, uncertainty over a change in monetary policy, worries about economic growth and seasonal patterns (September has historically been the weakest month of the year for stocks) have all combined to push stock prices lower. Plus, the market had simply gone through an extended period without enduring a correction, so a notable drop was bound to have occurred sooner or later.

Some of you have viewed this as a buying opportunity. Others are viewing it with concern. If you are in the latter camp, I encourage you to consider two things. First, the speed at which volatility has returned shows how difficult it can be to correctly time the market. If you didn’t reduce your stock holdings in May or June, ask yourself: Why should you have confidence that you’ll know when a bottom to the current correction has been reached? Second, the odds of stocks being higher five years from now are very good; the Ibbotson SBBI Classic Yearbook shows that large-cap stocks have realized gains during 86% of all rolling five-year periods since 1926. The odds get even better as stocks are consistently held for longer periods of time.

I realize it can be tough to embrace the uncertainty, but the long-term gains from stocks will reward you for staying with them. In the shorter term, keeping a large enough allocation to cash and short-term securities to cover living expenses and other emergencies (money needed for the next three to five years should not be invested in equities) can help give you the confidence to stick with stocks throughout the current turbulence.

There is much to be said for maintaining a level of simplicity when investing. This is particularly the case if doing so allows you to stay focused on your long-term process. The trade-off is the possibility of following a strategy with lower potential returns. However, the strategy with lower potential returns may help you build greater wealth in the long run if it is easier to stick with than a more complex strategy with potentially higher returns.

There are several reasons why this is the case (including more than I discuss in this week’s commentary). One of the biggest is what researchers refer to as “bounded rationality.” Bounded rationality, in economic terms, is the limits of our ability to make utility-maximizing decisions. It is the limitations created by our cognitive abilities, knowledge, emotional tendencies and available time to formulate the most profitable course of action given what is known at a certain point in time. The more complex a strategy is, the more likely we are to bump up against bounded rationality. This in turn can lead us to make suboptimal decisions.

A related concept is often referred to as “paralysis by analysis.” This admittedly non-academic phrase refers to the difficulty of making a decision after having gathered too much information. Though there are certain characteristics you should look at when evaluating, say, a stock (valuation, profitability, financial strength, etc.), there is a point where gathering more information not only yields less incremental benefit, but can actually do more harm than good. An oft-cited study by Sheena Iyengar and Mark Lepper showed how too much information—or, as in the case of the study, too many choices—can lead to inaction. Consumers were less likely to buy jam when presented with 24 choices of jam than only six choices.

In addition, it is easy to get distracted by focusing on the wrong themes. Every once in a while I will get a question about some specific market event, fundamental/technical analysis indicator or economic data point that leads me to wonder why someone is focusing on it. It’s human nature to seek out patterns and/or explanations. It’s much harder to embrace uncertainty. Plus, though market anomalies continue to exist, the likelihood of identifying a new one—particularly a short-term one—is very small. This doesn’t mean that you can’t still benefit from exploiting existing anomalies, but rather that anything seemingly new that you or I come across likely has a high probability of having been identified by an institutional investor with more capital and faster computers.

Then there is the matter of complexity. The greater the number of rules to follow and the more data that must be monitored, the tougher it will be to stick with a strategy. Building on last week’s commentary about the link between wellness and investing, I suspect the reason so many diets fail is that they are too hard for people to stick with. It’s always easier to follow a strategy when the strategy is easy to follow.

The right level of simplicity varies by person. A 2013 webcast between University of Chicago professor Harold Pollack and journalist Helaine Olen received some press earlier this summer for Pollack’s assertion that a person’s investment strategy should be able to fit on a 3”x5” index card. In response to the webcast, he published a blog post showing his financial strategy completely fitting on an index card (albeit a 4” x 6” index card).

While I don’t think people should feel compelled to limit themselves to an index card, I do think a good rule of simplicity comes to down to answering a very simple question: How easily can you explain your strategy to someone who is completely unfamiliar with it? If you need to spend a significant amount of time doing so, you either need to simplify your strategy or have a plan B that your spouse or someone else you trust can easily follow should they need to suddenly step in and manage your finances. Better yet, see how quickly and easily you can write down your strategy. If you can’t do it quickly, it’s another sign that your strategy is too complex.

Keep in mind that perception of complexity varies by individual. A target date fund can be a great investment for an investor who desires a single investment choice or lacks the knowledge to make asset allocation decisions. An investing strategy requiring a stock screener or a related computer program may work well for investors with greater expertise and time. In between is a wide magnitude of strategies. Regardless of where you fall within the range of complexities, you should always be able to easily explain your strategy to others.

A good rule of thumb is to simply ask yourself how often you haven’t done anything because of a lack of time or ability to make a clear-cut decision. If you’ve found yourself procrastinating, it could be a sign that you need to simplify your strategy. After all, the optimal strategy is always the one you can stick with over the long term.

• My Investment Letter: Words of Advice for My Grandchildren – Charley Ellis shared 12 simple, but direct, guidelines for investing.
  
• Get Organized! How to Maintain Your Personal Financial Files – A simple, but very positive, action you can take is to ensure all of your financial information is properly organized. This 2006 AAII Journal article explains how.
  
• How Simple or Complex Is Your Investment Strategy? – Tell us on the AAII.com Discussion Boards.
  

The U.S. financial markets will be closed on Monday in observance of Labor Day. We hope you have good weather over the holiday weekend.

Just one S&P 500 member company is scheduled to announce its quarterly results: Kroger (KR) on Friday.

The first economic report of note will be the Labor Department’s July Job Openings and Labor Turnover Survey, released on Wednesday. Thursday will feature August import and export prices. The August Producer Price Index (PPI) and the University of Michigan’s preliminary September consumer sentiment survey will be released on Friday.

The Treasury Department will auction $24 billion of three-year notes on Tuesday, $21 billion of 10-year notes on Wednesday and $13 billion of 30-year bonds on Thursday.

The level of pessimism along individual investors has pulled back, though it still remains above average, according to the latest AAII Sentiment Survey. Neutral sentiment rebounded, while optimism was fractionally lower.

Bullish sentiment, expectations that stock prices will rise over the next six months, was nearly unchanged, decreasing by just 0.1 percentage points to 32.4%. The modest decline keeps optimism below its historical average of 39.0% for the 26th consecutive week, the longest such streak since a 29-week stretch in 1993.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, rebounded by 6.7 percentage points to 35.9%. The increase put neutral sentiment back above its historical average of 31.0%.

Bearish sentiment, expectations that stock prices will fall over the next six months, retreated by 6.6 percentage points to 31.7%. Though at a six-week low, pessimism remains above its historical average of 30.0% for a sixth consecutive week. This is the longest streak of consecutive above-average readings for bearish sentiment since a 16-week stretch between August 30 and December 13, 2012.

Reaction by individual investors to the volatility experienced by the stock market over the past two weeks has been mixed, as this week’s sentiment readings and the responses to this week’s special question indicate. The fact that the major U.S. indexes have not retested their recent lows also likely helped alleviate some of the pessimism registered in last week’s survey results.

This week’s special question asked AAII members for their thoughts about the market’s recent volatility. Responses largely fell into one of four primary groups. Nearly 15% have a positive view, with several describing the recent drop in stock prices as a buying opportunity. About 21% view the downward move negatively, saying either more downside or more volatility is forthcoming. Close to 19% say they had expected a downward move or are otherwise not surprised to see volatility increase. Slightly more than 12% say the recent swings in prices are not impacting their investment decisions. A small number of respondents blamed trading programs or panicking on the part of some investors for the increased volatility and downward movement of stock prices.

Here is a sampling of the responses:

• “This is the beginning of a long downward trend.”
• “It had to come sooner or later. It doesn’t deter me from my long-term investing strategy.”
• “Viewed it as a buying opportunity. Stocks on sale!”
• “No one likes volatility, but it creates opportunities for the astute and patient investor.”
• “It’s normal for a market that has run up this much to have a correction.”
• “All due to traders, now aggravated by ETFs, computer-driven trades and fear.”

Bullish: 32.4%, down 0.1 points
Neutral: 35.9%, up 6.7 points
Bearish: 31.7%, down 6.6 points


Bullish: 39.0%
Neutral: 31.0%
Bearish: 30.0%

Individual investors reduced their exposure to stocks and stock funds last month, according to the August AAII Asset Allocation Survey. The reduction put stock and stock fund allocations at a 10-month low. Cash allocations rose to a 15-month high and fixed-income exposure rose to a five-month high. The survey period covered the entire month of August, with many of the responses recorded before the late-month drop in stock prices.

Stock and stock fund allocations declined by 2.4 percentage points to 65.0%. This is the smallest exposure to equities since October 2014 (64.1%). Even with the decrease, stock and stock fund allocations remained above their historical average of 60% for the 29th consecutive month.

Bond and bond fund allocations rose 0.8%, to 16.3%. The modest increase follows three consecutive months with essentially no change. Fixed-income allocations are now above their historical average of 16.0% for the first time since April 2015.

Cash allocations rose for the fourth time in five months, increasing 1.6% to 18.7%. This is the largest amount allocated to cash since May 2014 (19.2%). Cash allocations were also at 18.7% in October 2014. Even with last month’s increase, August was the 45th consecutive month with a cash allocation reading below its historical average of 24%.

As stated above, the survey period covered the entire month of August. The correction in U.S. stocks did not start until August 20 (when the S&P 500 fell by 4.5%). As such, the survey incorporates, but does not fully reflect, the actions of surveyed AAII members in response to the recent drop in stock prices.

Exposure to equities among individual investors had been trending down somewhat prior to the start of the recent market correction; August was the third out of the last four months to show a decline in stock and stock fund allocations. At the same time, cash allocations have been trending upward. In addition, our weekly Sentiment Survey has been registering relatively higher levels of pessimism. Bearish sentiment has been above its historical average during eight out of the past 12 weeks. During the entire 52-week period prior to June 2015, bearish sentiment was above its historical average of 30.0% just nine times.

Last month’s special question asked AAII members whether there are any portfolio changes they are postponing until the after the first rate hike by the Federal Reserve is announced. The majority of respondents (62%) said “no.” Many of these members said that they follow long-term strategies or that they make buy and sell decisions based on the attributes of individual securities and funds. Others said that the first rate hike is already priced in or that it will not have any lasting impact.

About 20% said that they are waiting for a change in monetary policy before taking certain investment actions. Several of these respondents specifically said that they are postponing buying bonds or bond funds. Some respondents said that they intended to increase their equity allocations once the first rate hike is announced.

Here is a sampling of the responses:

• “No, I’m a long-term investor and not a market timer.”
• “No, the rate change should be small and the market has already taken it into account.”
• “No, because the fundamentals of a company are more important than interest rates.”
• “I will reallocate some cash to bonds after interest rates increase.”
• “Yes, purchasing more bonds after the Fed raises rates.”

• Stocks and Stock Funds: 65.0%, down 2.4 percentage points
• Bond and Bond Funds: 16.3%, up 0.8 percentage points
• Cash: 18.7%, up 1.6 percentage points

• Stocks: 32.0%, down 1.0 percentage points
• Stock Funds: 33.0%, down 1.4 percentage points
• Bonds: 3.2%, down 0.5 percentage points
• Bond Funds: 13.2%, up 1.5 percentage points

Take the Asset Allocation Survey.

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