Financial events on both sides of the Pacific Ocean are testing the ability of us humans to keep our emotions out of our financial decisions. On one side we have fear, with China’s stock market plunge. On the other side we have greed, with the Powerball jackpot now worth an estimated $700 million. Ironically, the default reaction of our brains to both is driven by loss aversion.

China’s CSI 300 index plunged 7.2% this morning before circuit breakers halted trading. It was the second time this week that trading was halted following a plunge in prices. Today’s drop followed a devaluation of the yuan and reflected fears about a weakening Chinese economy. Overshadowed by the headlines was a new limit on the amount of stock major corporate shareholders can sell.

The reaction of Chinese regulators was swift. First, Reuters said the People’s Bank of China intervened to reverse the decline in the yuan after the currency fell more than expected. Then the China Securities Regulatory Commission announced it was suspending the circuit breakers.

(It’s worth noting that the United States has circuit breakers as well. Trading is halted for 15 minutes if the S&P 500 falls by more than 7% or 13% before 3:25 p.m. ET. Should the index fall by more than 20% at any time during the trading day, trading in the U.S. will cease for the remainder of the day. Individual stocks may also be halted if their prices move too much in a very short period of time.)

The Powerball jackpot appears likely to set a new record on Saturday night. The previous U.S. record was a $656 million Mega Millions prize won in 2012. Last night, the local news here in Chicago aired a live report from a convenience store. My guess is that we’re going to see more such stories and longer lines inside (and potentially outside too) of stores selling lottery tickets.

What’s often ignored when lottery jackpots grow to huge sums is that the odds of winning do not change. The odds of winning anything, be it $4 or $700 million, are 1:24.9, or 4%. Put another way, when you spend $2 on a Powerball ticket, there is a 96% chance of losing the entire $2. Spending $200 doesn’t change your odds much either. While you might get a few tickets worth $4, there is a high probability that you will have just handed most of your $200 to your state lottery commission.

These odds are no secret. They are widely published and easily accessible. Yet when the jackpot grows large, our aversion to loss kicks in big time. Our minds fear missing out on the chance to win the big jackpot. We are hardwired to believe we’ll lose by not playing. After all, those who do not play are guaranteed not to win. What our brains don’t consider is the expected outcome: playing the lottery is a losing proposition.

This leads to a key problem with economic and financial theories. The human brain does not like to calculate the odds of making and losing money. It prefers to act on intuition, leading to suboptimal and often bad financial decisions being made. Influencing how the brain thinks is loss and risk aversion. As Nobel laureate Daniel Kahneman and his late colleague Amos Tversky found, humans feel greater aggravation from losing a sum of money than pleasure from gaining the same amount of money. You will feel greater aggravation from having wasted $4 on lottery tickets then winning $4. (Four dollars is the payout for matching the Powerball number or matching one number plus the Powerball.)

Which brings us back to China. The drop in Chinese stocks is front and center. If it makes you nervous about the implications for U.S. stocks, realize that you are not alone. You are feeling the pain of wealth lost due to this week's drop (and the volatility of the past few months) as well as the pain of wealth potentially lost in the future. The Chinese news is front and center, so your mind is focused on it even though what really matters is what your portfolio balance will be several years into the future.

I think it’s helpful to simply acknowledge our emotions. If you’re nervous about China, stop paying attention to the financial news. You may also find it helpful to hold the equivalent of one to five years of living expenses in cash, CDs, etc. Doing so can ease your short-term fears about the stock market while still helping you to make progress towards your long-term goals. As far as the lottery, if you really feel the urge to buy a ticket, spend a minimal amount and then put the same amount into in your savings. You’ll satisfy your craving, while still doing some good for your financial well-being.

• Driving Emotions from Your Investment Process: A 12-Step Program – Tom Howard offers steps for reducing the impact emotions have on your investing decisions.
  
• The Danger of Getting Out of Stocks During Bear Markets – One of the worst things you can do is let loss aversion prompt you to pull out of stocks when market conditions turn turbulent.
  
• How Big Does the Jackpot Have to Be for You to Buy Lottery Tickets? – Tell us on the AAII.com Discussion Boards.
  

I will speak at the AAII Milwaukee Chapter’s 26^th annual midwinter retreat on Saturday, January 16.

Dow Jones industrial average components Intel Corp. (INTC) and JPMorgan Chase (JPM) will report on Thursday. Joining them will be nine other S&P 500 member companies, including Alcoa (AA) on Monday, CSX (CSX) on Tuesday and BlackRock (BLK), Citigroup (C), U.S. Bancorp (USB) and Wells Fargo (WFC) on Friday.

The first economic report of note will be the November Job Openings and Labor Turnover Survey (JOLTS), released on Tuesday. Wednesday will feature the Federal Reserve’s periodic Beige Book. December import and export price data will be released on Thursday. Friday will feature December industrial production and capacity utilization, the December Producer Price Index, December retail sales, the University of Michigan’s preliminary January consumer sentiment survey, the January Empire State manufacturing index and November business inventories.

Several Federal Reserve officials will make public appearances: Atlanta president Dennis Lockhart and Dallas president Rob Kaplan on Monday; Richmond president Jeffrey Lacker on Tuesday; Boston president Eric Rosengren and Chicago president Charles Evans on Wednesday; St. Louis president James Bullard on Thursday; and New York president William Dudley 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.

Pessimism about the short-term direction of stock prices rebounded strongly as neutral sentiment pulled back from a 13-year high in the latest AAII Sentiment Survey. Bullish sentiment fell, extending its streak of unusually low readings.

Bullish sentiment, expectations that stock prices will rise over the next six months, fell 2.9 percentage points to 22.2%. Optimism was last lower on July 29, 2015 (21.1%). Bullish sentiment has now been below 30% for six consecutive weeks and is below its historical average of 39.0% for 42 out of the past 44 weeks.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, pulled back by 11.7 percentage points to 39.6%. The large drop follows last week’s jump to 51.3%, which was the highest reading since February 6, 2003 (51.4%). Neutral sentiment is above its historical average of 31.0% for the 17th consecutive week. Last year, neutral sentiment was above average every week except for two.

Bearish sentiment, expectations that stock prices will fall over the next six months, rebounded by 14.6 percentage points to 38.3%. The jump follows last week’s large drop to 23.6%, but only puts pessimism at a three-week high. Bearish sentiment has been above its historical average of 30.0% during three out of the last four weeks.

Optimism is at an unusually low level for the fourth consecutive week. Unusually low levels of bullish sentiment (defined as being more than one standard deviation below the historical average) have historically been associated with above-average returns for the S&P 500 over the following six- and 12-month periods. There is no guarantee that history will repeat, however.

The rough start to 2016, China and escalating tensions in the Middle East are all impacting individual investors’ short-term outlook. The above-average and often high levels of neutral sentiment recorded last year occurred during what was a mixed year for the major indexes, with more S&P 1500 Super Composite stocks falling rather than increasing in price.

During the week before Christmas, we asked AAII members for their thoughts about the Federal Reserve’s recent rate hike. More than 37% of respondents agreed with or approved of the rate hike. Nearly 29% said it was either about time to raise rates or that the rate hike was overdue. About 13% view the decision as a non-event, while 11% think the decision is a mistake.

Over the holidays we asked AAII members how big a percentage gain or loss the S&P 500 would realize this year. Nearly two-thirds of respondents (65%) anticipate stocks to rise. Slightly more than 20% of respondents think that the increase will be less than 5%, while 31% expect gains of between 5% and 10%. Nearly 29% of respondents expect declines. About 13% think that the market will fall between 5% and 15%, while 6% fret that the S&P 500 could plunge by more than 20% this year.

This week’s special question asked AAII members what they thought would most influence the direction of stock prices this year. China and geopolitics (primarily events in the Middle East) topped the list, with each named by 22% of respondents. Politics, particularly the November elections, and the economy (both domestically and globally) followed closely behind, with 20% of respondents listing either or both. Slightly more than 11% cited corporate earnings, while just 8% said that monetary policy will have the biggest impact. Many respondents listed more than one primary influence.

Bullish: 22.2%, down 2.9 points
Neutral: 39.6%, down 11.7 points
Bearish: 38.3%, up 14.6 points


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

Individual investors ended 2015 with their largest bond exposure since last January, according to the December AAII Asset Allocation Survey. Equity and cash allocations were both slightly down.

Stock and stock fund allocations declined by 0.2 percentage points to 65.3%. The change was not large enough to prevent equity allocations from remaining above their historical average of 60% for a 33rd consecutive month.

Bond and bond fund allocations rose 0.4 percentage points to 17.1%. Fixed-income allocations were last higher in January 2015 (17.5%). Last month was also the fifth consecutive month with fixed-income allocations above their historical average of 16.0%.

Cash allocations declined 0.1 percentage points to 17.7%. Cash allocations have decreased for three consecutive months and now sit at a five-month low. Nonetheless, December was the 49th consecutive month with a cash allocation reading below its historical average of 24%.

Equity allocations continue to remain below their pre-correction levels. Neutral sentiment ended 2015 at its highest level of the year (51.5%). Furthermore, the proportion of individual investors describing their short-term outlook for stocks as “bullish” remained below 30% throughout all of December. Last month’s decline in equity prices likely had a negative impact on the reported levels of equity allocations as well.

Last month’s special question asked AAII members how their current allocation compares to their expectations. More than four out of 10 respondents (42%) said their current allocation is either about the same or matches their intended strategy. Slightly more than 17% said they are holding more cash than anticipated. About 8% said they have a higher-than-anticipated exposure to equities. Similar numbers of respondents (6% each) said they have less in equities or less in bonds than expected.

Here is a sampling of the responses:

• “About the same. I rebalance twice a year.”
• “Less in stocks and bonds due to market volatility.”
• “About the same. I don’t change my allocation much year to year.”
• “Much less bonds. I’m not replacing matured bonds.”
• “More cash than I would have thought.”

• Stocks and stock funds: 65.3%, down 0.2 percentage points        
• Bonds and bond funds: 17.1%, up 0.4 percentage points              
• Cash: 17.7%, up 0.1 percentage points

• Stocks: 29.9%, down 2.7 percentage points
• Stock funds:  35.4%, up 2.5% percentage points
• Bonds: 4.0%, up 0.5 percentage points
• Bond funds: 13.1%, down 0.2 percentage points

Take the Asset Allocation Survey.

Local Chapter Meetings