When Huge Returns Aren't What They Seem

In the WSJ article "How Huge Returns Mess With Your Mind," written by Jason Zweig, the author explains a major issue that investors face during great weeks like the one we just had. After the White House and Congress agreed on a new tax-and-spending package to avoid the fiscal cliff, huge gains were seen in all major markets: the S&P jumped 2.5%, the Russell 2000 index surpassed its all time high, and markets in China, Egypt and Finland rose by over 4%.

However, Zweig warns investors that they shouldn't extrapolate these gains, and to avoid further taking irregularly high risks in the pursuit of yield. He attributes this to a psychological flaw of the human mind in understanding compounding interest.

A 2.5% return doesn't sound particularly hard to sustain, but if the market went up at that same daily pace of each of the other 20 trading days in January, investors would earn a 65% return... Because the human mind isn't very good at appreciating the power of exponential growth, thinking realistically about high returns is hard.

He elaborates on this by discussing the myth about the inventor of chess: how he made a deal with a king to be paid with one grain of rice on the first square of a chessboard and then have that amount doubled on each successive square-- mentally tricking a foolish king expecting to owe just a little but of rice, but in reality indebted much more.

People with this "exponential growth bias" believe that a boost in the compound rate of return from 2% to 3% will make as big a difference in their final wealth as an increase from 12% to 13% should.

With that said, it appears that the most logical thing to do is to stay rational and on target. Slight increases in gains will not change the game nearly as much as one believes. There are numerous investors who will "ratchet up their risk, trade faster or try squeezing out every last drop of yield," but the point that he makes is to continue to think long term amidst little peaks and valleys.

What are your thoughts on Zweig's words? Do they hold true, or should these small gains be realized further?