Oh That Feeling

We have provided regular statistics about the depth and duration of typical market declines. Here is an updated chart including the recent correction (defined as a peak to trough decline of 10% or more):

Facts are important, but often investors are driven not by hard cold numbers, but emotions. Most individual investors vastly underperform market averages for one basic reason: they panic and sell at lows, then when things are ‘calm’ they repurchase stocks. Translation: they buy high and sell low, even when they don’t need the money for years. These actions are not driven by facts or earnings or dividends or immediate cash needs or anything else objective. Rather, they are motivated by one simple thing: fear. Fear of ‘losing’ money. Yet these investors’ actions all but assure the very outcome they are trying to avoid.

That got me to thinking why some people are able to overcome their emotions – to their financial benefit – and others (in fact most others) can’t.

The Tale of the 7-Year-Old Wonder Investor

For full disclosure, my daughter got a heavy dose of brains and rationality. She decided to take Chinese because she figured that between English, Spanish, and Chinese, she’ll be able to communicate with about 96% of the world’s population. As a matter of course, she charges her older brother daily interest for outstanding debts (which she calculates down to the penny and provides regular outstanding balance updates, much to his chagrin). That said, she was born after the last major bear market so she is the perfect subject for my analysis as to why some people fear market declines while a select few embrace them.

During the recent market decline she asked me, “…how are things going at work dad?” “Well,” I replied, “stocks went down the last few days so some clients are concerned.” “Why would they be worried?” she asked sincerely, “I mean you told us that as long as you don’t need the money right away, then you’ll be fine. Not to mention those dividends…” (Yes, I do teach my kids about investing).

That made me realize that people who are ‘comfortable’ with something generally either have never experienced it (e.g. a bear market) or experienced it a lot (i.e. been in the market for decades). When someone has limited experience, then their brains often fear the worst, especially if the experience was a bad one. In this case, my daughter viewed the near-term decline in stocks totally rationally – as I do – without any bias or emotions.

A typical scenario for those who fear market volatility goes like this: “I started investing just before the huge bear market of 2007-2009, I just couldn’t take it any more so I got out. Stocks are dangerous. It is like gambling.” Or some variation thereof. An investor has a singular experience which was negative (their behaviors that is, not the market movement itself which for some was a great thing – Warren Buffett put billions to work and profited over $10B on his BAC investment alone made during the financial crisis) and that forms the basis of all future actions, which often means to not invest at all, or sell at the first sign of market volatility. The fact that the market declined wasn’t the problem; the fact that they panicked and sold at lows (or mismatched investments with time horizon) was the problem, as even with one of the worst declines in modern history, it didn’t take long for stocks to recover their full value and then some.

This emotions-based approach to investing is the single greatest cause of the massive underperformance most individual investors experience relative to market averages, the typical retail investor having achieved about 3% per year vs. around 9% per year for the markets over decades.

You can do all the analysis you want, watch Jim Cramer, read Wall Street reports, scour books… but if you don’t have the mindset to invest, you likely won’t do well. Most peoples’ brains simply are not wired to invest effectively. When stock prices were declining earlier this month, I walked into work each day with a smile on my face knowing that I could buy great companies for cheaper which by mathematical definition would lead to higher returns over time. This is a concept my 7-year-old understood intuitively. In my case, I’ve experienced every market movement since 1985 (when the DOW was trading around 1,000, the size of recent market drops) and realized the only thing that can keep someone from making money in stocks is themselves – and not having the correct time horizon for their holdings.

It seems pretty basic, but sometimes simple is powerful: for the portion of your money that you need for other purposes in the next few years, you should not be in stocks (there are plenty of great alternatives than can earn positive returns in a more stable way), therefore short-term market movements are irrelevant to you. If you don’t need the money for 3 - 5 years or more, then again short-term market declines are irrelevant to you other than providing an opportunity to accumulate more shares at lower prices – either through outright purchases, or via dividend reinvestments.

Don’t let your gut, your emotions, overrule your brain. Your intellect is smart enough to grasp the concept of aligning assets with investment time horizons. That said, it is equally important to “know thyself” as the Greeks say, so if you are prone to panic during market declines no matter how much you have studied trough to peak statistics, then make sure to set up structures in place – a highly rational, disciplined Financial Advisor, a cash hoard, a ‘no news’ policy during market declines – whatever works best – to ensure that you do not make an investment decision that feels ‘good’ in the moment but that hurts your financial well-being over time.

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