Why Bear Markets Are So Painful

In his book, Misbehaving: The Making of Behavioral Economics, Richard Thaler discusses a stock market experiment that says a lot about how people react to losses and their perception of risk:

As in the previous experiment, the subjects had only two investment options, a riskier one with higher returns and a safer one with lower returns. In this case, what we varied was how often the subjects got to look at the results of their decisions. Some subjects saw their results eight times per simulated calendar year of results, while others only saw their results once a year or once every five years. As predicted by myopic loss aversion, those who saw their results more often were more cautious. Those who saw their results eight times a year only put 41% of their money into stocks, while those who saw the results just once a year invested 70% in stocks.

Loss aversion tells us that losses hurt twice as much as gains feel good. Myopia deals with the fact that people have a tendency to evaluate outcomes on a frequent basis. Put them together and these two behavioral biases can wreak havoc on your portfolio because the more often you monitor your investment results the more likely it is that you’ll see a loss, and thus, suffer from loss aversion.

This is one of the reasons so many investors make mistakes during bear markets. Down markets force people to assess the damage in their portfolios more often, which leads to pain from seeing losses, which leads to even more monitoring of performance. It becomes a vicious cycle.

One of the reasons for this is because of the difference between the nature of bull and bear markets. There’s an old saying that stocks take the escalator up but the elevator down. Bull markets are fairly slow and methodical. Bear markets are violent and come in waves. Bull markets take time to climb the wall of worry while bear markets can wipe out a decent amount of those gains in a hurry.

I looked back at the historical track record of double digit gains and losses in the S&P 500 going back to 1928 to get a better sense of how they both played out in terms of magnitude and duration. First, here is a snapshot of the various rallies and bull markets:

In the first column I show all market runs of over 10%, but then break them down even further to show that the largest bull markets last for quite some time, on average.

Now take a look at the historical make-up of corrections and bear markets:

Double digit declines occurred much faster and lasted for a shorter period of time before bottoming out. A simple check of the ratios between the two data sets shows that rallies and bull markets have lasted roughly twice as long and gained twice as much as corrections and bear markets. The market went two steps forward for every one step back. Which would make sense when you consider that the stock market finishes the year up around 70% of the time.

It’s interesting that actual gains and losses follow something of a reverse loss aversion ratio. Losses hurt twice as much as gains make us feel good, but gains outweigh losses by a factor of two-to-one.

I’m on record saying that the majority of investor mistakes occur during bear markets. I think one of the biggest reasons for this is because of the speed in which markets move when they fall. When markets rise in a very orderly manner investors become lulled into a false sense of security. Volatility is typically far lower during an uptrend than a downtrend so investors start to believe that the markets are easy and that risk has been extinguished.

The painful reminders that this isn’t the case come very quickly and often without warning. No one really pays much attention to the markets when they’re rising because the gains tend to come in dribs and drabs. Then when markets reverse course to the downside the losses happen in rapid succession and everyone starts paying attention again.

Scary headlines dominate mainstream news outlets. Investors constantly check the market value of their portfolio. People assume that trying harder or doing something — anything — will help their cause. The combination of stress and the pain from seeing losses causes people to lose their cool and make emotional decisions.

It’s no fun to lose money. But checking the value of your portfolio more often during a downturn won’t help your cause.

Source:
Misbehaving: The Making of Behavioral Economics

Further Reading:
The Fear Principles