Author James Playsted Wood once said, “The thing that most affects the market is everything.”
Just think about the current list of worries for investors at the moment:
Stocks are in a bear market, bonds are down too, inflation is at 40 year highs, interest rates are rising, lots of well-known stocks are crashing, the Fed is raising interest rates, the war in Ukraine, China’s zero-Covid policy, consumer confidence is crashing and there are legitimate fears we’re heading for a recession.
Charley Ellis once observed, “Forecasting the future of any variable is difficult, forecasting the interacting futures of many changing variables is more difficult, and estimating how other expert investors will interpret such complex changes is extraordinarily difficult.”
In short, markets are hard.
There has never been a time when future outcomes are guaranteed in the markets but uncertainty feels like it rises when stocks are falling.
It’s during these times of uncertainty that we look to see what others are doing to guide our own actions. This is why the herd mentality is amplified during booms and busts. The crowd becomes a safe place when things are out of the ordinary.
Losing money is a stressful experience and most people have a difficult time making intelligent decisions in times of duress.
Researchers examined the stress responses of two groups of rats after they were subjected to painful electric shocks. Group 1 received the electric shocks 10 times per hour, while group 2 was shocked 50 times an hour.
The next day, all the rats were shocked 25 times an hour. At the end of that day, rats from group 1 that experienced an increase in shock rate had elevated blood pressure, which is a physical sign of stress. Rats from the second group that experienced a decrease in shock rate had normal blood pressure.
It’s not always good or bad that matters during times of stress but better or worse.
The same is true of down markets. The stock market will bottom at a time when the news is still really bad but not quite as bad as expected.
Researchers studied the stock market going back to 1952 and used the data to come up with a model that could explain the market’s past movements. They found that three factors explained 85% of the market’s moves over time:
(1) The productivity of the economy, which only matters over the very long term.
(2) How much of the rewards of the economy end up going to households through income, dividends, or earnings.
(3) Risk aversion, which is basically how we humans react unfavorably to uncertainty.
The conclusion of the study was that roughly 75% of the variation in the stock market over the short term has been explained historically by risk aversion.1
This means that emotions drive the stock market over shorter time frames but fundamentals drive the stock market over much longer time frames.
No big surprise there but it’s good to remind yourself that things in the stock market can always get crazier.
The prospect of making or losing money can cause people to act in bizarre ways.
Jason Zweig wrote about neuroeconomics in Your Money & Your Brain to show how financial decisions impact our brains. The research is illuminating.
Scans have shown the brain activity of a person that’s making money on their investments is indistinguishable from a person who is high on cocaine or morphine. Making money literally makes us feel like we’re taking drugs.
We need a bigger hit of adrenaline each time to get a bigger fix for the same emotional response. This is how leverage and speculation cause financial ruin.
Armed with this information, the insanity of 2020 and early-2021 in the markets makes a lot more sense.
Keeping your wits about you when others are too high or too low is not an easy task.
Building a portfolio comes down to your risk profile but our perception of risk is constantly changing depending on the environment.
If I had to boil investing into two simple questions, here’s what I would ask:
(1) When do I need the money?
(2) How much can I afford to lose in the meantime, both mentally and financially?
Every other decision more or less branches off from these two questions. The problem is that even if you’re able to determine the answers to these two questions, it’s difficult to keep the same attitude about risk when the markets are in a constant state of change.
Even if your circumstances don’t change much, your perception of risk will be all over the map as the markets move.
Studies show that we humans are terrible at forecasting how we’re going to feel during future situations. The actual experience of an event is normally a lot less scary than we imagine it to be. This can have a huge impact on the decision-making process.
In one study, researchers picked nine risks that included things like deadly disease, crime, and teen suicide to compare people’s level of concern about each risk with some objective measures about the probability of the risks themselves.
For some, as the concern rose and fell for each risk in the media and society at large, their concern followed the same path. But for others the concern about any particular risk rose and fell for no apparent reason. There was no connection whatsoever that should have made the perception of the risk change, but it did.
There was no relationship between actual and perceived risk. It’s basically how each individual reacts based on their environment, personality, and experience.
The same holds true for the financial markets.
In another study, researchers found that cloudy days increased the perceived overvaluation of the markets for both individual stocks and the market as a whole. This led institutional investors to make more sales on cloudy days when they were in a gloomy mood.
Investing in the financial markets can be infuriatingly counterintuitive.
Lower quality companies can become bargains at the right price while high-quality companies can become far too expensive after a string of gains. Great companies don’t always make for great stocks but terrible companies can become great investments at the right price.
The best time to buy stocks is often when it feels the worst.
There is no one size fits all for surviving a bear market.
You have a plan.
You build the occasional bear market into that plan.
You create an asset allocation that balances your willingness, need and ability to take risk with your time horizon.
You avoid timing the market.
And you follow your plan come hell or high water.
How the Stock Market Works
This post was adapted from my first book, A Wealth of Common Sense. I thought it made sense for the current environment.
1I’m not convinced you can put an exact number on something like this but it feels in the ballpark to me and makes sense.