Panic or Profit?
In times of market stress, investors are faced with the option of panic or profit. While humans are wired through evolution to flee loss, this tendency is not well-suited for investing.
Contributed by Doug Walters , Max Berkovich , ,
With investor emotions running high, we deviate from our standard Insights to take a deep dive into recent market moves and provide a roadmap for avoiding common behavioral pitfalls.
U.S. stocks fell sharply, extending last week’s losses. Equities are down around 13% since last Wednesday’s all-time high as fears spread that the Coronavirus will disrupt global trade and impact corporate profitability. As painful as this can feel, declines of 13% in a year are not unusual. In fact, since 1928, stocks have dropped at least that much in over half of the years (see chart below). What makes this week’s move unique is its speed. By comparison, stocks fell nearly 20% in 2018, but that was spread over three months. Such is the nature of the stock market. Equities are volatile, and the reward for the patient investor historically has been attractive gains!
Figure 1: Maximum declines of the S&P 500 by year
Despite big moves in stocks being normal, when we get a shock like we had this week, we tend to see two responses from investors: panic and profit.
The “panic” response to declining markets is to run for the hills. Risk aversion is a natural human behavioral bias. We are wired for survival and feel strong emotions in the face of loss. A famous study (Shiv et al., 2005) looked at this behavior. It demonstrated, with a simple coin flip, that investors are much more likely to invest after experiencing profit than they are after experiencing loss. This, despite the odds of winning being a constant 50%. Those who follow instinct and panic in the face of market disruption are at risk of damaging long-term returns.
The patient investor who can set aside their natural behavioral biases has a chance to profit in the face of disruption. A stock market decline of 13% has opened opportunities that did not exist two weeks ago. Nobody likes to see their investment portfolio decline, but rational long-term investors will see this market move as an opportunity to identify some newly discounted stock market bargains.
The Big Picture
We find it useful in times like this to take several steps back and look at the big picture. The chart below shows the price of the S&P 500 going back to the 1920s. Over the past 90+ years, the general trend has been up, but there are times when the market appears to get ahead of trend. The Tech Bubble in 2000 is the most evident case from relatively recent history. Today, we are close to trend, and this week’s pullback barely registers. While this chart says nothing about valuation, we still find it helpful in putting this week in its proper perspective.
Figure 2: Historical Trend of the S&P 500 Index
Preparation not Prediction
The first step to success for an investor is admitting that you cannot predict the future. No one can, and trying to do so is a recipe for underperformance. That is just as true during bull markets as it is during virus pandemics. At Strategic, we do not predict the future, but we prepare for it, by:
- Constructing well-diversified portfolios grounded in rewarded factors,
- Consistently monitoring the market for attractive asset classes, and
- Following a process of regular rebalancing to lock in outperformance as it happens.
We appreciate the trust that our clients have put in us. Sometimes markets misbehave, and our goal, particularly in difficult times, is to provide complete peace of mind so that our clients can continue to pursue their best life!
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