Sitting tight is the best way when emotions are all over the place
• The coronavirus pandemic and end of the bull market run are testing investors’ risk tolerance
If you were going to design a stress test to determine investors’ risk tolerance, the past few weeks would provide a nearly perfect blueprint. We have a virus without a vaccine that’s brought the world’s leading economies to a standstill (nobody’s sure for how long). It is damaging the global economy (nobody knows how badly), which governments are trying to minimise (with policies the implications of which nobody’s sure about) at a time when there were already good reasons to be anxious about an extraordinarily long bull market that’s pushed valuations to worrisome levels.
If that hasn’t done your head in here are few behavioural traits that might:
Hindsight bias. Also known as the I-knew-it-all-along phenomenon, it refers to the tendency for people to perceive events that have already occurred as having been more predictable than they were before the events took place.
Admonitions against hindsight errors are common. As the saying goes, it’s easy to be wise after the event. Yet not all hindsight is about errors. Indeed, good hindsight shortcuts lead us to repeat actions that resulted in good outcomes and avoid those that resulted in bad outcomes. But hindsight shortcuts can easily turn into hindsight errors where randomness and luck are prominent.
Because this bull market lasted so long, many investors have been expecting a bear market for some time — and been proved wrong. Nevertheless, there’ sa risk that some of these folks will now decide they predicted the crisis, buoying the belief in their financial acumen and thus the chances of again being proved wrong.
So, ask yourself: did you see the crisis coming? Is it all too obvious to you that current prices are a great buying opportunity? Are you putting longterm capital into stocks right now? Or are you absolutely certain that selling is the right thing to do? Convinced that stocks won’t bottom any time soon? Here’s the thing: unshakeable beliefs are not to be trusted.
The recency effect. This is another bias that speaks to our tendency to estimate probabilities, not on the basis of longterm experience but on the latest outcome(s). It is perhaps best explained by Victor Niederhoffer when he said: “I thought silver was cheap at 14 bucks. But my friends in the pit remembered it at three bucks and told me it seems expensive to them. I’ve made the same mistake over and over with other stocks I’ve owned.”
This penchant for overweighting recent events is one of the main reasons we fail to heed the lessons of reversion to the mean. Reversion to the mean essentially says that what goes up must eventually come down, and vice versa.
Coupled to loss aversion, the recency effect also has us fretting over the last downturn instead of celebrating the huge gains enjoyed over the past decade. But, as Ben Carlson recently pointed out on the website A Wealth of Common Sense, a 40% market crash would erase only about three-and-a-half years of gains. Sure, it would feel awful, but weren’t stock market investors feeling pretty good about themselves back then?
Loss aversion. We simply loathe losing money. The experts tell us we get at least twice as much pain from losses as pleasure from gains. Since the daily performance in the stock market is more or less a 50-50 proposition, loss aversion means that checking the value of your investments on a daily basis will make you feel terrible. All those warm feelings you get from the winning days will be completely wiped out by the double dose of pain from the down days.
Unstable risk tolerance. In theory, we’re supposed to figure out how much risk we can stomach and then build a portfolio that reflects that. In practice, our appetite for risk tends to rise and fall with the financial markets — and right now a lot of investors are probably discovering they aren’t nearly as brave as they imagined.
How else might our brain be working against us? There’ sa seemingly endless number of ways: anchoring and availability, overconfidence, the illusion of validity, selective cherry picking of evidence, self-justification, our reluctance to confront disconfirming evidence, false memories ... the list goes on and on. Unfortunately, being aware of them apparently doesn’t help much. How we feel at any given point in time has a material influence on the way in which we perceive risks and assess opportunities.
Faced with danger, our instinct is to act. That can make us feel more in control but may not always turn out to be advantageous to our financial future. If there is any chance that emotions are overwhelming your thinking — and what are the chances they’re not? — postpone decisions. If the idea is really a good one, it is likely to still be a good one tomorrow, next week and even next month.
Make doing nothing the default. The more we are bombarded with news, information and opinion, the greater the temptation to be busy fools and justify our role as investors by taking action — any action.
For a variety of reasons doing nothing may be the hardest decision to come to, but it is often the right one.
A LOT OF INVESTORS ARE PROBABLY DISCOVERING THEY AREN’T NEARLY AS BRAVE AS THEY IMAGINED
IN PRACTICE, OUR APPETITE FOR RISK TENDS TO RISE AND FALL WITH THE FINANCIAL MARKETS