From time to time we have guest posts on Validea’s Guru Investor blog from others who we admire, respect and are providing valuable insights to investors. Today’s post is from Joe Wiggins, who publishes the Behavioural Investment Blog and is Director of Liquid Markets at St. James’s Place Wealth Management, a multinational wealth management business based in Cirencester, England.
By Joe Wiggins (@BehaviouralJoe) —
Bear markets are an inescapable feature of equity investing. They are also the greatest challenge that investors will face. This is not because of the (hopefully temporary) losses that will be suffered, but the poor choices we are liable to make during them. Bear markets change the decision-making dynamic entirely. In a bear market, smart long-term decisions often look foolish in the short-term; whereas in a bull market foolish long-term decisions often look smart in the short-term.
If we are to enjoy long-run investment success, we need to be able to navigate such exacting periods. There are certain features of bear markets that it pays to remember:
They are inevitable: Bear markets are an ingrained aspect of equity investing. We know that they will happen; we just cannot know when or why. That they occur should not be a surprise. The long-run return from owning equities would be significantly lower if it were not for bear markets.
It will feel predictable: As share prices fall, hindsight bias will run amok. It will seem obvious that this environment was coming – the warning signs were everywhere. We will blithely ignore all the other periods where red flags were abundant and no such market decline occurred.
We won’t call the bottom: Market timing is impossible, and this fact does not change during a bear market. The only difference is the attraction of attempting it when portfolio values are falling can become overwhelming, and the damage it inflicts will likely be greater than usual.
Economic and market news will be conflated: The temptation to interlace economic developments with the prospects for stock market returns can become irresistible during a bear market. Weak economic news will make us increasingly fearful about markets, despite this relationship being (at best) incredibly tenuous.
Our time horizons will contract: Bear markets induce panic, which means our time horizons shorten dramatically. We stop worrying about the value of our portfolio in thirty years and start thinking about the next thirty minutes. Being a long-term investor gets even more difficult during a bear market.
We won’t consider what a bear market really means: In the near-term, bear markets are about painful and worry-inducing portfolio losses, but what they really are is a repricing of the long-run cash flows generated by a business / the market. The underlying value of those businesses doesn’t change anywhere near as much as short-term market pricing does.
Lower prices are good for long-term savers: For younger investors saving for the long-term, lower market prices are attractive and beneficial to long-run outcomes (it just won’t feel like it).
Some losses won’t be temporary: For sensibly diversified, long-term investors the losses from most bear markets should be temporary (there is a long-run premium attached to equity investing after all), but we should not naively assume that everything will recover. Injudicious or ill-conceived investment decisions will be exposed in bear markets. Inappropriate leverage, unnecessary concentration and eye-watering valuations tend to bring about permanent losses of capital that time will not heal.
Emotions will dominate: Our ability to make good, long-term decisions during a bear market is severely compromised. Rational thought will be overcome by the emotional strains we are likely to feel – what happens if things keep getting worse and I didn’t do anything about it? It is during such times that systematic decision making – such as rebalancing and regular saving – come to the fore.
Our risk tolerance will be examined: Bear markets are the worst possible time to find out about our tolerance for risk. Everyone becomes risk averse when they are losing money. The problem for investors is that living through a 37% loss is a far different proposition to seeing it presented as a hypothetical scenario. If possible, we should avoid reassessing our appetite for risk during tough periods.
We will extrapolate: During a bear market, it is hard to see anything ahead but unremitting negativity. Our tendency will be to believe that things will keep getting worse – prices will be lower again tomorrow.
Each bear market will be different: We should ignore all charts comparing current declines with other bear markets in history, they are entirely unhelpful. There is no reason to believe that such a deeply complex, unpredictable system should mimic patterns of the past. Each bear market is unhappy in its own way.
Bear markets are the ultimate behavioural test: The outcomes of bear markets are more about us than they are about the market. Investors entering a bear market with identical portfolios will have wildly different results based on the decisions that they make during it.
Equity bear markets make all the usual challenges of being a long-term investor that much more difficult. The noise of daily market fluctuations will become deafening, we will check our portfolios even more frequently and may find the urge to make short-term trades irresistible.
Everyone has an investment plan until they experience a bear market.