Sit tight and don’t be tempted by your prejudices
The famous response of the pilot when asked about his job is: “Hours of boredom punctuated by brief moments of terror. This applies perfectly to investing, with the brief moments of terror being the rise and fall of markets.
You could say that we have just had one of the worst nine-month periods in history, not only for equities but also for bonds and even more so for the popular 60/40 portfolio (60% equities, 40% bonds).
At this stage of the market, investors may feel the need to understand each security and the immediate impact it may have on their investments. And as we devour every article or watch every daily, weekly, and monthly decline and rise in our investment portfolio, it becomes extremely important to know and recognize our behavioral biases.
What is worse – action or inaction?
Our minds take shortcuts every day when making decisions. Like deciding to stick with a more familiar brand when purchasing an item. Usually these shortcuts are for the best, they help us react quickly and help us manage the thousands of decisions we have to make every day.
There are times, however, when mental shortcuts aren’t helpful and tend to lead us astray, and that’s when they become biases.
What is a bias? Behavioral biases are irrational beliefs or behaviors that can unconsciously influence our decision-making process.
The markets have been brutal and it can feel like they are only going one way, and that is down. Taking action seems like the only rational decision to make. A common bias is called action bias and is best explained by the feeling of “well, at least I tried”. This common solace can be comforting and justified in many decisions, but not in all circumstances.
In some situations, it may be better to do nothing.
The chart below shows the effect of switching to cash during a market downturn, using the global financial crisis as an example.
- An investor who capitulated and went cash during the crisis would have ended up with an investment portfolio of $160,096
- An investor who stayed the course would end up with an investment portfolio worth $523,740.
The difference amounts to $363,644.
In our mind, it hurts less to try something and lose than to do nothing and still lose.
During periods of market volatility, if investors do not calmly consider the appropriate course of action and give in to the action bias, it can objectively compound losses even though they subjectively feel better.
It is important to recognize that inaction is also an active decision.
Investors are inherently averse to losses, which means we hate losses more than we love gains.
One of the most well-known and often-cited behavioral biases is “loss aversion,” and it, too, can be particularly prevalent in times of market volatility.
A 20% portfolio loss seems much more intense than a 20% gain to many investors, and taking a loss is usually twice as bad as gaining the same amount is nice.
This strong emotional reaction to losses and the need to “do something” can cloud our judgment in times of volatility and it is essential to recognize that losses are part of a well-functioning market.
If the markets had never experienced losses they would not be risky, if they were not risky they would get really expensive, when they get really expensive they would suffer losses.
Learn to accept constant and guaranteed turbulence
Over the past 20 years, the average return of the S&P 500 and the All Share Index has been around 11% and 15% in rand terms. Investing our hard-earned money in the stock market would be much easier if we could count on an 11-15% gain every year without any volatility. But this is not the reality, and throughout our investment horizon we will have to endure constant and guaranteed volatility.
Historically, in both local and global markets, every year has seen a “terror moment” or decline and the chart below looks at the S&P 500’s annual returns (blue bars) and each year’s maximum decline (red dot) . The maximum decline shows the movement from the highest peak in the market that year to the lowest point.
This chart shows that every year of the 35 years saw maximum drawdown, while only 10 of the 35 years ended the year in negative territory.
Probably the four most expensive words in investing are “this time it’s different”
During a boom, greed dominates. After the accident, the residual emotion is fear.
If we look back, March 2020 was the most volatile month since the Great Depression. An overwhelming amount of headlines said “This time it’s different”, it was a pandemic, unprecedented times, markets would take years to recover, if they ever recovered. But it was the fastest recovery we’ve seen in stock market history.
In the 2020 sell-off, we hit a market low on March 23. Historically, it has taken the market about two years to recover from a decline of this magnitude. This time it happened in 149 days, and by the end of August 2020 the market had already reached new highs.
Now that we look back, it seems obvious that the market would recover.
Hindsight is 20/20
Many events seem obvious in hindsight, this is called hindsight bias. This bias tends to occur in situations where we believe (after the fact) that the onset of a past event was predictable and completely obvious, when in fact the event could not have been reasonably predicted.
Identifying when things are really different and when the collective madness of the crowd is in full force is the difference between missing out on a stock market rally or participating in one.
In an article by Morgan Housel, author of The Psychology of Money. Little Rules About Big Things, he talks about how important it is to remember that most of our lifetime returns on investment will be determined by decisions that take place during a small minority of time. Most of these times come when everything we thought we knew about investing is thrown out the window.
We all know we expect things like market volatility and inflation, but the emotions we feel when they happen can be even more dangerous than the market moves themselves.
Carefully Consider Both Sides of the Argument
Learning to embrace slowdowns is easier said than done. We tend to look for information that supports our beliefs, such as that the stock market will never recover, rather than looking for information to the contrary. This is confirmation bias in action.
Consider an example of confirmation bias investing. It’s December 2015 in the middle of Nenegate, the finance minister has just been sacked, the 10-year bond yield has just hit an all-time high of 10.4%, causing a sell-off in the bond market, and the rand depreciated to more than R16/$.
You have the feeling that South African bonds are on the verge of major losses and that the rand will continue to weaken, the economy is on the verge of collapse. You look for every headline or piece of research that confirms your belief and plan to shift your fixed income holdings into cash accordingly.
Just before making the switch, your financial advisor shows you the probability distribution of historical bond returns and points out that South African government bonds offer attractive value at this particular time. When you are presented with this data, you say to yourself “This is crazy, this would never happen” and you continue to modify your portfolio.
What happened in the following two years, between January 2016 and March 2018? South African government bonds returned 15.23% annualized, while cash returned 7.45% annualized over the period.
Remember to consider market noises and movements on both sides when reading the news or reviewing your investments. It may seem like the only decision is to move into cash in times of market volatility, but as we have shown above, the other side of the argument turns out to be much more cautious.
Turn on the autopilot and hold on tight
For investors, it is essential to recognize these biases and make good decisions in times of volatility. Making big changes when there has been no change in your time horizon, situation, or needs can hurt your long-term financial plan. Stay on autopilot during turbulence.
When stress and anxiety are high, it’s easy to give in to our biases and let them cloud our judgment. Research shows that understanding our biases can help us spot them in our decisions, which can add immense value to our financial plan over time.
When you find yourself questioning your investments and feeling depressed by the market, take the time to talk to your financial advisor, who will be in the best position to give you a realistic picture of what is really happening in the markets and actions – or inaction – would be best suited to your unique investment needs.-
Roné Swanepoel is Head of Business Development at Morningstar Investment Management SA.