With so much uncertainty and speculation surrounding the markets; a trade war on the horizon; with more than $10 trillion worth of bonds globally at a negative yield; and the prospect of a market crash, volatility comes as no surprise. Making extreme changes to portfolios, such as capitulating and selling everything to go to cash, has historically proven less fruitful in accomplishing long-term objectives. Short-term tactical changes can lead to a better long-term result, and market ups and downs typically are no reason to panic. As evidenced through historical analysis and fervently vocalized by Warren Buffett, owning and holding good companies and investments are likelier to pay off in the long-term, which is why behavioral investing during market uncertainty is an important consideration. However, “Las Vegas is busy every day, so we know that not everyone is rational.” – Charles Ellis
Behavioral Finance & Investing
If Men Are From Mars and Women Are From Venus, from what planet is the investor? The fundamental psychology of people and their distinct ways of responding to stressful circumstances has been questioned and addressed for years, in hopes of developing solutions for dealing with stress factors and how people respond to one another, news and the markets. Behavioral finance investigates the influence of investors’ psychology, their lack of self-control and its effect on the markets. There are pitfalls to making extreme changes to portfolios based upon sharp sell-offs, and it is imperative that advisors and investment managers address behavior when constructing investment portfolios. On average, the market sees a 10% correction approximately every 18 months, so it is a common occurrence even in a secular bull market like we’re experiencing today to encounter a correction from time-to-time. It is vital for investment professionals to address investor angst in curbing panic, overreaction and irrational selling, because selloffs create a snowball effect. Behavioral investing is an effort to bridge the gap between one’s psyche and the pitfalls that may take place during corrections, recessions, bubbles popping, crashes – those stressful times of investing. History has given us many examples of periods in time where lack of constraint, ego and emotion have proven costly. Let us explore a few of those instances and thereafter, I will touch on the differences between a correction, bear market and crash.
Crashes & Burns
1873 – The Vienna Stock Exchange Crash was largely caused by economic factors such as the demonetization of silver, American Post Civil War inflation and speculative investments, overwhelmingly in the railroad industry. Railroad construction was the craze in 1873, involving abnormal growth and a great deal of risk, which put a massive strain on bank reserves. As big banks were anxious for more capital and heavily investing in railroads, public speculation began to mount and set off a chain reaction of panic selling that led to a massive fall in share value, putting an end to economic growth in Europe.
1929 – The Wall Street Crash on October 29, 1929, was triggered by reckless overconfidence in the US stock market and its sustainability of economic growth, the collapse of share values and banks. The “Roaring Twenties” economic period of prosperity gave way to an irrational eagerness for the public to capitalize on wildly overpriced stocks that led to an asset bubble. Unemployment was low and working-class citizens with little investment acumen became interested in investing. Banks were allowing purchases on margin with as little as 10% down for share value. As banks were giving out easy credit, the government raised interest from five to six percent which created public unease. Subsequently, the market crashed and as panic sell-offs took place, so did investors’ liquidation of banks. Bank officials had given away loads of credit and invested so much in a collapsed market that they were unable to return funds to investors. Many lost their life savings and banks and companies went bankrupt, leading to the Great Depression. A worldwide collapse in share values was the result.
1987 – Black Monday occurred on October 19,1987, following a long-time rally, trade deficit, a weakening dollar, hiked interest rates and tensions between the US and Iran. And when stock prices in the US took a one-day decline of 22.6%, nothing screamed panic more than first-time media coverage of worldwide traders agonizing over the markets. Although this crash did not result in an economic recession, its effect was felt around the world beginning in Asia, next in London, then the United States. Modern computerized trading exacerbated the selloffs, and this “Flash Crash” taught investors that future investment portfolios should be diversified and built to withstand extreme conditions.
1990’s – The Dotcom Bubble was centered around technological advancements, namely the internet, where investors sought out online businesses (i.e. ‘dotcoms’) to invest their money. The assumption at this time was that all online businesses engaging in e-commerce would be successful, and overconfidence in a dotcom business name led to reckless investing. This overconfidence, cheap money and easy capital commanded a dotcom bubble that burst in March of 2000, following a $5,048.00 NASDAQ peak, as some of the leading tech companies like Dell and Cisco placed large sell orders and prompted panic selling. This panic selling triggered a 10% stock market loss, and many tech companies became worthless in a matter of months.
2008 – The Housing Bubble & Financial Crisis was caused by the deregulation of the financial industry that allowed derivative trading, interest-only loans on mortgages, and an increased Fed rate. As the number of homes outpaced demand, panic swept the financial system and home prices plummeted as people were unable to meet mortgage obligations. Financial institutions were afraid to loan to one another, fearing lack of repayments; and as homeowners and companies heavily borrowed, many banks had to file bankruptcy. Subsequently, the government provided bailouts and despite this effort, stock markets around the globe fell, and we are still feeling the effects today – making evident the necessity to be rational during times of volatility.
Crash Course on the Market
Investing is a complicated sport and market ups and downs are part of the game. How you play the game and respond to volatility is the difference between winning and losing. The point I am trying to drill home is that panic selling is not the way to go. A market correction does not always mean we are heading for a crash. Corrections, as defined by a market falling more than 10%, happen frequently. It’s not the end of the world. A correction typically spawns from some sort of catalyst like a US-China trade war. Markets loathe uncertainty, so when the market receives bad news, investors panic, which then leads to more selling; the next thing you know, the market (or security) has sold off 10%. Corrections give investors pause, and get them evaluating their current investment strategy. Investors typically stay the course, stop putting eggs in certain baskets, or continue selling everything. My belief is strongly tied to staying the course, with one caveat; corrections often times create opportunity to make portfolio adjustments, and opportunistically make small tactical adjustments that may prove beneficial. It’s like going to your company party that starts at 7pm and you’re averaging one drink per hour. Then you realize that the party ends at midnight, and you re-evaluate the pace at which you’re drinking so that you don’t make a fool of yourself and can last the duration of the party. You apply a correction to the pace at which you are drinking – say 10% – you’ve adjusted your behavior and are back in action!
Traditional corrections occur before a bear market correction and are more devastating to a portfolio because they are defined by a drop in value of 20% or more. Bear market corrections also occur commonly in a secular bull market like we experienced 4th quarter last year. Typically, these are catalyst driven like fear of growth and recession, and are overreactions to anxiety, downward pressure and not being comfortable. But like a 10% correction, it’s important to stay the course. Such corrections typically occur when a large institutional investor sells their shares to capitalize on the profits. This creates panic amongst the average investor who sees the stock price drop, triggers fear and speculation, and leads to more selloffs. A bear market occurs roughly every 3.5 years, and once worry subsides usually within one year following the bear market, losses are recouped and the market resumes is ascension. Recoveries like we experienced in the first four months of this year are not the normal type of recovery. However, given the magnitude of last year’s bear market was driven by irrational selling, it wasn’t too surprising to witness the veracity at which it recovered.
Crashes are virtually impossible to predict, but generally are accompanied by a recession. By definition, a recession is an economic slowdown involving two consecutive of negative GDP growth and typically see a rise in unemployment, restricted purchasing power and bankruptcies. It’s during these situations, an investors’ grit is tested the most. Maintaining your conviction to your long-term investment strategy, and proper and adequate diversification are paramount. When volatility spikes and stocks sell off, diversification across multiple asset classes help limit an investor’s downside or loss. While that sounds nice, I find it helpful to add some context because minimizing loss helps reduce the amount of time to recoup those losses when the market recovers, and reduces the required gain needed to get back to whole. For instance, if an investment falls 20%, a 25% return is required just to get back to even. However, if an investment only falls 10%, only an 11.13% return is needed to make up the losses. It’s also important to point out that you always need more in gain than you lost. From my experience, when investors panic and capitulate, by selling everything and going to cash, they derail their long-term goals and objectives. Often times they are selling at the market low. Fear forced them out of the market, and that same fear often keeps them out too long; they fear the market already rebounded too much and miss their opportunity, so they stay on the sidelines far too long.
JP Morgan does a great job of demonstrating the importance of both diversification and emphasizing a long-term investment focus by maintaining conviction to your investment strategy. Below are two charts. The top chart shows two portfolios compared against the S&P 500. One portfolio is moderately conservative with an allocation of 40% stocks to 60% bonds, while the other portfolio is slightly more aggressive, but balanced, with 60% allocated to stocks and 40% in bonds. The chart illustrates the difference in movements between the S&P 500 and the two respective portfolios from the peak of the market in October of 2007, to the trough (bottom) in March of 2009. The chart also indicates the recovery time of each portfolio for the losses to be recouped. As you can see, the S&P 500 fell far more than either portfolio and took more than two years to recover its value. The second chart speaks to keeping the course and benefits of maintaining a long-term, strategic asset allocation. This chart shows 20-year annualized returns by asset class (i.e. S&P 500) and by portfolio (i.e. 60/40). I want to turn attention to the “average investor” on the chart below. The 2.6% annualized return is a measure of investor behavior, and represents the annual return an average investor receives when they fall victim to common investment behavior faux pas. Compare that return to the 60/40 portfolio return of 6.4%, and we’re talking about a significant deviation in outcomes over the long haul. That’s a difference of 3.8% per year an investor would’ve earned had they sustained their long-term investment focus. In dollar terms, over the 20-year period on an initial investment of $10,000, the average investor’s investment would be worth $16,709, while the investor who maintained their 60/40 balance would have $34,581. The power of compounding is a beautiful thing.
So if nothing else, after reading this novel of a blog, please remember to stay diversified. Try and refrain from making knee-jerk reactions, and contact a trusted advisor who can hold your hand through all the noise, who talks you off the ledge, reminds you why you invested, and what you’re trying achieve.
Follow me on twitter https://twitter.com/ChrisOsmondCFA
The preceding commentary is (1) the opinion of Chris Osmond and not necessarily the opinion of PCIA, (2) is for informational purposes only, and (3) should not be construed or acted upon as individualized investment advice. Past performance is no guarantee of future results. Advisory services offered through Prime Capital Investment Advisors, LLC. (“PCIA”), a federally registered investment adviser. PCIA: 6201 College Blvd., 7th Floor, Overland Park, KS 66211. PCIA doing business as Prime Capital Wealth Management (“PCWM”) and Qualified Plan Advisors (“QPA”).
Chris Osmond is the Chief Investment Officer at PCIA. Bringing 13 years of experience to his role, Chris has won numerous awards for his work in wealth management and financial services. Chris received his Bachelor of Science from the University of Arizona, and is a Certified Financial Planner, as well as a Chartered Financial Analyst.