Fear and Markets

It’s a bit auspicious that I am reading a book about behavioral economics at the exact moment global stock markets start roiling again. Richard Thaler’s “Misbehaving: The Making of Behavioral Economics” is a memoir of sorts. It explains the short history of this important field of study. The book was a gift from a sales contact at a fund management company. I can’t think of anything better to be reading at this exact moment.

A jaw dropping 1,000 point down open for the Dow Jones Industrial Average this morning followed a 6% decline in US markets last week. Wow, 1,000 points! That is the largest intra-day decline ever, if you are measuring in points. I vividly remember the 777 point drop in the heart of the financial crisis in September 2008. Was this morning’s drop larger than that? Today’s market hysteria quickly snowballed, and by mid-morning people were using a #BlackMonday hashtag on social media. I do not watch television during the day, but I imagine this term was plastered all over the 24-hour news shows as well.

Let’s take an enormous step back here. Black Monday refers to a Monday in October 1987 when the Dow Jones Industrial Average lost 22.6% of its value. In one single trading day, the market lost almost one quarter of its value. In contrast, this morning’s 1,000 point drop was only 6.6% of the market’s total value. A 22% drop today would be more than 3,700 points. Referring to today’s market as Black Monday is inaccurate and irresponsible.

Why is it that investors always whip themselves into hysteria over stock market corrections? A market correction, or drop of more than 10%, happens almost every calendar year. Yet time and again, investors seem surprised. Almost every investor today lived through the 2008-2009 financial crisis, a time when major market indices declined by more than 40% from peak to trough. We have the marks to show for it, too.

The answer to market hysteria is simple: Fear is a powerful emotion. One of the earliest discoveries in behavioral economics is that losing money feels twice as bad as winning the same amount. In fact, people exhibit risk-seeking behaviors when faced with a loss. When asked to choose between a sure loss, or a 50% chance of twice that loss or no loss at all, almost 70% of people choose the risk.[1] In simpler terms, humans are so pained by the thought of losing, they will risk losing twice as much just to avoid any loss at all. This sounds an awful lot like the gambler who doubles down at the casino.

The investing implications of this behavior are frightening. We are hardwired to react in a way that is detrimental to our financial health when markets scare us. The Dalbar study shows us every year that investors underperform the mutual funds they own. How is that possible? A large portion of the answer (and I don’t know the exact percentage attributable to this) is that investors sell out when markets drop and can’t decide when to get back in. By waiting on the sidelines, investors inevitably miss part of the recovery. By waiting too long, investors start to regret that they’ve missed their opportunity. I’m willing to bet there are investors today who never got back in to the stock market after 2008-2009. I wonder if they feel confident enough to buy today.

Fear, and our reaction to financial loss, is an overpowering emotion. Behavioral economists have the evidence to prove that humans react irrationally in these situations. Market corrections (10% or more) and bear markets (20% or more) are going to happen again in our investing lifetimes. Since no one can predict the timing of these market movements (believe me, if I could, I’d be on a desert island somewhere) the path of least destruction is to stay invested through all market cycles. I haven’t found an easy way to make money yet, and investing is no exception to that rule. The difficult times, like today, are the times investors “earn” their returns.

 

[1] Kahneman and Tversky, Prospect Theory: An Analysis of Decision under Risk, March 1979.