Bear Market Behaviour And The Emotional Risks For Investors

17th Dec '18 by Ben Hobson

6 comments 4537 reads

There was a good line in a post by the American blogger Ben Carlson back in February 2018. At the time the stock market was in ‘correction mode’, and he made the point that investors always need prepare for turbulence if they’ve got any chance of riding out the pain of falling prices. He wrote: “No amount of one-liners or Warren Buffett quotes are going to save you during a downturn if you haven’t planned for it to occur ahead of time.”

Part of the reason why planning is important is that emotions and bad behaviour can run riot in the stress of a correction (or a crash or even a bear market). Without a plan or a process, there’s a risk that instincts will lead to poor (and potentially expensive) decision making.

In his book Anatomy of the Bear, Russell Napier points to research by the finance professor Jeremy Siegel, who has studied total real returns dating back to 1802. Siegel’s work shows that in order to not lose money in the stock market, all you need to do is hold for 17 years. History suggests, according to Siegel, that if you can ignore market prices for some time less than 17 years, “the bear will simply go away”.

But as Napier says: while everything comes to those who wait, “few investors are sanguine enough to ignore market movements for 17 years”. One study in 2005 showed that the average holding period of the 84 million stock owners in the US is just 12 months. That confirms the view that when it comes to investing, it’s more instinctive to ‘do something’ than it is to sit on your hands and do nothing.

Bad behaviour

Since the start of October 2018 the FTSE All Share has fallen by around 9.8 percent (and it’s down by 13.9 percent from its 2018 peak in May). Meanwhile, the US S&P 500 is down by nine percent since hitting a high in October and the FTSE Eurofirst 300 is down by about the same.

With political and economic turmoil ahead, the UK in particular is heading towards the year-end with a fair amount of uncertainty about where markets might go next.

In uncertain times, it’s worth remembering some of the big behavioural errors that can be triggered when equity prices start spiralling. Here are a few of the most…

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mmarkkj777

17th Dec '18

Thanks for your post Ben. Some really good points to consider.

I went mainly to cash in October (leaving me about 11% down for the year at the time).

I've noticed that I have allowed my invested level to creep up to 20% (from 15% invested) since end Oct, as I was trying to spot new emerging bargains. The problem is the falling tide has dropped all my other shares lower over the last few weeks. I have been finding a few which have managed to swim against the tide, but, the problem is, I have been over occupied with these and allowed some of my bigger holdings to drift down reducing the overall value of my holdings further. I now wish to cut my share holding back to the 10-15% level again.

I want to reduce my risk to manageable levels whist continuing to be in the market to a small extent, ready for the upturn (whenever it happens).

I'm sure many investors are juggling with the same issues and decisions. It's about damage limitation I guess until the tailwind of a rising market returns.

Mark.

GregC

19th Dec '18

Thanks Ben

Loss aversion is a universal feeling and having recently read Peter Bernstein's book, Against the Gods, it now understand the mechanism behind it. I highly recommend the book.

Imagine our wealth to be a tower of bricks with each brick slightly smaller than the one below. When we have only one brick, adding another is a very valuable event and certainly losing the only one we have is to be avoided. This is loss aversion at the extreme. What if we have say, 1,000 bricks? Adding another will have a much smaller relative impact which is why, if you are fortunate to have a lot of something good, adding a bit more is well, not that exciting, However, losing always means that ever bigger bricks are being discarded from the tower and it is this that makes up so unhappy about losses.

Regards

Greg

timarr

Loss aversion is a universal feeling and having recently read Peter Bernstein's book, Against the Gods, it now understand the mechanism behind it. I highly recommend the book.

It's a great book, well worth the effort. Bernstein was a great writer on difficult topics.

Loss aversion is a bit more complex than that, though. Roughly we hate a loss twice as much as we love a gain: this was the first, and one of the most important findings of behavioural finance, as it breaks the traditional economic model of people behaving identically in the face of equal losses or gains.

One outcome of loss aversion is the disposition effect which leads us to sell winners to harvest gains and to hold losers in order to avoid crystallising a loss. That tends to lead to underperformance in bull markets as people sell winning stocks that carry on gaining and in bear markets where they hold losing stocks that keep on falling.

This is closely related to another bias, anchoring, where we attach to a specific price level - either a buying price, which we won't sell below, or a peak portfolio value which we compare future returns against. This applies regardless of our total net worth.

Research has shown that the areas of the brain that respond to pleasure and pain are stimulated by these behaviours. Typically people will keep on holding as markets fall in the hope of recouping their gains until the pain becomes too great and they capitulate, usually as markets are turning.

Broadly people need to either have short-term triggers to sell on a market fall or need to position themselves to ride out a bear market (which obviously means avoiding holding blue sky, speculative stocks). Both approaches lead to decent medium term performance although people who like trading in and out also tend to suffer as markets ratchet down in a series of steps - remember the biggest one day falls and the biggest one day rises happen in bear markets.

Broadly, then, it's the hope that kills. However, patience, and a sensible approach to stock selection, will eventually win out.

andyfwwrench

This is an area where folk law is much more actionable than more complicated advice. Just three rules, protect capital at all costs, never catch a falling knife, and the trend is your friend. These can be set biggest lie told by the financial industry is that it is impossible to time markets; see also the poison words time in the market not timing the market.
The mathematics of losses are simple, a 10% loss requires an 11% gain to recover, a 20% loss requires a 25% gain, a 50% loss requires a 100% gain, and a 90% loss requires a 1000% gain. In a secular up-trending market gains of 10-25% abound, indeed are almost everywhere. In a secular down trend they are almost nowhere. The power of the small investor is to be able to liquidate almost instantly without moving the share price; micro cap excepted. Use that power to exit anything that isn't working, i.e. that has moved lower than its natural volatility envelope, as soon as possible. Taking losses (and of course profits) this way is both invigorating and empowering. Eventually it becomes an emotionless kill. Back analysis will demonstrate that in the vast majority of cases it was the correct thing to do.
Stocks and markets move, consolidate, then move again. The consolidation areas are the inflection points. After consolidation price will show its direction, which is to be respected. Price will tend to anticipate a change in fundamentals, which is why cyclical stocks tend to be cheap at the top and expensive at the bottom. This is exactly what happened in the US in the summer, with GDP growth at its peak the market slowed and consolidated. Even absent a recession growth will slow, and revenues and profits will undershoot those derived from linear growth models. SP500 has now broken down through a year long consolidation, and companies, latest example Fedex last night, are guiding down expectations. There will be ample signs when a market reverses, and ample signals in the lead up. In the meantime one has to accept a lean time in terms of gains, but with the capital to take advantage of the next up trend.

DaviStoVest

Hi andyfwwrench,

There is a reason why we break down text into paragraphs ... as your post amply displays.

I am sorry ... although I tried, I have no idea whatsoever what you were arguing.

Metatron

Bear market or not ,technical anaylsis or not I find it difficult to sell stocks labelled 'superstocks` unless new news occurs that changes the fundamental story .

Bear market behaviour and the emotional risks for investors

Bad behaviour

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Ben Hobson

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