Investor Psychology in Uncertain Times

Mar 25, 2020 | Warren Andrukow


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Good Afternoon,

I’m quite certain you don’t need another email reminding you that we are in a big mess right now. Obviously our portfolios and the economy have been impacted, but so too has our health and safety, and that of our loved-ones. As we grapple with the uncertainty we are facing, it can be easy to get drawn into an extremely negative narrative, that left unchecked can entice us to make decisions that will having lasting and negative impacts on our financial well-being. To date, we have focused on providing you with a fair amount of data – data that shows you how every major market setback has been recovered from, given enough time and discipline. Unfortunately, data is not always an effective tool when people are fearful. Today, we want to focus in on why markets have responded the way they have to the COVID-19 pandemic, and what we feel you should understand about investor psychology in times like this.

Before I begin, let me remind you that I am not a psychologist, but we do spend a great deal of time studying investor behaviour and psychology to help our clients (and ourselves) avoid some of the most common traps. In a recent blog post I detailed many of the most common traps – I encourage you to refresh your memory if interested. Here is a snippet from that post on the subject of loss aversion:

 

“…many of our mental tendencies, have their roots in evolutionary biology. The notion of loss aversion, is probably best explained by a well-worn (yet effective) analogy, which goes something like this: imagine one of our primal ancestors, roaming the savannas of Africa, when she hears a rustle in the grass beside her. Without giving the source of the sound any real consideration, our ancestor immediately scrambles up the nearest tree. Most likely the rustling sound was caused by the wind, but on the off chance it was caused by a lion, our ancestor was hard-wired to react very rapidly, to even the slightest hint of a threat. Fast forward to today. Most of us at least, no longer face the threat of a lion in the grass, but our brains react just as rapidly to perceived threats. In fact, psychologists have found that we experience twice as much pain associated with a loss of X dollars, as we would experience joy from an equal but opposite gain of X dollars. Putting this in terms of investment returns, research shows that we appreciate but forget gains, while our losses can haunt us forever. This can lead investors to be overly cautious, and paralyzed by an endless stream of negative business news, when in reality, they are best served by sticking to their investment strategy, come what may.”

 

I anticipate that many of you may be thinking, “yeah, but this is different, we have never seen a pandemic like this…”. That is true, almost no one alive has seen a global pandemic in their lifetime, especially of this magnitude. However, we have lived through many periods of great uncertainty, and that is why drawing comparisons to past market downturns remains a relevant exercise. Downturns all have one root cause – the behavioral response humans have to uncertainty, which causes markets to decline. At their base, financial markets are a forward-looking machine that gathers information and opinions from all market participants and rapidly incorporates the information into security prices. This includes the long-term effects of COVD-19, as well as ongoing geopolitical factors such as trade agreements, oil prices, interest rates, the upcoming US elections, and on and on. To say that markets are complicated, is an understatement. Back to uncertainty – above all, markets abhor uncertainty, which we currently have in spades. When things become very uncertain, people begin to respond with the same fight or flight response discussed earlier, and a herd mentality can begin to develop. We saw this last week when everyone decided to go and buy a month’s worth of groceries on the same weekend. Many of those people were likely thinking that their emergency shopping trip was possibly an over-reaction, and that the food supply would persist. Then again, those same people likely also thought that if everyone is buying groceries, they don’t want to be the one left without a can of beans… i.e. herd mentality. The natural comparison here is to follow those selling all of their investments. The normal thought is that maybe, just maybe, they’re right, and we should join them. Well, we shouldn’t.

Those of you old enough to remember the dot-com crash of the early 2000s, the financial crisis of 2008-09, and the more recent turmoil the markets experienced in the fourth quarter of 2018, will remember that those events seemed to have come out of nowhere. It also seemed as though they would never end, and that there may be no hope of recovering the losses. You might also remember that the so-called experts, though more vocal than ever during times of uncertainty, endlessly sharing their forecasts and recommendations, were more often wrong than right. I hope you know us well enough to understand that we cannot offer you any tangible predictions as to when this might end, nor can anyone else. We can, however, remind you that in times like these, eventually the uncertainty that got us into this mess will subside. The human spirit will prevail. We will continue to innovate, start businesses, better ourselves, and push for a higher standard of living for all. These truths will help those who remain disciplined get back what was lost, at least financially. To borrow a quote from a revered leader in the investment and financial planning industry, Bob Veres:

“I know only one thing: which direction the next 100% movement in the stock market is going to be”.

When fear and uncertainty subsides, the other dominant human emotion will begin to control the markets: greed. As in past downturns, once the herd decides that the “all clear” signal is imminent, no one will want to be left behind, and everyone will rush in simultaneously. This will likely occur long before we rid ourselves of COVID-19 – more likely this will occur while COVID-19 is still a very real threat, but once it becomes clear that an end is in sight. We can confidentially make this prediction, but only because we are not attaching a timeline to it. That means we must remain in our seats if we want to participate in the rebound, come what may in the short-term.

I realize that human emotions are complicated, and that a few paragraphs on behavioral finance may be woefully inadequate at addressing the concerns we all face today. Please know that my team and I are eager to provide you with sound advice that will help us navigate successfully through this crisis together.

As always, please do not hesitate to reach out with any questions or concerns you may have. We wish you the utmost health and wellness.

Warren