How to deal with the behavioural challenges of bear markets

By JOE WIGGINS

It is at times of severe market stress that our worst behavioural impulses come to pass. Whilst the recent losses in the value of portfolios are undoubtedly painful; the poor decisions that we will make as a result of the torrid environment will likely prove more damaging to our long-term outcomes.

Against such a turbulent market backdrop, which behavioural issues should we be most concerned about?

Myopic loss aversion

Short-term losses are difficult, but they are also an inevitable feature of investing in risky assets. Indeed, the high long-term returns from equity investment are a consequence of their volatility and the potential for severe losses – to enjoy the benefit you must be behaviourally disposed to bearing exacting periods. For most investors (particularly younger ones) it makes sense to reframe the issue – rather than markets falling precipitously we should think about the likelihood that long-term expected returns from risky assets are now materially higher.

Recency

Our obsession with recent and salient issues means that they overwhelm our thinking. Whether it is trade wars, Brexit or coronavirus. This is not to say that such issues are not important but from a long-term investment perspective they are less vital than we think and feel they are at the time. Try to make investments on the basis that we have to leave them untouched and unseen for the next ten years.

Risk perception

We are poor at judging risks. We are prone to ignoring certain threats whilst hugely overstating others. Our judgement about the materiality of a risk tends to be driven by its availability (how aware we are of it) and its emotional impact on us. The coronavirus is a particularly pernicious risk for investors both because the magnitude of the impact is highly uncertain and it is deeply salient. We also need to be clear about what risks we are considering when making an investment decision – is it the risk of short-term losses, the risk of being whipsawed by volatile markets, or the risk of failing to meet our long-term objectives?

Narratives

Although we should be driven by evidence many of the investment decisions we make are founded on compelling stories. In times of profound uncertainty this flawed feature of our decision making becomes highly problematic. It is incredibly uncomfortable to acknowledge that we have no clarity around a major issue such as coronavirus; so we construct stories to relieve our discomfort. These narratives help us ‘understand’ what has happened, but also, more damagingly, give us undue confidence about what will happen in the future. It is better to admit that we don’t know, rather than concoct a story.

Overconfidence

In the past three months everyone has become an expert in virology, despite having no previous grounding in the subject. It is okay to have an opinion, but the vast majority of people are guessing, and nobody knows the near term market or economic impact of the virus. We shouldn’t make investment decisions that suggest we do.

In these environments making sensible long-term investment decisions is highly likely to leave us looking foolish in the short-term. This doesn’t mean, however, we should not make them. Remember if we are looking to invest in assets that appear to have become materially cheaper it is almost certain that we will not call the bottom and things will get worse filling us with regret.

The advantage of being able to invest for the long-term is at its greatest when it is the hardest thing to do. The only way to benefit from this is to have a sensible investment plan that is clear about objectives and the decision-making process. Sticking with this through tough times can provide a major behavioural edge.