How to Deal with the Behavioural Challenges of Bear Markets

How to Deal with the Behavioural Challenges of Bear Markets

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

Against such a turbulent market backdrop, which behavioral issues should investors 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 equities investments are a result of their volatility and the risk of significant losses; in order to reap the benefits, investors must be willing to endure difficult periods. For most investors (particularly younger ones) it makes sense to reframe the issue – rather than markets falling steeply, they should think about the likelihood that long-term expected returns from risky assets are now materially higher.
  • Recency: Obsession with recent and salient issues means that they overwhelm one’s thinking. Whether it is wars, inflationary pressures 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 one thinks and feels they are at the time.  Investors should make investments such that they would have to leave them untouched and unseen for the next ten years.
  • Risk Perception: Investors are poor at judging risks.  They are prone to ignoring certain threats whilst hugely overstating others. Their judgment about the materiality of risk tends to be driven by its availability (how aware they are of it) and its emotional impact on them. The Russian invasion of Ukraine is a particularly damaging risk for investors because the magnitude of the impact is highly uncertain and it is deeply important.  Investors also need to be clear about what risks they 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 their long-term objectives?
  • Narratives: Although investors should be driven by evidence, many of the investment decisions they make are founded on convincing stories.  In times of profound uncertainty, this flawed feature of one’s decision-making becomes highly problematic.  It is incredibly uncomfortable to acknowledge that investors have no clarity around a major issue such as the Russia-Ukraine war; so, they construct stories to relieve their discomfort.  These narratives help them ‘understand’ what has happened, but also, more damagingly, give them undue confidence about what will happen in the future.  It is better to admit not knowing an issue, rather than concocting a story.
  • Overconfidence: In the past three months everyone has become an expert in diplomacy and economics, 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 war.  Investors shouldn’t make investment decisions that suggest they do.

In these environments, making sensible long-term investment decisions is highly likely to leave one looking foolish in the short term. This doesn’t mean one should not make them.  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 behavioral edge.

Source: How to Deal with the Behavioral Challenges of Bear Markets by Joe Wiggins

Asset Multiplier Comments:

  • In these uncertain times, the only thing investors can control is their investment process. So, investors should try not to get consumed by immediacy and noise.
  • One advantage of bear markets is that they allow you to buy quality stocks at high margin of safety. Fundamentally good companies tend to perform better in the long run so buying them at cheaper valuations may turn out to be advantageous.
  • Diversifying investments across various asset classes and sectors may help investors contain their portfolio risks.

Disclaimer: “The views expressed are for information purposes only. The information provided herein should not be considered as investment advice or research recommendation. The users should rely on their own research and analysis and should consult their own investment advisors to determine the merit, risks, and suitability of the information provided.”

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