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Tuesday, August 3, 2010

Coping With Emotions in a Volatile Market

Yesterday's post elicited a comment from Shawn in which he asked "...I do wonder how investors can deal with the emotions of the roller coaster ride we have been experiencing." This is the most important question facing do-it-yourself investors and the present environment is a great test. One day the market is falling off a cliff, all the news is negative, and doomsday commentary is everywhere. You feel like the character in Edvard Munch's painting. It makes a normal person want to cash it all in and sit on the sidelines.

The next day we get a piece of positive news: different commentators argue that the economy is in a recovery mode and that the worst possible scenario is a slowdown - not the dreaded double dip.

In the background, the news du jour is the sub-par long-term under performance of stocks. Over the last decade, investors were not rewarded for taking on risk which, of course, undercuts one of the main tenets, supposedly (actually investors can expect higher returns for incurring greater risk), of investment theory. Then there is the ongoing argument that a bond bubble is building.

All of this, as Shawn implies, is causing the arrow on the emotions meter to register in the danger zone. Again, how does the do-it-yourselfer cope?

Well (I'm taking a big breath here), we do know a couple of things. First, the average do-it-yourselfer is not going to do well in this environment. Simply, some who are completely out of stocks today will dive in aggressively if the S&P 500 rises 400 points. We know that there are diyers who capitulate every time the stock market drops by triple digits and then jump in when it's up a couple hundred points. DIYers like to buy high and sell low and tend to chase the best performing sector. Today that's bonds.

This behavior is the result of DIYers focusing on prices and not on the underlying businesses. Simply, if DIYers are not going to put in the time and resource-consuming effort they need to understand individual businesses, they need to index and capture market returns. Focusing on the erratic day-to-day price movements of individual stocks in a volatile market would even drive the Fonz to lose his cool.

Secondly, the last 10 years have been highly unusual. Ten years ago was near the end of the best 3 years in the history of the stock market! It was the most bullish environment ever experienced in the U.S. Valuations were skyrocketing, investors were convinced that old valuation metrics were irrelevant, and the bubble was wildly over inflated. We're not in a stock bubble today. In my view, it is a mistake to fixate on the last 10 years.

Thirdly, it is easy to emphasize what we can see; and it is impossible to see what is around the corner. Typically, on the business front, positives have been around the corner.

Some perspective: when I was the age of many of today's personal finance bloggers, I had to carry boxes of punch cards to the computer center at the university and get my results the next day. If I had a question about house prices over the past 20 years, I went the library; I didn't google "house prices." Businesses didn't have PCs on every desk. People had to actually answer their phones and, if you wanted to see a TV show, you had to be there when it aired.

Today's world is completely different. And it will be very different in 25 years. In terms of products produced by businesses (notice I'm steering clear of politics and the fiscal mess we are in!), it will likely be much better. We'll have completely different automobiles, medical technology will be much improved (and may actually lower medical costs), and, yes, today's computers will be like "pong" is to today's games.

Thus, for me, when I put all of this together, I go 100% with the advice offered by the school of thought that emphasizes low-cost indexed investing. Give a lot of thought to risk tolerance, how much you need to reach your retirement goals, and structure assets accordingly. Then live life - don't let the ups and downs of daily stock prices on the computer screen mesmerize you. To me this is how the DIYer copes.


  1. "Thus, for me, when I put all of this together I go 100% with the advice offered by the school of thought that emphasizes low cost indexed investing"

    I completely agree with you. I also can't wait to see what cool things come down our way through the technology pipeline.

  2. Robert, you nailed it with emotions which have resulted in many losses to diyers. Letting your emotions roam free will simply make you follow the herd buying high and selling low with all of it ending in losses. Neutralizing your emotions on the other hand helps you ignore the noise and base your investment decision on fundamentals and the value you perceive. It's not easy to do. I mostly buy when we have triple digit losses during a day.

  3. Kevin & Mich: thanks for stopping by. In my opinion both of you have taken the most important step in investing - thinking about dealing with emotions. Having been in this business for a number of years and working with people through very rough markets (as well as euphoric markets) I can tell you that it is not pretty when people capitulate, start second guessing etc.

  4. Hey Robert,

    This is a great post. I think the immediacy of information today (and in the future) will make things a lot more volatile. That bodes really well for indexers who choose to dispassionately balance their portfolios. I've sold a lot of bonds over the past couple of months--rebalancing into stocks. I like what Graham said, "You pay a high price in the stock market for a rosy consensus."
    And the irony is this: there has NEVER been a good time to buy stocks when everyone felt safe and secure about great, high double digit returns. It's actually kind of funny, don't you think?

    Oh--and thanks for that link you put on Kevin's post. It was exactly what I was looking for. I have a Canadian example of rebalancing with indexes (stocks and bonds) with the Canadian Couch Potato historical returns, but I couldn't find an American example. Thank you!

    Kevin, if you didn't write your last post on indexes, I'd still be searching for what Robert put on your site.

    Gentlemen--thank you!

  5. RE: Andrew You're welcome on the link. I really like the so-called periodic table of sector returns because it so vividly shows how people who chase the hottest sector will under-perform. The Blackrock table is especially revealing because it shows how diversification dampens volatility. It is a starting point in my presentations in talking about risk tolerance.

  6. Phenomenal post Robert!!!! This certainly puts the impact emotions on investing decisions in perspective. This has really been quite challenging because what has transpired in the last 10 years really has eroded my confidence in much conventional wisdom. It is hard to know who to trust because many of the "trusted" pundits have this economic climate completely wrong. The longer term viewpoint does seem more rational. Very timely post!!!! Thanks for the link and for the detailed answer.

  7. Re: Shawn Thank you for getting my wheels turning on this important subject. One of my favorite books in this area is "Money & Your Brain" by Jason Zweig. If you haven't read it you may want to pick it up. It gives some really good insights into the psychology of investing.