Why do humans make poor decisions when it comes to their money? The study of behavioral finance attempts to shine light on this topic. Essentially, humans are flawed because our logical brain conflicts with our emotional brain and, as a result, we make the wrong decision or wait too long before making decisions.
How can investors best navigate this inherent conflict of interest during bull and bear market cycles? If I knew the exact answer I wouldn’t be writing this article; I would be on a beach somewhere enjoying the easy life.
Warren Buffett exemplifies an investor who has gone against the crowd and relied on his logical brain during times of market stress, buying stocks and investments when prices are significantly on sale or depressed. Buffett is often quoted as liking market selloffs because he can find bargains. His contrarian approach has resulted in investment gains well beyond those of most professional investors. We love his sage advice, and he has helped shape some of our decision-making for clients.
Left brain: More logical and analytical.
Right brain: More intuitive, thoughtful, and subjective.
Some folks decide to work with an advisor to help navigate the investment of their portfolio, and often experienced advisors can help clients put market cycles into perspective.
An advisor can put an imaginary wall between a client and her portfolio, which allows for more rational thinking during times of market stress. Many inexperienced investors left by themselves buy high and sell low, based on greed and fear overtaking rational left-brain thinking. A famous quote from Buffett, “Be greedy when everyone else is fearful, and be fearful when everyone is greedy,” is important to note here.
During the Great Recession, I had a client who called frequently during the two weeks when the S&P lost 25 percent of its value. Every day the market fell further, as investors saw pictures on television of employees leaving Lehman Brothers with their belongings after the investment banking firm collapsed. Market chatter rang louder and louder that the U.S. banking system could collapse without a government bailout. My client was unable to withstand the downside pressure and sold almost to the day at the bottom of the market, March 9, 2009. What investors should have done was stay invested or even buy at those low or extremely oversold levels. Stocks were on sale. I am happy to confirm that I had only one client sell out at the bottom, and the clients who remained in the market have seen their portfolios flourish.
More recently, the U.S. stock market selloff in late 2018 is starting to look like the precursor of a bear market cycle. We had a remarkable recovery at the start of the year. However, we have higher interest rates and a Federal Reserve that is determined to eventually hike rates further. The Federal Reserve did back away from its interest rate hike expectations and communicated it will be more data-dependent before hiking rates further. We also have a trade war with China, which may last longer than most expect.
Yet there seems to be progress being made on the trade front as well, with President Donald Trump extending the timeline for implementing higher tariffs. Both of these messages, the one from the Federal Reserve and one from the administration, are music to the ears of Wall Street. We shall see how long the music lasts and whether the last song is good enough to keep the stock market charging forward. The good news is the stock market usually is a good predictor of future economic activity, and we can often look to the market to gauge where the market and the economy are heading and adjust our outlook and client portfolios accordingly.
While there are several in-depth studies on the topic of behavioral finance, I like to look at human behavior in relationship to bull and bear markets. We have a strategy for clients when bear markets arrive. Remember, the stock market keeps score on a daily basis, but you don’t need to. Play the long game and invest in great companies, and ignore the negative right-brain chatter as much as you can, and your portfolio will advance beyond your wildest dreams.