One of the nation's top-ranked money managers, Jim Stack takes a "safety-first" approach to investing. Here, the editor of InvesTech Research offers a "must read" overview of behavioral finance—outlining the psychological factors most evident at various stages of bull and bear market.
In most economic reports today—from leading indicators, to consumer confidence, to the latest employment data—the news has become so positive and so euphoric that it is difficult to find any clouds on the horizon.
Therein lies the problem or dilemma for investors. How does one justify implementing portfolio defenses when it seems that none are required? The only way to answer this question is to venture backward in time and examine stock market history. So here, we step into the psychological aspect of investing.
Behavioral finance attempts to understand and explain stock market movements by incorporating investor psychology.
This differs from traditional finance, which is grounded in economic theory and assumptions. At its core, traditional
finance is based on three key premises:
* Investors are risk-averse. This means that when faced with two investments with a similar expected return, investors will consistently prefer the one with lower risk.
* Investors are rational. This means that individuals will always try to obtain the highest possible personal economic well-being without regard for anything else.
* Markets are fully efficient. This assumes that stock prices continuously incorporate all available and relevant information.
The reality is that as human beings, investors are genetically predisposed to behave irrationally. Rather than make assumptions, behavioral finance focuses on market observations (e.g., bubbles and crashes) and draws conclusions from the data.
To better clarify behavioral biases and how they play into the picture, we have broken down the market cycle into four distinct phases: Early-Stage Bull Market, Late-Stage Bull Market, Early-Stage Bear Market, and Late-Stage Bear Market.
Early-Stage Bull Market
As stocks begin to emerge from a bear market, investors feel battered and bruised by the long severe carnage. Those paying any attention to the media will invariably be scared and skeptical. While investors should view such a period as the investment opportunity of a lifetime, they instead suffer from two key behavioral biases:
* Loss-Aversion Bias (Oh-No!): At this point, fear of further loss is far more powerful than the desire for gain. Unfortunately, this behavioral bias is most detrimental to investors at the best buying opportunities. As stated by Warren Buffett, “Be fearful when others are greedy and greedy when others are fearful.” Easier said than done.
* Status Quo Bias: People find it easier to do nothing (maintain the “status quo”) with their portfolio rather than make changes. After bear market crashes, people prefer to keep things the same and tend to avoid looking for opportunities. As bear market bottoms tend to be rather abrupt and v-shaped in their reversals, this behavioral bias can cause investors to miss the most profitable portion of a new bull market.
Early-Stage Bull Market
Contrary to early-stage bull markets, late-stage bull markets are feverish affairs. Surveys that analyze consumer confidence tend to reach meteoric levels as highlighted by the chart on the right from the University of Michigan Consumer Survey. Market valuations become stretched and headlines reflect excessive optimism.
The current bull market is exhibiting many of these typical late-stage phenomena. Below are two behavioral biases that are apparent at this stage of the market:
* Overconfidence Bias: Investors become overconfident and demonstrate unwarranted faith in their own reasoning, judgement, and abilities. Risks are significantly underestimated and expected returns are significantly overestimated.
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* Self-Control Bias (FOMO): At this point in the bull market, people fail to act in pursuit of their long-term investment goals due to a lack of self-discipline. Instead, greed takes over and long-term risk management strategies are exchanged for short-term satisfaction. As market historians, we’ve seen this behavioral bias rear its ugly head time and time again. The loss of self-control at a market top can be devastating to an investor’s portfolio.
Just as investor behavior can be irrational during bull markets, bear market cycles may also exemplify unique cognitive biases. Additionally, the elongated time frame of bull market tops creates distinct challenges –and opportunities– for investors as many bull markets tend to end with a whimper rather than with a bang.
Early-Stage Bear Market
The beginning of a bear market is generally a drawn-out process. In fact, as highlighted by the chart at right, the average bull market top since 1950 has taken approximately six months to evolve and fully confirm we are entering a bear market. This slow and painful process brings with it these key behavioral biases:
* Illusion of Control Bias: Individuals believe that they can control or influence outcomes, when in fact, they cannot. During the lengthy topping process, many investors trade excessively under the false impression that they can control the outcome of their investments. Needless to say, this is ultimately a futile effort.
* Anchoring Bias: Investors unconsciously establish a price level –an “anchor”– which becomes the baseline on which all decisions are based. For example, as the bull market begins to fade, the most recent market top becomes the target investors believe they need to reach in order to sell their shares. This idea of getting back to an upside target can lead to large portfolio losses and an inability to properly assess the weight of the evidence in the bear market downturn.
While drawn-out market tops create the above biases that trap investors into holding on, they also offer an opportunity for the few who are actively watching for warning flags to proactively implement bear market defenses.
Late-Stage Bear Market
Rather than the uncertainty experienced at the beginning of a bear market cycle, late-stage bear markets are often extremely volatile. The table to the right highlights this fact, as it breaks the bear market period down into thirds. Since 1960, the final third experiences approximately 60% of total bear market declines as investors panic into the bottom. This brings us to our last behavioral bias:
* Herd Behavior: Herding is the common tendency for individuals to copy the actions of the larger group, regardless of whether it’s rational or not. These types of actions result in large market downdrafts which many times carry stocks far below what would be considered fair market value. Investors finally decide to bite the bullet, which often leads to capitulation selling at the bottom.
With leading economic data suggesting that good times are set to keep on rolling, investors’ “Fear of Missing Out” (FOMO) once again appears to dominate the current market psychology after last month’s brief correction. Yet, the signs of excess and speculation highlighted in previous issues have not resolved, and some potential warning flags are precariously close to waving.
Mature bull markets are emotional traps. In the absence of economic storm clouds, and with the painful lessons of the previous bear market long forgotten, most investors treat today’s market as if it is riskless. It’s not!
From both a historical and psychological perspective, we have few doubts that this is a “late-stage bull market.” It is likely that inflationary pressures, the dollar, and Federal Reserve actions will play a decisive role in how this market top develops.
We have increased our cash reserve in recent months in response to the rising level of market risk. And as mentioned inside, we continue to watch closely for bear market warning flags. Our objective is to be proactive and preemptive in implementing defenses before major trouble strikes.
