BEAR MARKETS ARE A TEST OF INVESTOR EMOTIONS.

In a bear market it can be impossible to escape the pervasive negativity. Not only will our portfolios be falling in value, but there is likely to be an incessant flow of news highlighting the harsh realities of the prevailing backdrop. Dealing with this is not just an uncomfortable experience, it changes how and why we make investment decisions. BTW: There is also a German translation available .

Our ability to make consistent and considered choices can quickly be overwhelmed by the negative emotions we experience; be it fear, panic or anxiety. It does not matter how many charts of past market declines we have seen; it won’t appropriately prepare us for the challenges of a severe bear market. It is critical that we don’t ignore the emotional demands of investing through such exacting market conditions.

There are three pivotal means by which the emotions evoked during a bear market can lead us astray:

EMOTIONS CAN DIVERGE FROM RATIONAL ASSESSMENT

In 2001, George Lowenstein and colleagues proposed the ‘risk as feelings’ hypothesis; it’s contention was that “emotional reactions to risky situations often diverge from cognitive assessments of those risks”.[i] Not only do emotions impact decisions, they can dominate them; leading us to make choices contrary to what we would rationally believe to be the best course of action.

There are three critical elements of the hypothesis that are relevant for investors and the emotional strains of bear markets:

• The strength of our feelings is closely linked with vividness – the more powerful and salient the images and stories are, the greater our emotional response will be.
• Our fear will increase markedly as we approach “the moment of truth”. There will be no comparison between how we feel about knowing there will be a bear market in the next ten years and being in one right now.?We are likely to hugely understate how much emotion will impact us prior to actually experiencing such a negative scenario. Bear markets are easy to navigate on paper.
• The feeling of fear and a heightened sense of risk will be amplified by the behaviour of other people. Anxiety and panic in others will create a damaging, self-reinforcing feedback loop.

Bear markets are a breeding ground for emotions-based investing. We won’t anticipate how we will feel during them, we will be besieged by intensely negative stories (and realities) and be surrounded by investors reacting in a similar fashion. It is no surprise that they can transform our decision making.

EMOTIONS CAN PROVOKE RAPID, SHORT-TERM DECISIONS

Psychologist Paul Slovic and colleagues suggested that individuals use a mental shortcut called the affect heuristic, which can lead to rapid, emotion-led decisions. [ii] Here, how a situation makes us feel generates an automatic, rapid response that serves to “lubricate reason”.

The severe negative emotions that we may experience during a bear market, such as fear or dread, leave us vulnerable to overstating the risks of a given situation (because we gauge it based on the severity of feeling). It is also likely to drastically contract our time horizons – the heuristic pushes us towards dealing with the emotion that we are feeling in that moment.

As with most heuristic or instinctive decisions, it is easy to see its underlying usefulness. Acting rapidly to respond to strong emotional cues (particularly related to danger) is clearly an effective adaption in many instances, yet one that inevitably undermines our ability to withstand periods of market tumult or invest for the long-term.

EMOTIONS CAN CAUSE US TO IGNORE PROBABILITIES

Although investors are not renowned for their consistent use of probabilities, strong emotions can make this problem significantly worse.?In 2002, Cass Sunstein wrote a paper on probability neglect, in which he argued that when powerful feelings are stirred our tendency is to disregard probabilities.[iii]?In particular, salient examples of disastrous, worst-case scenarios tend to overshadow the consideration of how likely they are to occur.

Sunstein offers the example of a study where participants were asked about their willingness to pay to eliminate cancer risk.?Across the subjects both the probability of cancer (one in 1,000,000 or one in 100,000) and its description (clinical or emotional) was varied.?When cancer was described in in a vivid and “gruesome” manner, the impact of a tenfold change in its likelihood on the willingness to pay to remove the risk was markedly less than when the disease was described in non-emotive terms. Simply altering the wording to provoke emotion – in a hypothetical setting – rendered individuals far less sensitive to changes in probability.

In a bear market our fears will be amplified by the inevitably lurid stories of how much worse things will get. Our ability to reasonably assess the likelihood of future developments will be severely compromised. Strength of feeling will outweigh strength of evidence.??

HOW CAN WE DAMPEN THE INFLUENCE OF EMOTIONS?

There is no easy or failsafe solution to diminish the impact of emotions during difficult market conditions, but there are some steps that all investors should take.

Although we cannot replicate the lived experience of a severe market decline, we can better prepare ourselves for their unavoidable occurrences. It is very common for investors to be informed of a reasonable expectation for losses over a cycle; for example: ‘with this global equity portfolio you should expect periods of drawdown of at least 40% over the holding period’.?Yet this type of framing does not go far enough.

The presentation of an anodyne historic number is no guide whatsoever to what this sort of loss actually means and how it might feel. While we will never anticipate the precise cause of a bear market, we do know that it will often arrive amidst ceaselessly negative news, bleak forecasts about the future, some cataclysmic predictions and perhaps a recession with all that entails. Investors need to prepare as best they can for the emotional realities of losses and be forewarned of what a period of severe decline might mean about the broad backdrop.?

As we are currently experiencing a challenging market environment, now is not the ideal time to plan for how we might cope with one in the future. So, what can we do now to ward off the dangers of emotion-laden decision making?

There are two key behavioural actions. First, is to remove ourselves from emotional stimulus – turn off financial market news and check our portfolios less frequently. Long-term investors should stop doing anything that provokes a short-term emotional response. Second, we should never make in-the-moment investment decisions, as these are likely to be driven by how we feel at that specific point in time. We should always step away and hold off from making a decision, and reflect on it outside of the hot state we might find ourselves in.

These actions are no panacea; we cannot disconnect ourselves from the impact of emotions on our investment decisions. We know, however, that the negative feelings of stress, anxiety and fear that we experience during a bear market are likely to encourage some of our worst behaviours and we must do our best to quell them.?

Reading tip:?Joe Wiggins' new book "The Intelligent Fund Investor" explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can find out more?here .

Joe Wiggins also publishes very readable posts on his blog 'Behavioural Investment '

----

If you think this newsletter might help someone, please share with them - and support our mission 'Alpha for Impact'. Thank you.

----