May 19, 2010
"The time to buy is when there's blood in the streets." –Baron Rothschild
Investing requires faith and fortitude. One of the absolute keys to long term investment success is developing emotional reactions that are uncorrelated to market volatility.
Capital markets are a complex web of information, expectations, and emotions. The 24-hour news cycle of today competes for our attention constantly. The media preys on our behavioral biases. They want you to be concerned so you will listen up. It is very difficult in the static of the information age to filter out all the noise and focus on fundamentals.
It is easy to look at a long term growth of wealth chart and say yes, I want a piece of that action. I can handle that. But when you drill down to more isolated time periods, do you have the fortitude? The S&P 500 was down -36 percent during the full two-year period from 1972-1974 and down -44 percent during the most recent bear market from January 2008 through March 2009. That’s a long time for some people. People are more tolerant of risk in bull markets and less tolerant of risk in bear markets. It depends on the heat of the moment.
Some of the most critical financial decisions of our lives are made during periods of extreme market turmoil and peak emotional involvement. One of the worst equity bear markets that culminated in the spring of 2009 was too much to take for many people. Diversified portfolios were liquidated in a massive flight to safety driving the prices of the most conservative investments—U.S. Government securities—up and forcing yields down to essentially zero. Where do you go from there?
The question then became when to reinvest, if at all. History shows, however, that secular bear markets are often followed by extremely abrupt bull markets, and this one was no different. Many people who tried to time the market wound up missing one of the biggest bull markets in 75 years when the S&P 500 was up more than 65 percent, trough-to-peak, from March 2009 through April 2010.
Successful investors are able to counter the natural human emotions as depicted below. A typical stock market cycle displays human emotions along with typical decision-making thought processes. Some people have the ability to resist natural impulses while others must rely on other people like a financial advisor to help them through difficult times and stay focused on their goals.
While nothing in life is guaranteed and there are always legitimate things to be concerned about, the key is to counter these emotions and recognize that euphoric times are periods of increased risk where stock prices are high and expected returns are lower, and times of fear represent opportunity where stock prices are lower and expected returns are higher.
Data Source: Standard & Poor's
