May 25, 2020
Excerpted from a letter to clients sent on May 14, 2020. Anyone can sign up for our quarterly updates here.
“When it comes time to buy, you won’t want to.” Doug Kass
In mid-March, it was pretty clear to all that COVID-19 was going to be a disaster for many people and economies around the world. It has been exactly that, but the direction of the stock markets has not been as easy to predict.
March did turn out to be the most volatile month of all time and we saw the biggest monthly drop since October 2008 (the height of the Global Financial Crisis). Pessimism was at an extreme at the bottom of the decline with many holding out little hope for the near future of the stock markets. Yet, as deaths and unemployment continued to rise, April was the best month for the stock market since 1987.
It’s been an emotional roller coaster. Particularly during the worst of the March decline, factors like long-term prices, fundamentals, and rationality weren’t driving most people’s investment decisions. To justify their fear-based instincts, many convinced themselves that they “knew” that the situation was worse than everyone thought, that they “knew” the market would continue to go down in the next month, and that they’d get back in after further declines. But, as they’ve come to find out, they didn’t know. It was emotion that dictated decisions as people just wanted the pain to stop.
The investors who sold near the lows are now unsure whether to get back in with the markets higher and uncertainty and volatility still high. We see this experience as another in a long line of futile attempts by investors to try to predict market moves based on their feelings.
This is certainly not to say that the worst for stock markets is behind us. There could be another leg down and we could even reach new lows. It could happen, but it might not and we’ll only know in hindsight. What we do know is that the bottom tends to come at a time when things seem absolutely terrible. The above quote from investor and writer Doug Kass sums it up: “When it comes time to buy, you won’t want to.”
How snakes impact our investment decisions
It turns out that the type of fear-based response from investors we’ve seen through this and prior bear markets isn’t surprising at all. It’s actually the result of our nature. It comes from an instinct that has been developed through evolution as a means of survival.
James Montier of GMO recently wrote about a psychology study that demonstrated the existence and the roles of two separate, but interconnected, parts of our brain. There’s the quick-decision making, instinctual part (X-system) that is there to protect us from immediate potential harm, and there’s the more logical, but slower part (C-system), that uses reason to weigh in on the situation.
Both play key roles in our lives and Montier offers a good simple example of the interplay between them: Imagine that you’re up close to take a look at a rattle snake that’s in a glass box in front of you. Now picture the snake suddenly rearing up, hissing, and bearing its fangs at you. You will surely flinch and back away before your rational side reminds you of the protection afforded by the glass box.
That initial rapid response part of the brain can be life saving in the face of immediate danger and it usually carries a low cost of being wrong compared to the potentially fatal cost of not reacting. But when it’s wrong, we need the logical C-system to take over and dictate further action.
Our fear instinct often leads to mistakes
The scientific study that we’re going to look at here isn’t about life and death in the wild. It’s based around gambling on a coin-toss game, and it illustrates how those same two parts of our brain have a big effect on our financial decisions when it comes to risk and reward.
The people observed in the study were divided into three groups:
- People with normally functioning brains.
- People with a very specific type of brain damage that prevented their instinctual, fear-driven “X-system” from working, but that left their logical, reason-based mental capacity untouched.
- A control group of people with other forms of brain damage unrelated to the processing of emotion.
The rules of the game are that there will be 20 flips of the coin. Participants can bet $1 or $0 on each flip. The player will win $1.50 for each Heads and lose $1 for each flip that comes up Tails. With a 50/50 probability of getting a Heads with each flip, the average outcome for every 2 flips is that $1.50 is won once and $1 is lost once, for an overall profit of 50 cents. That’s translates to an average profit of 25 cents per $1 bet for an average return of 25%… in almost no time at all! Our rational minds sitting here thinking about this tell us that one should want to flip that coin as many times as possible and wager each and every time in order to maximize the opportunities for that 25% profit expectation.
What happened in real life is fascinating. Depending on whether the subjects were on a winning streak, a losing streak, or no streak at all, participants in all three groups declined to wager sometimes. Most significantly, after a toss where the participant lost, those with brain damage preventing the fear instinct from interfering then wagered 85% of the time on the next round. But the normal people, the people like you and me, afraid of losing again, only wagered about 40% of the time after a loss.
Assuming that all of these people could actually afford to lose their bet (or even the entire $20), each round that they didn’t wager $1 was an emotionally driven, fear-based mistake that is very likely to have cost them money in the long-run.
Other ways to lose the game
This impact of emotions can get worse as the stakes rise. If the cost to wager were $1,000 instead of $1, the fear response would probably loom even larger.
And at some level of stakes, opting out would actually be the rational move. If a player simply couldn’t afford the losses that might result from an unusually long streak of tail flips, it would be best not to play at all. The problem is that, for players who hadn’t thought it through well enough in advance, this realization might only come after a losing streak had taken place.
The favorable odds for our theoretical game don’t do any good if the size of the volatility and potential losses cause players to make bad decisions or quit, locking permanent losses. Continuing to play the game maximizes the chance of long-term success, so it’s crucial that the shorter-term fluctuations can be tolerated both economically and psychologically.
Applying all this to investing
The applicability of the above to the investment markets is pretty obvious. An investment approach that’s subject to feelings/emotion or one where the investor is taking on more risk than can be tolerated or afforded are recipes for failure.
The first thing we must do to avoid these types of mistakes is to gain an understanding of the instinct we have to make emotionally driven decisions based on fear. Recognizing the problem allows us to come up with a solution.
We believe that a big part of the value we offer is the ability to take that instinctual X-system part of our brains out of the equation. We do it by having a disciplined, value-based process that focuses on observable fundamentals, prices, and history. During the good times or prior to investing at all, it’s easy to say, “buy low and sell high.” However, it’s not easy to stick to the plan during the bear markets without a pre-set discipline. Having a disciplined process protects us from our own human instinct to do what we can to make the pain stop. It’s during these painful times that such a discipline is needed the most.
The other key is to do our best to limit the amount of volatility to a tolerable level. That’s why we have 5 different risk tolerance-based models of our global allocation. It’s our way of preventing clients from getting in over their heads. If the risk level is appropriate for your situation, there is a better chance of making good decisions, sticking to the plan, and achieving success – “success” being defined by achieving your long-term financial goals.
The path forward
These are uncertain times. Economic numbers are some of the worst ever seen. But, at the same time, there are positives. The $2.5 trillion borrowed and the $4 trillion pumped by the Fed are incredibly large amounts with more coming. Governments and central banks from around the world are doing much the same. There have been medical advancements towards treatments and vaccines and there could be a new medical breakthrough at any time. We still have a way to go in terms of preparedness, but we’re clearly much more prepared for future waves than we were for the first one in terms of knowledge, treatment, medical equipment (such as ventilators and masks), and testing. Additionally, despite the many daily cases and deaths, the original goal of flattening the curve enough to prevent overwhelming the healthcare system (as opposed to preventing everyone from getting infected) has been achieved to a large degree. There is hope that a targeted, carefully monitored reopening can start to bring the economy back in a relatively safe way.
That said, we know that a second leg down is possible as additional waves and other challenges are likely to appear and be difficult. If things do go back in that negative direction, we know that it will not be easy to endure. But if/when those times come, focus on the long-term, check your emotions, and consider this recent advice from two legendary investors:
While is it always tempting to try to time the market and wait for the bottom to be reached (as if it would be obvious when it arrived), such a strategy has proven over the years to be deeply flawed…. the price recovery from the bottom can be very swift. Therefore, an investor should put money to work amidst the throes of a bear market, appreciating that things will likely get worse before they get better.
– Seth Klarman
Buy, sell or hold? I think it’s okay to do some buying, because things are cheaper… What I would do is figure out how much you’ll want to have invested by the time the bottom is reached – whenever that is – and spend part of it today. Stocks may turn around and head north, and you’ll be glad you bought some. Or they may continue down, in which case you’ll have money left (and hopefully the nerve) to buy more. That’s life for people who accept that they don’t know what the future holds.
– Howard Marks
Such great wisdom and humble truth in both of those pieces of advice. We must be realistic and accept that nobody knows and that all we can really do is try to put the odds in our favor.
Whether the next downturn is in a week, a month, or a year, know that it’s that realistic mindset described by Marks and Klarman, along with our value-based discipline, that will be driving the decisions we make when managing your accounts.
We will make it out of this devastating period of history and we look forward to seeing you face to face on the other side. In the meantime, we will be offering review meetings via phone calls and Zoom meetings.
We’ll leave you with this last piece of timeless wisdom from Abraham Lincoln:
It is said an Eastern monarch once charged his wise men to invent him a sentence, to be ever in view, and which should be true and appropriate in all times and situations. They presented him the words: “And this, too, shall pass away.”