Most people have heard the ominous lines of professionals, the media and even those who know nothing about the market issue the following warning: “The market has been up for so long, the next drop is right around the corner.” They will advise by saying, “It’s time to sell; we are due for a recession.” But the funny thing is, they repeat these same lines year after year, regardless of whether there really is a recession around the corner.
So, why do these words work so well at instilling fear in investors? More importantly, what are investors supposed to do with their portfolios?
Fighting Emotion and Loss Aversion
The foundation for these dark comments is fear. The market brings about two major emotions in people: fear and greed. Most investors would all love to believe they can trade emotionless in the market, but the research on investors shows otherwise. Retail investors are entrapped by their own emotions. And one of the strongest triggers of these emotions is loss aversion.
Loss aversion simply means that investors do not like losses. They seek to avoid losses even if this means behaving irrationally. In its most basic form, loss aversion shows that the pain investors feel from a $100 loss is greater than the joy of gaining $100. This happens even if the amount is the same.
Here is a classic loss aversion example:
An investor is given the choice of a guaranteed $500 or a 50/50 gamble between winning $1,000 or winning $0. In this case, most investors will choose the guaranteed $500. However, the results are different when the tables are turned. When the investor has the choice of losing $500 or a 50/50 gamble between losing $1,000 or losing $0, the common choice is the gamble.
So, what does this mean?
Investors don’t like to take a loss. When given the choice, investors prefer to gamble on the losing investment and take the guaranteed cash on a winning investment. But this is irrational since the options have the same expected value in both cases. A 50/50 gamble of $1,000 and $0 has a value of $500. A direct result of this irrational decision-making is selling winning stocks too early or holding on to losing stocks too long when, in reality, investors should do the opposite.
Market Timing: Can Investors Predict the Future?
These emotional investment decisions ignite the recession fear mongering. When stocks have been up and investors are winning, they are anxious to sell. They would rather take the gain instead of gambling on a greater win. Once a recession begins and stocks drop, investors hold on, hoping for a bounce to higher prices. They are gambling on the losers.
When the market has outperformed expectations and prices have risen, the fear of what’s next builds and the pressure to sell increases. Many investors are tempted to take the gains and wait for the market to pull back, so they can buy low.
Trying to predict what the market will do next is market timing and researchers have explored it for many years. Decades of research shows that investors can’t predict what the market is going to do. Selling in anticipation of a market pullback is a good way to miss out on future returns, especially if the market continues to increase.
There is a Recession Coming: Market Cycles
It is inevitable that a recession is coming. The reason is that the market is cyclical. There are good times and bad times. there are economic booms followed by recessions. However, trying to predict when one cycle ends and another begins is a fool’s errand.
Look at the 50-year graph of the U.S. Gross Domestic Product (GDP), below. The shaded areas denote recessions. The gaps between these recessions are anything but consistent. In addition, the recessions themselves vary in their duration. An investor could correctly predict a recession two years ahead of time, but the recession could be small and only last for two quarters. That is an unnecessary two years of missed opportunity in exchange for two-quarters of a downfall. This is a big loss because of downfall that may be insignificant.
Even if an investor sold at the right time, when should they buy back? In addition to predicting the fall, they must predict the bottom, as well. If the investors timing is incorrect, and the market starts to increase quickly before they have reinvested their full portfolio, they will miss out on even more opportunities.
Emotions Suck: How to Fight Back with the Facts
The advice to ignore your emotions is difficult for anyone to follow. Although most investors can’t suppress their emotions completely, they can fight back with the facts. Everyone feels the effects of fear and greed, especially after consistent market movements in either direction.
Worse yet, the media kindles these emotions by covering scary topics like, “How long will the stock market rally last?” or “Is now the time to get out before the crash?” You can find some of these articles at the end of this post.
There are decades of research that warns investors about attempting to time the market or predict downfalls. Investors should use this emotionless advice to combat their own emotion-based opinions about the market.
So, what is an investor to do? Stay the course. Follow your preplanned asset allocation and savings plans. Don’t limit savings in preparation for a drop and don’t change the percentage of your portfolio that you have invested in stocks. The same goes for a market drop. Stay the course. Don’t let fear tempt you to sell your portfolio. The cycle will continue and the lull will be followed by a rally.
If you have a proper investment plan that matches your risk tolerance, there should be no issue. Any changes you make to your account will be fear taking over the hard work you have put into your savings plan and investment choices. Be confident in your plan and when the market inevitably drops, you’ll be able to buy regularly at a discount.