This Too Shall Pass
Sometimes one of the hardest things in the world to do is nothing. This is most particularly the case when we are fearful. Our bodies evolved a very deep-seated “fight or flight” mechanism to keep us safe. When we were puny primates on the savannahs of Africa with rudimentary weapons, the ability to sense danger and run away from it saved us from being eaten by lions and tigers and bears. That deep-seated mechanism is still with us today, and participants in capital markets react to sudden drops in prices the same way our distant ancestors did to the sound of a roaring lion. We want to run away. As fast as possible. That was a great strategy for our forebearers, but today, and in this context, not so much.
One of the most significant advances in economics in the past ten years has been the incorporation of behavioural science into economic thought. We no longer believe that market participants are dispassionate, rational and fully informed actors, always making the optimal decisions – clones of Star Trek’s Mr. Spock, creatures of pure logic without emotion. We now know, and most economists recognize, that humans are consistently human. We react to fear and loss, to joy and gains, with emotion. We are prone to quick decisions, often not taking the time to think about the consequences. We are prone to any number of cognitive biases, one of the most common being loss aversion. Simply put, humans hate losing money, and have a very strong built-in bias to stop doing whatever is causing the loss.
The first nine months of 2022 have certainly triggered the fear response in lots of investors, and at the same time, pushed their loss aversion buttons. Most market participants have had a tough time and have little appetite for more pain. They want the losses to stop. Now. This is a totally understandable response, entirely in keeping with our evolutionary development and what modern behavioural science would predict. That does not mean that the emotion driven reaction is the right one. If we could put on our Mr. Spock hats (or ears) we would remember the following facts:
- The best stock market gains are made after the market has had a steep decline. This is because the sentiment pendulum often swings too far. Just as the market was likely over-valued at the top, it is almost always under-valued at the bottom. Baron Rothschild is famed for saying, 200 years ago, “The time to buy is when there is blood in the streets”. He was not wrong.
- Great companies are rare. The opportunity to invest in them at a significant discount to their stock price a year earlier is rarer still. So, when we see Amazon, without doubt the world’s greatest retailer, down 40%; or Microsoft, equally without doubt the world’s greatest software company, down 30%; or Alphabet, the world’s favourite website, down 33%, we should be paying attention. Such bargains don’t last forever.
- The inexorable trend of the stock market is upwards. Through wars, famines, floods and plagues, the values of great companies rise over time. One of the most profound pieces of reassuring advice is the simple phrase “This, too, shall pass”. Whether it be wars in Europe, COVID in China or rising interest rates in the developed world, things we view as existential risks today will, in ten years, likely be minor downward blips on a line that is rising to the right.
We do not wish to minimize the extent of the market decline in 2022. The period to September 30th has seen the largest drop in the value of bonds in history. The drop of 24% for the S&P 500 is a gigantic drawdown for the most important stock index in the world. The fact that there has been almost nowhere to hide has made this bear market even worse. Investors seeking safe havens outside of North America have seen the values of their holdings devasted by a rising US dollar. Those investing in alternative assets have seen redemption freezes and defaults. The brave (or foolhardy) dabblers in cryptocurrency have seen losses that in most cases dwarf those of the stock market – Bitcoin is down 59% for the year as of this writing. It has been a horrible nine months for all investors.
A recent research study examined the behaviour of investors during and after the great financial crisis of 2007-08. It found that more than 30% of investors who had sold in fear during that period never got back into the market. They missed the greatest bull market in history which saw the S&P 500 go from 667 to 4,809, a gain of 618%, in a period of 12 years.
We can’t predict a further similar gain in the years ahead; we simply don’t know. We certainly expect values to recover the highs of late 2021, and to exceed them over time. We do know that those who let their emotions overrule their rational sides run the risk of missing out, as did the sellers in 2009. If we could go back in time, we would have told them: “See, this too shall pass.” And it did.
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An Ernest Opinion
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Is the Fed braking too hard? – New York Times