Almost every investor has heard the cautionary statement, “Beware of greed in a bull market and fear in a bear market.” This interdiction is a valuable one. Today we want to take you to a higher level of understanding about this statement especially as it applies to emotions felt in down (bear) markets.
Let us begin with the happier days of up or bull markets. Most investors during a bull market (the exception being traders) do not so much experience greed as they do marked happiness or excitement. Rising markets stimulate ideas of retirement and the fulfillment of dreams. The higher the market goes, the more extreme the hopes become. Remember back in 1998 and 1999 how many people were going to, or in some cases actually did, leave excellent jobs and professions to “play” the market full time. How many friends and acquaintances were planning to retire at age 55.
“Never confuse genius with a bull market.”
The significant fact about this kind of euphoria is that it means that the person has become grandiose. Grandiosity is a stage gone through in early childhood which can easily be rekindled. The easy money of the late ‘90s came from being a participant in a market mania or market bubble. However, the exuberant investors believed that it was their skill which led them to a sense of grandiosity. They had never heard the sage Wall Street saying, “Never confuse genius with a bull market.” Wise investors in the late ‘90s made some easy money and then battened down the hatches even if it meant being on the sidelines during the latter part of the bubble.
The same grandiose aspect of the personality is at play in bear markets, but in reverse. Having taken a huge amount of undue credit for itself in the bull market, the self now blames itself for the failures in a bear market. The combined pain of loss of self-esteem and loss of money damages an investor's narcissism in a severe way, sometimes even to the point of an actual depression or at least a mental state highly similar to a depression, which I call the bear market depressive syndrome or BMDS for short. In BMDS individuals experience some combination of dysphoric mood, sleep disturbance, decreased concentration, irritability, guilt, discouragement, and somatic symptoms such as gastrointestinal disturbance or headaches. The rational person would say to himself, “I know markets are cyclical. I know a market bubble must be followed by a severe correction to get values back to normal.” In fact, rational and experienced investors know that while a bear market may be painful, it affords the opportunity to buy good stocks at bargain prices. For the mutual fund buyer, he or she knows that dips provide a useful way to dollar-cost-average and ultimately give superior results.
The very important lesson for all investors is to appreciate that every investment carries risk, some greater than others. U.S. and Canadian government bonds (as well as those of other developed nations) are sometimes perceived of as risk free. However as buyers of U.S. T-bonds have learned in recent years, currency and interest rate risks are associated with government bonds and can be fairly severe. Therefore, remember every investment carries risk and it is not always possible to tell in advance what the risk will be.
Before investing think about risk and consider it in two dimensions. First, calculate the risk in the usual ways. Be cognizant that most investments carry both market risk and company specific risk. By market risk, I mean interest rate risks, wars, political risks, acts of God, broad market declines, and others too numerous to mention. Company specific risks mean management skills, management honesty, product problems, lawsuits, and whatever competition can throw at the company. When assessing these risks, it is helpful to discuss them with a neutral third party, a friend or, perhaps better, a financial advisor. You will gain valuable insight from the process, something akin to financial psychotherapy. Be warned that Wall Street and academia have a different definition of risk than you do. To them, risk is volatility. It is measured by beta, the measurement of how closely an investment mimics the market as a whole. A beta of one means that stock rises and falls exactly with the market, generally meaning the S&P 500. A beta of less that 1.0 indicates low volatility and a beta of greater than 1.0 indicates high volatility, but remember volatility and risk are not at all the same thing.
John W. Schott, M.D., is a member of the Boston Psychoanalytic Society. He is director and portfolio manager at Steinberg Global Asset Management. He also publishes a monthly newsletter on investment psychology, The Schott Letter.
The second aspect of risk, equally if not more important, is the psychology of risk and what it means to you individually. People differ widely from each other in this important dimension. Certain reality factors will bear on this. They include your age, your earnings, your inheritances and expected inheritances, your health, and whether or not you are married and have children. In addition, your attitudes about risk will be shaped consciously and unconsciously by your genes, by your parents' attitudes toward risk, by your feelings about money, by your confidence, and by your past experiences with losses. If you are a person who has experienced many painful losses in your life, you may be very loss averse. Yet this is a highly personal quality, because some people with a history of many painful losses are driven to repeat them in an attempt to gain mastery, a form of repetition compulsion.
At first glance this may seem daunting. It is truly complicated, but be assured most people can invest successfully. Be aware as you begin to think about risk and how to manage it that research has shown we tend to overestimate our capacity to tolerate loss. Danny Kahneman, a psychologist at Princeton University who shared the Nobel Prize in economics for his work in behavioral finance, and his mentor Amos Tversky demonstrated that the average individual believes he can tolerate twice as big a loss as he actually can. In other words, if you believe you can tolerate a 20 percent decline in the market value of your investments without feeling much pain, you will actually begin to panic at 10 percent decline.
What can you do with all this knowledge to become a better investor?
Consider being a dollar-cost averaging investor. Select good mutual funds or stocks that you regard as excellent long-term investments and systematically invest the same dollar amount at fixed time intervals, e.g., quarterly.
Diversify your investments. If you have all growth funds, add some value funds or vice versa. If you buy individual stocks, diversify by always investing in many sectors which are uncorrelated, meaning that they tend to perform independently of each other. Therefore your results may be smoother causing you less anxiety. Beware of “di-worsifying.” Do not make a bad investment for the sake of diversification. Incidentally, 17 stocks, if chosen from different sectors, will give 90 percent of the diversity of the market as a whole. Thirty stocks will give you 98.6 percent of market diversity.
Emulate the great investors.
First, these investors know they will make errors. In fact, it may not even be their error. Remember no one can accurately predict the future. If 60 percent of your investments turn out to be successful, you will do well. If your batting average is higher, you will do really well.
Second, concentrate on your investments as businesses. Follow the companies' business results more than you follow the shares' prices. If the business is doing well, ultimately the stock price will follow.
Third, my colleague Dick Geist has observed that many of the greatest investors have had a friend or partner on whom ideas could be tried out. Warren Buffett and Charley Munger are the most famous example of this. At first glance, they seem like an odd couple, but their differences apparently complement each other. Certainly no one could challenge the results. So if you have a friend whose input you value, try running investment ideas by him or her. Absent such a person in your life, try to utilize your broker or advisor this way.
Repeat to yourself every day that this is the kind of market Warren Buffett and the other truly great investors relish. Keep a wish list of the companies that you consider the greatest investments and at what price you would like to buy them. If the share price is reached, buy the stock without trying to get it more cheaply.
Time is your friend. In growing economies like the U.S. and Canada's, the long-term trend of the market is almost always up. If you have shares in a good business, even if the price drops, your odds of doing well in time are very good.