Conquering Your Animal Spirits
Updated: Apr 4, 2020
"The stock market is the only market where things go on sale and all the customers run out of the store...." - Cullen Roche
October was a wild ride for stocks, with the S&P 500 shedding 6.9%. Here’s a summary of what’s going on in the market.
1) Interest rates have risen rather significantly. This is partially the result of the Federal Reserve raising interest rates to more normal levels, as they have been doing since 2015 when the U.S. economy began to emerge from the Financial Crisis of 2008. This will likely subdue economic growth (by design), as the Federal Reserve attempts to prevent the economy from overheating. For this reason, some investors are selling stocks in anticipation of that likely subdued growth. The silver lining is that those higher interest rates are trickling into the bond funds that we own, entitling us to higher interest payments.
2) The trade-war going on between the U.S. and China is still a big question looming over the heads of investors. Until we get some clarity as to how and when this may be resolved, it’s likely going to contribute to future volatility.
3) As always, there’s a hefty dose of randomness and inexplicability. Trying to explain every last bit of the market’s movement is a fool's errand. After all, prices, especially over the short-term, are frequently driven by emotional and algorithmic buying and selling, and are not necessarily based on the fundamentals of the economy, which remain incredibly strong.
Conquering your Animal Spirits.
In finance, there is a term that describes the emotional side of the decisions people tend to make when it comes to their finances: Animal Spirits, coined by John Maynard Keynes.
These emotions can most easily be summed up as fear and greed. They tend to emerge most frequently during the peaks of bull markets (greed), or during the troughs of bear markets (fear).
In both situations, people get themselves into trouble by extrapolating the present into perpetuity. There's either a supposed new normal of exceptional growth that's going to last forever (1999, due to the internet), or a supposed new normal of near stagnation that's going to last forever (~2014, after the financial crisis). It's vital to remember that, at least thus far in our history, neither has been true for the United States.
As Mr. Cullen Roche points out, the natural, fearful, reaction to a declining market is to stop the pain by selling your holdings. That reaction is as natural as immediately taking your hand off of a hot stove. The inverse is just as true and just as natural; we do not like experiencing the pain of seeing someone else gain while we do not (think bitcoin, or any other "hot stock tip".) However, when it comes to investing, those natural traits tend to do us a disservice, as attempting to buy into or sell out of investments due to the circumstances or emotions of the moment almost never works out to your financial benefit.
For one, not even the talking heads of the financial industry can make reliable predictions of what the market is going to do next. Here's a chart of the U.S. stock market (S&P 500) with various bold claims made by those same industry experts. You'll quickly gather how wrong many of them are, and how costly it would have been to act on them. (Click the image to expand it.)
Here's another example. The following table shows us that if you had invested $1,000.00 in the S&P 500 in 1988, it would have been worth $21,106.00 by the end of 2017. Had you missed out on the ten best performing months, a mere ~ 3% of the time, perhaps because you acted on the advice of one of the experts above, your return would have been reduced to $8,487.00. If you sell and remain out of the market for any amount of time, there's a very real chance you'll be financially worse off for it.
Here's more proof that resisting your natural inclinations and staying put is your best bet. This chart, courtesy of J.P. Morgan, is based on the performance of the S&P 500 back to 1945.
The center dotted line represents the average of all market peaks. Check out the "12 months prior" bar towards the left of the image. That tells us that if you had sold out of the stock market 12 months prior to the average peak, you would have missed out on an average of a 23% return (as greed invariable pushes prices higher). This is why attempting to "get out of the market before the top" can be so costly. This is also why jumping into the best performing investment as of late is usually a bad idea.
Now look to the far right at the "24 months after" bar, and you'll see that, on average, within 24 months after a crash, nearly all of the losses have been erased, assuming a portfolio comprised of 100% stocks. With the bonds that we use in nearly every portfolio that we develop for our clients, you would be back to whole even sooner. Again, this is why selling during a crash can be so costly; you will likely miss out on the recovery.
The solution is two fold. One, we must focus on our time in the market, and not on timing the market. Two, and most importantly, we must do our best to be prudent; the optimal middle ground between being fearful and being greedy.
Remembering that the great times never last forever, and that the bad times don't either, can go a long way in helping us remain prudent. Lastly, while having these Animal Spirits is completely natural, we can exhibit prudence by being cognizant of them while also refusing to act on them.