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BMT Quarterly Market Insights, Spring 2021

From Fear to FOMO:

4 Behavioral Finance Lessons to Live By

“As we look ahead to 2020 and beyond, the one thing we can be sure of is that there will be many more unforeseeable occurrences that will be part of what shapes the investment landscape.  If the history of financial markets teaches us anything, it’s that things that have never happened before happen all the time.  What might have worked in the past doesn’t always work now or in the future, and expecting the unexpected is the best way to control our emotions when things don’t go as planned.”

Introduction

If you close your eyes, it probably doesn’t take much effort to recall the emotions you felt in March 2020 – confusion, anger, fear, to name a few.  As we pass the first anniversary of the COVID-19 market low, you may find yourself on the opposite end of the emotional spectrum – hope, optimism, and the fear of missing out have taken center stage.  All it took was the quickest 30% decline in the history of the S&P 500 (22 days – with the runners up all having occurred in and around the Great Depression), followed by a 78% rally over the next 12-months to take investors from optimism, to complete despair, to non-fungible digital tokens selling for $70 million.  What a ride.  When it comes to investing, this kind of emotional roller-coaster can do serious damage, with both sides of the emotional scale being equally treacherous.

2021-Q2-chart-1
Sources: FactSet, Inc.; BMT

Engaging with the behavioral side of investing is, in our view, perhaps the most important thing people can do if they want to have success navigating financial markets.  Amid the graphs, equations, market-jargon, and flashing Bloomberg screens, it’s easy to forget how much of our investing results are driven by behavior – and behavior is hard to fix.  Morgan Housel put it best, “When people say they’ve learned their lesson they underestimate how much of their previous mistake was caused by emotions that will return when faced with the same circumstances.” [1] This is true in life and undoubtedly true in investing.

Here, we attempt to analyze the past 12 months through a behavioral finance lens, highlighting lessons that can help make all of us better investors.

The Basics – Behavioral Finance 101

Behavioral Finance is based on one basic idea: financial markets are not perfectly efficient. Rather, they are driven by the characteristics of the participants in that market.  Market efficiency, in the traditional sense that prices are always rational and reflect all available information, cannot be evaluated outside of the context of human behavioral dynamics. Put simply, we are our own biggest risk when it comes to our investments.  Years of genetically coded biology lead us to take cognitive shortcuts that can lead to suboptimal results.  Recency bias, panic, fear, and greed all need to be constantly managed to increase the chance of investment success.  The amygdala, which manages our body’s fight or flight response, has been critical to the success of our species.  However, that part of our brain is running a 2 million-year-old piece of software that often leads to bad investment decisions.  In other words, it’s good for avoiding being eaten by a sabretooth tiger but bad for avoiding panic after a 20% decline in the stock market.

The Human Mind – How Much Will Someone Pay for $20?

Seems like a dumb question, but the answer is almost always more than $20.  The results of this experiment provide clear evidence that things like greed and loss aversion play a role in setting prices.  The rules are simple: A $20 bill is for sale, and you can try to buy it at any price. Bidding starts at $1 and moves in $1 increments.  Other people also get to bid on the $20 bill. If you are outbid and decide to drop out of the game, you still must pay your final bid. You receive nothing in return.

The experiment always ends the same way.  Initially, people are excited about the idea of getting $20 for $5 or $10…free money, right!?!  Once the bidding heats up and approaches the $20 level, it is no longer about winning, it’s about not losing.  Eventually, someone offers $21 for a $20 bill – which makes sense within the confines of the rules.  If the bidding stopped there, the “winner” would only lose $1, while the loser would lose their entire $20.  However, the bidding never stops there.  Loss aversion takes over and prices rise to absurd levels.  Wharton professor Adam Grant recalls a game when someone ended up paying $500 for his $20 bill. 

The lesson here is simple, yet powerful.  Irrational decision making is a feature, not a bug, of financial markets.  Humans don’t always make decisions based on a perfectly rational process, and prices can move in ways that are hard to explain.  Especially with near-term price movements, the same behavioral biases that drive people to pay more than $20 for a $20 bill also drive people to sell their stocks after a big loss or purchase a piece of digital art for nearly $70 million.

The Tools – 4 Things All Investors Should Remember

Whether during the depths of the COVID-19 plunge or while riding the market to all-time highs, these behavioral finance rules are nearly universal.  Some will be more useful when fighting fear and some will be better suited for managing greed. Understanding these fundamental principles will lead to improved investment decision-making. 

Properly Anchor Your Perspective

Volatility in the present always feels worse than volatility in the past – probably because we know that past volatility didn’t result in complete disaster.  Whatever the reason, at the moment it can be very hard to see the forest for the trees while maintaining a perspective that is properly distanced from the visceral emotions of the moment. 

Part of this is simple recency bias, one of the most difficult behavioral challenges to overcome.  Whether positive or negative, human beings extrapolate the recent past too far into the future.  For example, when gas prices fall, sales of SUVs and trucks tend to rise. It’s not difficult to see the connection – consumers believe what’s happened recently (a move lower in gas prices) will continue.  Herd mentality can also cloud our better judgment regardless of market direction.  Whether it’s panic or greed, it can be very hard to move against the crowd.  In periods of market stress, loss aversion kicks in.  As Daniel Kahneman once wrote: “Organisms that treat threats as more urgent than opportunities have a better chance to survive and reproduce.”[2]  Therefore, humans often perceive pessimism as critical thinking, while optimism can look overly simplistic or even uniformed.

Perspective is our best weapon when battling these mental obstacles, and properly anchoring one’s perspective during a significant market sell-off is a critical tool when managing things like loss aversion.  If you own a stock that is down 20% one year, it is easy to forget that it might still be up 100% over the past five years.  2020 provided the perfect example.  From January 1, 2020, to the stock market low on March 23, 2020, it was very easy to wish bonds made up a larger part of your asset allocation.  That 40% bond/60% stock portfolio sure looked good last March compared to risker allocations.

2021-Q2-chart-2
Sources: FactSet, Inc; BMT

However, re-anchoring your perspective could have gone a long way in helping to reaffirm conviction in a riskier portfolio.  Looking at the same asset allocation profiles over the previous decade told a much different story.  Even after the 30%+ sell-off in many stock indexes, you still would have earned almost double the return in a 100% stock portfolio versus the most conservative 40/60 allocation during the previous ten years.  Fast forward to today, and that performance advantage has widened even more dramatically. 

2021-Q2-chart-3
Sources: FactSet, Inc.; BMT

It’s Probably Not Different This Time[3]

“History is deep. Almost everything has been done before. The characters and scenes change, but the behaviors and outcomes rarely do. Everything feels unprecedented when you haven’t engaged with history”.[4]  Every time the stock market falls a few percent, people get anxious.  After a 5% drop, the anxiety grows, and after 10% you’ll surely see a CNBC “Market’s in Turmoil” segment where every market bear who’s been calling for a crash gets the opportunity to plead their case.  The news flow might be different this time, the narrative “explaining” the market’s current decline might not be the same, but the emotions associated with these moments never change.

We expect that the stock market will correct at some point this year…it usually does.  In fact, the average annual drawdown in the S&P 500 over the past 41 years is about 13%.  That said, among those 41 years, the market has only finished negative for the year 7 times.  Stocks are always volatile…it’s the price of admission.  Each of the following charts ends at the bottom of a correction.  Just when it felt like the wheels were really about the fall-off…they didn’t. 

Remember Ebola in 2014?  Yeah, it’s fuzzy for me too.  Felt pretty scary at the time.

2021-Q2-chart-4
Source: YCharts

How about 2015?  Oil prices crashed from $105 to $30.  That was fun.

2021-Q2-chart-5
Source: YCharts

What about that pesky trade war in 2018?  Feels like a distant memory.

2021-Q2-chart-6
Source: YCharts

Later in 2018, Fed Chair Powell insinuated rates were heading much higher.  That one felt really bad.

2021-Q2-chart-7
Source: YCharts

Yes, 2020 was a bona fide crash.  It took a global pandemic to do it, and these are exceedingly rare.  However, even later in 2020, most probably forget the 10% correction as fears of a second wave emerged.

2021-Q2-chart-8
Source: YCharts

The point here is not to minimize the emotions we feel during times like these.  In fact, we must embrace these feelings, understanding that although the “crisis of the day” may appear to be different (and often more dangerous) than past episodes of strain, it’s likely something that has happened before.  We can use history to our advantage and engaging with past moments of market stress can help add context to present-day market stress.  It might feel different, but it’s probably not.

Extremes Don’t Last Forever

Especially when it comes to volatility and sentiment, extremes don’t last long.  Periods of low volatility are always followed by periods of high volatility (and vice versa), while periods of pessimism are always followed by periods of optimism (and vice versa).  Investor sentiment is particularly useful when trying to anticipate a market bottom during a severe decline.  Over the past decade, we’ve experienced four significant declines in the S&P 500.  Each was different in terms of catalyst, duration, and magnitude, but they all shared one common element: The bottom of each decline was marked by an extreme in negative investor sentiment.  The chart below is a depiction of investor survey results conducted every week by Investor Intelligence. In general, investors are more bullish than bearish – as they should be given the stock market rises over time.  However, each time the percentage of bears became greater than the percentage of bulls, the market was very close to reaching a bottom.  Extreme fear is often a sign that the selling is over during a large decline.  Knowledge of this cannot only help identify potential buying opportunities, but it can help us manage our emotions during the market’s most difficult periods.   

2021-Q2-chart-9-bear-bull
Sources: FactSet, Inc.; BMT

People Like Simple, Even When It’s Wrong

“Simple explanations are appealing even when they’re wrong. ‘It’s complicated’ isn’t persuasive even when it’s right.”[5]  Investors love to explain why the market is doing what it’s doing.  The creation of market narratives is a major Wall Street export, even when we know assigning an accurate motive to the behavior of millions of market participants on any given day is likely impossible.  However, human beings like when things “make sense,” even if the explanation might not be true. 

Once again, 2020 provides an excellent example.  After the market bottomed in March, the S&P 500 returned 45% by the first week of June.  At the time, the loudest calls were for a re-test of the March lows – unemployment was still over 10%, businesses around the country were being crushed under the weight of economic lockdowns, and the risk of a second wave of the virus was significant.  The narrative was simple – the market was completely divorced from economic fundamentals, and the recent bounce was unsustainable.  However, as is often the case, simple was wrong.  Massive monetary and fiscal stimulus overwhelmed the economic pain, and corporate earnings began to recover much more quickly than anticipated.  Vaccine development surpassed even the most optimistic forecasts, and the market never looked back.

The election of Donald Trump is another very clear example of obvious not being correct.  Conventional wisdom in 2016 was if Trump was elected president, an era of deregulation would propel Financial and Energy stocks higher.  Simple, logical…and wrong.  We now know that during Trump’s presidency, Energy and Financials were both laggards.  Other key variables overwhelmed the regulation thesis, as appealing as it initially was. 

Don’t be fooled by seemingly simple explanations for market behavior.  The market is complex, and second- and third-level thinking is often needed to better explain asset price movements.     

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