Asset prices rise and fall each day and at times, as now, the fluctuations can be unsettling. A stream of news flow, often highly emotive, can prompt investors to take action. But should they?
Our data indicates that investors do much better when they hold onto their investments through periods of volatility rather than trying to time their entry and exit. However, history shows that when we find ourselves in the midst of a market panic, we don’t always pursue the most logical course of action.
In this paper, we explore how investors can prepare for the next market crisis through a better understanding of stock market history and the psychological theory that underpins some of our behaviour.
Stock market declines
The chart below shows that short-term downturns are commonplace. In 25 of the last 33 calendar years, the UK equity market has fallen by more than 10% at some stage during the year (indicated by the blue dot). However, in most of these years, the full calendar year return has been positive (indicated by the green bar).
Source: DataStream, FTSE, JP. Morgan Asset Management. Returns are based on local price only and do not include dividends. Intra-year decline refers to the largest market fall from peak to trough within a short time period during the calendar year. Returns shown are calendar years from 1986 to 2018. Past performance is not a reliable indicator of future performance.
Attempting to time the market
When negative news headlines are prolific and investors are panicking, it can be tempting to pull out. We ask ourselves, “if we act quickly, can we sell our stocks before they lose too much of their value?”
History suggests that this would be mistaken. Returns in the days, months and years following very sharp drops in the market have been strong: missing the recovery can be costly.
The table below shows how the US equity market behaved following the 10 worst one-day falls in the last 30 years. The light green boxes show positive returns, the dark green double- or triple-digit returns. The overriding theme is that returns are primarily positive; almost always in the day following a dramatic fall, double-digit in all but two occurrences over one year and extraordinarily strong over five years.
Ten worst one-day falls for the S&P 500
Source: Datastream, Cazenove Capital, December 2018. Past performance is not a guide to future performance.
This pattern is not exclusive to the US equity market.
Between 1986 (when the total return index was created) and the end of 2017, the UK’s FTSE All Share has generated an annualised 9.6% per annum. However, if you had panicked and sold your investments after falls in the market, you would have missed the rebound that followed, rendering long-term returns far less impressive.
Analysis of the FTSE All Share over the period shows that missing the best 50 days would have reduced your average annualised return to just 2.8%. Missing the 30 best days would achieve only 4.9%, and missing as few as the 10 best days would yield a still significantly lower 7.5%.
An investor would have to be uncommonly nimble to time correctly a sell-out and then to buy back in at the optimal moment to capture the bounce that follows. Evidence shows just how difficult it is to "market time" with any consistency.
Why, then, do investors continue to capitulate when it least makes sense?
The problem: logic vs instinct
The problem is that more often than not, human emotion overrides calculated logic, leading to poor investment decision-making. Much of the way we react when under pressure makes perfect sense from an evolutionary standpoint, but when applied to 21st century financial markets make no sense at all.
We outline below some of the behavioural biases that can lead investors astray, especially during volatile times.
The market extrapolates the future based on the past. Supply and demand, company-specific news-flow, sector trends, geopolitical developments; all of these have an impact on short-term market performance. When a piece of negative news hits the headlines, we often act instinctively and as markets start to decline, we become fearful of further losses. Greed is one thing, but fear is quite another. The long-term evidence in favour of equity investment counts for a great deal less if you have just suffered a 25% fall in the value of your equity portfolio. Those fears are compounded by the barrage of media outlets – designed to target our emotions – that fan the flames of those fears, often leading to a withdrawal of capital at the worst possible time. This is also known as “panic selling”.
This behavioural bias refers to our instinct to do the same as everyone else. Herding often involves people using the actions of others as a guide to sensible behaviour, instead of thinking and acting independently. From an evolutionary standpoint, it makes perfect sense. However, applying it to the market can be a huge mistake. Investors often have limited access to information about how markets are likely to develop, so they base their decisions on the actions of others. In a falling market, herd instinct falls in the face of logic, rendering a plummeting market self-fulfilling.
The process of remaining focussed on what happened previously and not adapting to new developments is known as anchoring. This situation can be exacerbated by our tendency to avoid changing our views as much as we should in light of new information, and the fact that groups tend to shift decisions to the extreme when compared to decisions taken by individuals (a process known as group polarisation).
In the height of market turmoil, we often feel that doing something is better than doing nothing. However, from an investment point of view, short-term reactions might hinder long-term goals. Investment professionals work in an industry where frenetic dealing activity is seen as a sign of confidence and ability. Doing nothing is sometimes the hardest thing to do but frequently the best.
This article includes contributions from behavioural economist Paul Craven who has worked for a number of leading asset managers, including Schroders, and is an adviser to pension funds and trustees.