A number of market commentators have noted the historic nature of the recent market decline, which caused us to fall more than 10% in major stock indexes in just a few days. My job as a performance psychologist for hedge funds and trading companies has never been more busy. The uncertainty and the potential economic and market risks associated with a coronavirus outbreak are driving investors to seek the relative safety of higher-quality fixed income securities and to move away from growth stocks that were recently the darlings of the market. How can psychology help us in such times of risk and uncertainty? Below are a few themes that stood out in my conversations with professional fund managers:
1) Knowledge of the history of the market can be valuable – History is far from being a perfect predictor of the future, but it beats ignorance. In the last Forbes article, I highlighted a number of research services that track the markets on a daily basis and look at historical performance under similar circumstances. A common theme in these reports is that the stock market tends to rebound from extreme weakness, but the way forward tends to be volatile, with plenty of up and down movements in the near term. This can offer promise (and over-excitement) to agile traders looking for movement and challenge (and risk aversion) to investors looking for stability. For example, I note on the Index Indicators site that at the close of Friday, February 28, less than 5% of all stocks in the Standard and Poor’s 500 index closed above their moving value of 5, 10, 20 and 50 days. medium. This is proof of the very great weakness of the market. Since 2006, when I started my database, there have only been nine daily occasions with such reads. Five of them occurred in October and November 2008; two merged in August 2011. Returns have been very volatile going forward, reflecting a market VIX that has averaged over 50 on all occasions. Six of the nine occasions saw daily close more than 6% higher the following week. The opportunities of 2008 and 2011 finally saw us make lower lows in the months to come. A mere state of mind of pessimism or “buy the down” optimism is not supported by history. The bottom line is that volatility is more persistent than directional movement, and we need to be prepared for it.
2) Knowledge of the history of the market can be dangerous – Whenever your sample size is nine, with overlapping occasions, you have a small group of examples that you can draw conclusions from. Nor is it the one that leads to a robust statistical analysis. It is easy to see in the story what we want to see. The smart investor or trader uses history to formulate hypotheses, not to fuel confirmation bias and get locked into conclusions. In the current market situation, overconfidence in the history of the market can be particularly misleading. The circumstances that led to the recent market weakness – a potential global pandemic – are not circumstances that occurred during similar market downturns. That’s why the savvy investors I speak with closely follow case reports in Asia and Europe, consult epidemiology experts, and pay attention to economic statistics from around the world. Finance professor Campbell Harvey argues that one of the systemic risks of the virus is the economic recession. Indeed, a further spread of the virus could create a situation in which workers cannot afford to stay at home, exacerbating the health and economic impacts. A history of past outbreaks may be more illuminating than recent market history and suggests that such issues may take some time to manifest.
3) How we manage ourselves determines how we manage risk – We know that stressful conditions introduce a fight-or-flight response from the mind and body that can cause us to make short-sighted reactive decisions. The smartest fund managers I work with take extra steps to maximize their energy and mindset, realizing that volatile market conditions can introduce unusual risks and opportunities. A common theme in our discussions is to redouble our efforts to slow ourselves down when markets accelerate.. It is the extra efforts of mindfulness that combats cognitive biases. We have lost about 10% of the major stock indexes in the United States; it is not uncommon to see larger declines than during times of recession. However, many of these recessionary periods have presented unusual investment and trading opportunities, penalizing healthy assets as well as the weakest. In a world where interest rates continue to fall, it’s hard to believe that companies with strong balance sheets and attractive returns won’t find the interest of asset managers. When the markets fell significantly in 1973, 1987, 2000, and 2008, it took some time for the troughs to form. Ultimately, however, these declines led to unusual opportunities. At the end of the line ? It’s impossible to win the game if we don’t stay in the game. The best traders and investors I work with constantly maintain market and economic scenarios and update them regularly, keeping enough dry powder to weather storms and seize opportunities.