Meaningful Returns

Although it feels like an eternity ago, it has been only three years since the Ebola virus sent a jolt of physical devastation through several countries in West Africa, and a jolt of fear through the American psyche. I recently revisited a piece from The Atlantic which dealt primarily with the latter jolt, entitled “The Psychology of Irrational Fear.” The article looked at some of the ways that irrational reactions to fear of a legitimate threat ended up making things worse, and not for the first time in human history, either.

Most of the ways that the fear of Ebola was overblown related to the method and likelihood of transmission of the virus, and how to best prevent that transmission from happening. Prominent senators and other public personalities grossly misstated or overstated the threat on American soil, causing people to react in irresponsible ways, and potentially increasing the potency of an outbreak were one to occur. This lead Catherine Belling, an associate professor at Northwestern University’s Feinberg School of Medicine, to comment on a sort of collective hypochondria that arose from these fears: “What hypochondria is, then, is the inability to put that very rational fear into context, where you can continue to function normally rather than being paralyzed by it.”

The inability to put that very rational fear into context, where you can continue to function normally rather than being paralyzed by it.

If you keep up with the stock market at all–even at a very casual level–you’ve undoubtedly seen or heard folks discussing the fact that it seems, even feels like a market correction/hiccup/downturn is imminent. This is a rational fear for two reasons: 1) Strictly speaking a downturn is always imminent, in that while we have some high level ideas about the health of the market at any given time, surprises will always surprise. 2) Because valuations in the market are relatively high (based on historical data), there is legitimate evidence which could suggest a downturn is around the corner. The problem is, we don’t know which corner. We just know it’s out there. Somewhere.

The problem arises, then, not necessarily from the acknowledgement that the fear is legit, so much as from our reactions to that fear. It’s that inability to put the fear into context, and like my dad says, “Context is king.”

And what are some of these reactions to the fear that a downturn is imminent? Broadly speaking, I usually see this taking one of a few different forms:

1. Pulling back equity exposure significantly (if not altogether).
2. Pausing regular savings into the stock market to wait for “a better time” to invest.
3. Looking for some more exotic strategy that may or may not include the words “black swan,” and which ostensibly will insulate the person from the downturn, whenever it happens.

But before you engage in one of these reactions, I think you need to be able to clear two hurdles:

The first one is, Is this reaction consistent with your financial plan and the investment process therein? Because if not, then the reaction ought to be off the table immediately. Maybe it’s time to go back to the process and plan and think about whether the fear you feel necessitates a strategic shift that will help you stick to the plan and process in the long run, but it’s not a time to depart from the plan in some ad hoc fashion.

The second hurdle is, How likely is it that this reaction will work? In other words, my fear of imminent downturn is a fear that my portfolio value will decrease enough to have a material negative impact on my future lifestyle, so how will this reaction prevent that material negative impact? But this one is super tricky because all of the reactions above, in some form or fashion, rely on your (or some third party’s) ability to make two extremely difficult decisions regarding the timing of the stock market: The first is the obvious one, which is reacting on the front end of a downturn to in theory reduce your exposure to it. But the second, equally important decision is, when to get back in. And the reality is some people get the first one right, but good luck finding someone who can get both right. In fact, as Larry Swedroe’s recent piece entitled “More Money Is Lost Waiting for Corrections Than in Them” points out, part of the reason it’s so hard is inherent in the nature of the stock market to produce its outsized returns in very short intervals of time. In fact, in the last 91 calendar years (1092 months), almost 100% of the S&P 500’s returns have come in the best 91 months, or roughly 8.5% of the months that make up those years. So it’s not good enough to get those two decisions generally right; you have to be dead on, or you could end up making things worse through your reaction than the imminent downturn you’re reacting to.

If you can clear those hurdles, awesome. But if you can’t, the best thing you can do is take a deep breath and attempt to place your fear in context. Remember that “Sometimes when we’re afraid of something, even if our fears are irrational, that can lead us to make choices that will actually cause the thing that we are avoiding.” Try to step away from the feedback loop that only stokes the flame of fear, and consult your plan and the professional who put it together with you in mind. Even as adults we retain some version of the kid in us who’s just a little less fearful knowing we’re not alone.

Here’s some of the best of what I read this week:

• The Next Bear Market. “Regardless of when it happens, it’s intelligent behavior for investors to plan ahead to know what they’ll do when it does.”
• A Little Knowledge is Dangerous. I played a lot of basketball growing up. When a kid learns to dribble through his legs, good luck getting him to do anything else on the court. Same thing works in the markets.
• The Rot That Lies Beneath Some Index Funds. Jason Zweig is phenomenal at these exposés. “The word ‘index’ is related to the Latin word for forefinger. Index funds are meant to be indicators. If you own one, it should passively track the performance of a broad basket of stocks, bonds or other assets — and its own returns should indicate, almost exactly, how the underlying investments performed. If they don’t, something is wrong.”