Fear and Contrarian Investing in Uncertain Times
You may have found in recent months that simply checking the movements of the markets, or turning on a business news channel is an exercise in psychological discomfort. During periods like these, investors are bombarded with reasons to mourn recent losses and to fear for the future of their investments. This information overload combines with our human natures and fertile imaginations to create disaster scenarios that can have the steeliest captain of Wall Street cowering under his bed. Unfortunately, given enough fearfulness, investors may become too focused on avoiding a new catastrophe, and so let opportunities for long-term gain pass them by.
It’s easy to see how many of these emotions (especially those which occur along the bear-market slope of the graph) market participants have gone through over the past year. The question, for our purposes in this paper, is to analyze how these understandable (and, indeed, unavoidable) emotional states may impact our ability to follow through on the solid investment ideas that we formulate during more stable or positive periods in the markets. And that analysis must begin with a quick look at the evolutionary underpinnings of our emotional reactions.
When it comes to investing, it can be incredibly difficult to overcome our instincts and make smart decisions, especially during bear markets. This problem is exacerbated by the fact that we are also both social and emotional animals. Again, these are useful traits, but they can work against us in the investing world: the market is often driven by the herdlike movements of millions of investors, each reacting emotionally to turmoil.
Research in behavioral finance has shown a clear link between heightened emotional reactivity and below-average investment performance. While we know we should be dispassionate in our analysis of investment opportunities, we often make snap judgments using poor or irrelevant data. We want to make the same decisions that all other investors are making, because it makes us feel better (even though we know that the markets rarely reward those who do what everyone else is doing).
History shows us that, during market crashes, panics, and other extreme situations, making good decisions that serve our long-term interests means stepping outside of our “comfort zones.” This means ignoring the inner voice that tells us to remove all of our investments from a troubled marketplace and stash them in the metaphorical mattress until conditions improve. It means working against our tendency to remove all profit-driving risk from our portfolios and following everyone else into risk-free investments that may not even keep pace with inflation. It means maintaining long-term investment discipline while rationally determining which tactical adjustments to our overall portfolios may be most beneficial during the short-term. But most of all, it means ignoring our emotional responses in favor of our rational determinations.
Overcoming Our Programming
Evolutionary history is not the only pressure that urges most people into irrational investing behavior, or “following the herd.” Doing what everyone else is doing is also very comforting, and helps to reduce feelings of anxiety and conflict in our own minds. On the other hand, moving in a fashion contrary to the rest of the markets can make many investors feel very uncomfortable. Being one of only a few contrarian investors who are ignoring this week’s hot stock, or investing in a proven, old-line company is a much less pleasant feeling than putting your money somewhere that all of Wall Street is trying to buy; you may feel exposed and question your own judgment. After all, it certainly seems more likely that you are wrong, than that everyone else is.
Most of us are not looking for ways to make our lives more difficult. When we consider the problem rationally, though, it’s easy to see that the slow, careful, often contrarian path is the one that is most likely to help us reach our investing goals. Conducting in-depth, unbiased, fact-based research may not be as much fun as chasing hot stocks recommended by a television personality, but it’s the best method for achieving success in our investments. Below, we have listed some of the many strategies you can employ as you strive to act sensibly in a frequently senseless investing world.
On the Contrary…
If there’s one thing that the market has consistently rewarded, especially in times of crisis, it is the willingness to sell when most people are buying, and to buy when most are selling. In both cases, contrarian investors like these are providing liquidity to the market, while those who are on the other side of the transaction are using that liquidity. At moments when almost everyone in the market is seeking to buy, it’s very likely that the market is getting crowded and that values are overinflated. The most likely result is that many investments will lose value in the inevitable correction, and that those who invested near the peak will lose out. On the contrary, when everyone is selling, the odds are good that the market is entering a panic. In the wake of panics, the smart move is to identify assets that have been oversold, and strategically invest in those. Yet consistently, most trend-following investors don’t heed this advice.
Many investors are well aware of these facts. Why, then, do they tend to buy and sell at moments when they should know they shouldn’t? As we noted above, a major component of this behavior is the fact that it simply “feels right”: buying a stock that has just experienced a significant run-up makes investors feel that they have placed their money into an asset that has a proven, winning record. Selling into a panic relieves the anxiety that an investor feels as he watches his portfolio’s value continue to fall. Sure, locking in losses hurts, but it may not be as distressing as not knowing how much farther down the bottom may be.
Unfortunately for these investors, true winners and losers in the capital markets are determined by future price movements, not what transpired in the past. Following the line of thinking described above means that many investors will find themselves using liquidity in both rising and falling markets. On the other hand, the contrarian investor who provides liquidity to the markets is buying assets “on sale” and selling them at a premium, pocketing the instinct-driven investor’s money at every turn.
Becoming a liquidity provider is not natural. It is, instead, a learned behavior, through which investors reassess their natural instincts, and reprogram the way in which they perceive investment opportunities.
Playing the Devil’s Advocate
Questioning our own values and assumptions is one of the best avenues through which to determine whether or not the faith you place in your assumptions is warranted. Here again, asking tough questions about our assumptions is not much fun. It’s far more satisfying to act on a hunch and anticipate a reward than it is to take the time to investigate the downside of your investment. If you need evidence of this, look no farther than the millions that people pour into lottery drawings every day, knowing that they have a far greater chance of being hit by lightning than winning the lotto.
In each of these cases, it is a good idea to understand the argument against your own preference. The object is not to make you so confused about the merits of your ideas that you become unable to act decisively. Rather, some limited consideration of the opposing side can help you to develop an additional level of conviction in your strategy (if that conviction was originally warranted), or to suggest caution if it turns out that your convictions aren’t as unshakeable as you had originally assumed. In fact, whenever you find yourself confronting what seems like a totally unambiguous investment situation, it’s probably a good idea to ask this question: if it were really that obvious, why is someone else on the other side of this transaction?
One recent situation in which money managers would have been well advised to consider the devil’s advocate position is the 2008 auction-rate securities crisis. Recall that this situation arose because many managers purchased these securities based on the perception (and recent market behavior) that auction-rate securities, which paid higher yields than a money market, also had the same tiny degree of liquidity. Meaning, they thought, that they could park funds in auction-rate securities temporarily, and earn more than they would with a traditional money market, without incurring greater risk that they would be unable to withdraw the funds in a timely fashion. As we know now, the liquidity risk was greater than they anticipated, and when buyers for these securities dried up, many managers found themselves unable to retrieve their funds. These managers would have done well to recall that there is no such thing as a free lunch, and that if something sounds too good to be true, it probably is. Auction rate securities, as it turns out, paid more than money markets because they were not, in fact, as safe.
What’s Your Timeframe?
- Set Reasonable Expectations: Always remember that, in the absence of extraordinary good luck, portfolio strategies don’t work immediately. For most investors, whether institutions or individuals, the proper planning horizon may be decades long. Even shorter-term investments should be measured in years, and never in quarters or months. This simple concept is very difficult to maintain, especially in the face of the 24-hour business news cycle and the real-time data available to every investor over the Internet. Still, it is something that you should reinforce in your mind whenever you consider your overall portfolio.
- Establish Benchmarks: When it comes time to review your portfolio with your investment advisor, the primary focus should be on evaluating how well the overall portfolio is tracking its designated goals. This approach can help to put poor (or uncommonly strong) short-term results in the proper perspective. Even if a portfolio or a particular investment strategy underperformed over the last quarter in relation to a benchmark or peers, it may be working as planned in context of your long-term portfolio goals. Remember that long-term investing is not a “winner-take-all” contest, and that your objective is not to “beat” other portfolios’ performance, but rather to ensure that your investments are on track to deliver the growth you expect, at an acceptable level of risk, within the time horizon you have set.
- Customized, Diversified Solutions: Many investors find it easier to focus on the big picture when they utilize a well-diversified investment program. With proper diversification, the performance of a given portfolio segment or investment strategy is not a make-or-break affair for the overall portfolio. Recall, though, that while the inherent power of diversification helps to reduce volatility, it does not assure a profit or protect against loss in a falling market.
In 2002, Equitas Capital Advisors, LLC was established as a unique company that blends the resources of a large global corporation with the flexibility of a small boutique firm. The registered service mark of Equitas Capital Advisors is Engineering Financial Solutions® and the purpose of Equitas is to design, build, and deliver investment solutions to meet the goals and objectives of our investors. Equitas Capital Advisors, LLC, located in New Orleans, has over 200 years of combined investment management consulting experience providing professional investment management services to investors such as foundations, endowments, insurance companies, oil companies, universities, corporate retirement plans, and high-net-worth family offices.