Logic and Emotion in Times of Market Volatility

Joss and I worry about our clients. A lot.

What we don’t worry about is stock markets or bond markets or global economics, which we understand from decades of reading, research, analysis and experience, to be volatile and unpredictable in the short term. We understand investing is a marathon not a sprint, so we build our portfolios with that in mind, stay focused on our strategic goals, and won’t be over-reactionary when the ill winds blow as they are now.

What we really worry about is how our clients perceive and process and react to these volatile markets, and whether they might be losing sight of long-term goals when they open their statements.

Market Fluctuations

I’ve been following markets for 55 years now, and I like to think that’s a pretty good sample size with which to frame current economic events, which are admittedly nasty. I’m old enough to remember all of the downturns since the ’70s, and have seen every recovery that has followed. Granted some recoveries take longer than others. But in the grand scheme of things, you can look back and see that these declines have invariably presented grand opportunities to collect shares in undervalued companies. And as long as the company thesis remains intact we continue to own them.

Admittedly, the situation is different for those who are drawing down their savings, and care needs to be taken in how this is executed. We spend a great deal of time thinking about that and doing the best that we can to help our clients maneuver through uncertain times.

But if you are young, you want to see this market decline even further so that you have the aforementioned opportunity to collect undervalued shares. If you have job security, a 5-10+ year time frame and abundant cash flows, you should be aggressively dollar cost averaging into the market and looking to up your monthly contributions.

So much investing success is dependent on how one reacts to events in the markets, even more so than knowledge of economic cycles and interest rate movements, monetary and fiscal policies, and the effect these have on our financial lives.

So, we will worry less if you understand more about how markets work. With economic forecasts being decidedly gloomy, we thought it would be useful to pass on a few historical facts and a little dose of wisdom to arm yourself with when you confront your own emotions about managing your wealth in uncertain times.

Understanding the Stock Market

The simple concept that expected returns go up when prices go down is extremely tough for many investors to digest. History tells us that as stock prices get lower, both in absolute terms and relative to their valuations, the opportunities to make money prospectively increase. Human emotion makes it feel as though the opposite is true – losses can make us believe additional losses are more likely. 

Every bear market has two things in common.

  1. They come to an end
  2. Expected returns go up

The simple concept that expected returns go up when prices go down is extremely tough for many investors to digest. History tells us that as stock prices get lower, both in absolute terms and relative to their valuations, the opportunities to make money prospectively increase. Human emotion makes it feel as though the opposite is true – losses can make us believe additional losses are more likely.

The reality is, as the price and valuation of stocks drop, so does your risk of losing money, while the probability of making money increases. As shown in the S&P chart below, we haven’t seen these levels since 2020

History doesn’t predict the future, but money put to work now may yield some of the biggest pieces of your future returns.

Source: TheReformedBroker, Google

Consider this, the historical odds of not losing money in the Canadian or U.S. markets are 50/50 over one-day periods, 75% in one-year periods, 98% in 5-year periods, and 100% in 10-year periods. 

Interesting, isn’t it?

Source: Bloomberg; data through 7/31/22. Data for TSX Composite goes back to 1977. Data for S&P500 goes back to 1945. 

“The stock market is a device to transfer money from the impatient to the patient.”

“The intelligent investor is a realist who sells to optimists and buys from pessimists.”

The art of surviving a bear market involves courage, patience, and humility. The courage to look wrong while buying into a falling market, the patience to wait for the eventual recovery, and the humility to know that you won’t time the bottom. That is what sets successful investors apart.

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