Ignore That Bear Market Headline, Part 2

 

“We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.” – Warren Buffett.

The title of this post (and the previous one) is intentional. When market prices plummet, as they do from time to time, it is important to avoid panic. Do not discard your well-thought-out asset allocation and your long-range plan. And don’t even think of using the phrase, “In the long run, we are all dead.” That’s a rationalization for following your natural inclination of reacting to fear.

How do we avoid acting emotionally? Well, it helps if we have an understanding of investor psychology (especially our own) but also the perspective of market history. This post goes into each realm.

For an understanding of investor psychology, a great place to start is with Jason Zweig’s book Your Money and Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich. In this book, he discusses how neuroscience, economics and psychology explain how we make good or bad investment decisions.

Zweig’s weekly column, The Intelligent Investor, published in The Wall Street Journal is always interesting, because he is insightful and brings an independent approach to the investing scene. This weekend’s article entitled Should You Fear the Ostrich Effect? may be particularly relevant. If you don’t have access to the Wall Street Journal, here’s a summary, as well as my analysis.

Zweig observes that investors pay much less attention to their portfolios when the market news is bad. The term “ostrich effect” was coined by behavioral economist George Lowenstein of Carnegie Mellon University. Lowenstein has done extensive research measuring the phenomenon.

Zweig comments that, “Turning yourself into an ostrich doesn’t make your losses go away, but it does enable you to pretend they aren’t there.”

Moreover, Zweig maintains that ostrich-like behavior isn’t all bad.

“Experiments by psychologist Paul Andreassen have shown that the more news that investors get on their holdings, the more they trade and the lower the returns they earn. When your head is stuck in the sand, you can’t open your mouth to trade.”

Absolutely! As Eugene Fama, Jr. said at a recent NAPFA meeting, “Money is like soap; the more you touch it, the less you have.”

Of course, Zweig is not recommending that you completely ignore the news and, therefore, reality, and neither am I. But, if you have a long-term approach and a well diversified portfolio, I believe that you don’t need to follow the news day after day, nor is it even recommended. It may just get you upset at the wrong time, enticing you to react inappropriately.

“When the headlines are overwhelmingly negative, as they are now, the market tends to feel riskier than it actually is. (The time to worry is when no one seems worried, not when everyone does.)”

That bears repeating. “The time to worry is when no one seems worried, not when everyone does.” That has been a favorite phrase that I frequently use with clients.

Zweig invites us to:

“Take a few moments to go back in market history and see how stocks did after other periods of despondency like 2002, 1998, 1991, 1987, 1982, 1974 and so on. If history is any guide, your inclination to act like an ostrich is a strong indication that the market is about to turn into a phoenix.”

Well, I have done what he suggested. What follows is my analysis.

While the S&P 500 had an average annual return of 11.1% from 1970 to 2007, the numbers for the year after recent market declines are much higher.

Bear Market	% Decline	Increase Next
Bottom	in S&P 500	Calendar Year
12/06/74	-45.1%	37.2%
08/12/82	-24.1%	22.5%
12/04/87	-33.5%	16.8%
10/11/90	-21.2%	30.5%
08/31/98	-19.3%	21.0%
10/09/02	-49.1%	28.7%

Source: Standard & Poor’s, cited in Simple Wealth, Inevitable Wealth, by Nick Murray and Dimensional Fund Advisors’ Matrix book.

Be Careful How You Use This Analysis

Please note that these numbers are merely illustrative, because we are using calendar years after the decline, and the declines did not end conveniently on December 31st. Still, in the calendar year following a Bear Market, the average return was 26%. This is an impressive number and makes Zweig’s point.

However, there is another caveat. We are looking back to notice what happened after a market decline. In choosing 1974 or 2002, for example, as our ending points, we are in effect doing a bit of data mining. (We are using the proverbial 20/20 hindsight.)

Recall, though, that 1973 and 1974 were both bad years. Certainly, no one could have known that in advance. So if you were thinking about this in 1973, and you saw a decline of 14.7% for that year, you might have thought that 1974 would be a pretty good year. It definitely was not — the S&P 500 declined by a further 26.5%!

Similarly, 2000, 2001, and 2002 were all down years. If you had thought in 2001 that the worst was over, you would have been spectacularly wrong! After two bad years, the S&P 500 declined a further 22.1% in 2002!

So while I acknowledge that markets tend to do very well after a spate of declines, unfortunately, we cannot know whether the bottom has been reached, at any given point in time.

Buy-and-Hold

But we do know that if you had gotten out of the market in 2002, for example, as so many people did, you would have lived to regret it. The next year, 2003, was a very good year for the S&P 500 with a gain of 28.7%.

Numbers like that reinforce our buy-and-hold philosophy. We don’t try to use “Market Timing” to decide when to get out of the market and when to get back in. It’s impossible to know when to do that. As Jane Bryant Quinn said, “The market timer’s Hall of Fame is an empty room.”

Diversifying Beyond the S&P 500

As an important aside, many indexes did much better than the S&P 500 Index in 2003.

Real Estate Investment Trusts	36.2%
International Developed Markets	39.2%
Emerging Markets Stocks	56.3%
U.S. Small Cap Stocks	57.8%

Please note that these eye-popping results came after a very difficult multi-year Bear Market. Do not expect these results to repeat in the future. And you can not invest directly in an index.

However, these results are indicative of why we recommend diversifying in many more asset classes than just the S&P 500.

“Past Performance is No Guarantee of Future Results.” The SEC makes us say it, and it happens to be true.

Finally, read the quote by Warren Buffet at the top of this post. Do you even imagine that the “Sage of Omaha” is selling today?