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Calm through the Storm: Understanding Investment Psychology During Market Downturns

Written by Calvin Ng | Jul 1, 2022 2:20:00 AM

Global markets have been highly volatile since the beginning of 2022. From rising interest rates to conflicts in Eastern Europe, to inflation led by supply chain constraints, and—for some countries—continued Covid-related restrictions, there are multiple factors at play. Major market declines have always been and will continue to be an integral part of investing. If you want to be invested in the market, one has to be ready for it. So, what’s an investor to do?

Warren Buffett famously said, “Be fearful when others are greedy and greedy when others are fearful”. This idea came about from understanding market psychology, where investors tend to be driven by emotions like greed and fear. While it is easy to quote, many find it difficult to practice. When panic or volatility ensues, the tendency for most is flight and not fight.

It is reasonable that the initial responses to market downturns are negative or reactionary. It takes time for many to recognize those market movements, up or down, never happen in a straight line but in fits and starts. Buffett once described the stock market as “a device to transfer money from the impatient to the patient.” When developing one’s own approach to volatility, this lesson is essential.

Understanding one’s own investing psychology is a great starting point when constructing a portfolio and managing risks. When constructing a portfolio, one must comprehend the level of risk aversion, risk taking, objectives, and time horizon involved in each asset. Downturns tend to sap investor stamina and belief. They tend to sell when the future looks bleakest, typically just when sharp rebounds begin. Getting your portfolio structure right from the beginning minimises panic at the worst possible time—preventing investors from bailing out and getting back in once potential gains are in the rear-view mirror.

Downturns and turmoil are facts of life, a constant recurrence. However, embracing it and being prepared should be its own reward. Data provided by an index analyst for the S&P and Dow Jones Indices, Howard Silverblatt, indicated that since 1929, the US stock market has been in a bear market approximately 24% of the time. On top of that, from 1945 till 2020, the US has been in a recession about 14% of the time, according to the New York Times.

For example, the S&P 500 hit record lows in March 2009 in the wake of the Global Financial Crisis, which had started two years prior. When Central Banks cut interest rates to nearly zero, it fuelled a bull market that lasted about 11 years until the COVID-19 pandemic hit in February 2020. A brief bear market occurred until Central Banks intervened again in March, but a month later, markets returned to bull territory again for another two years.

American economist Benjamin Graham once claimed that successful investing comes not from beating the market, but instead “whether you’ve put in place a financial plan and behavioural discipline that are likely to get you where you want to go”.  Numerous academic studies have consistently demonstrated that a well-diversified asset allocation to be responsible for approximately 90% of the returns for a portfolio, rather than from the ability to identify winners in a selection of individual securities. Most investors spend numerous hours and effort to pick investments but forget to identify risks and strategy.  Anticipating corrections and acting on that impulse can, at times, do more harm than enduring a correction. Without discipline, the fickle emotions that downturns provoke will likely take over decision-making, resulting in a potential recipe for failure.

Around-the-clock coverage of financial news often evokes fear because fear sells and tends to be the glue that keeps people hooked to their televisions, newspapers, or the internet. Groupthink emerges as market volatility takes hold, resulting in a breakdown of discipline and an uptick of emotionally driven decision-making. Another wise word of advice from Graham states that an investor’s “chief problem – and his worst enemy – is likely to be himself.”

Market turmoil is a constant. However scary downturns tend to be, they do end, and usually when the future looks darkest and bleakest. Short-term volatility and fear should not be viewed as a hindrance, but instead with patience, self-control, discipline, and most importantly, robust asset allocation. As history has demonstrated time and again, economies will grow over the long term and markets will reward those who are patient, courageous, disciplined, and diversified with handsome profits.

 

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