Picture of Christopher A. Hopkins, CFA

Christopher A. Hopkins, CFA

Discipline is the best weapon against a bear

“Stock prices have reached what looks like a permanently high plateau.”  – Legendary Economist Irving Fisher, October 16, 1929

“Wall Street Lays an Egg.” – Variety headline, October 30, 1929, following the Black Tuesday crash that touched off the Great Depression

With all the technology, education, experience, and resources at their disposal, why do market forecasters so often get it wrong? Retirement investors would clearly like to act upon accurate prognostications to adjust their portfolios in advance of a steep decline or a major rally, but history proves this to be a fool’s errand. For example, predictions by Wall Street firms regarding the direction of the market are about 70% accurate. Coincidentally, the stock market goes up 70% of the time, so a broken compass pointing north would do as well. And studies constantly show that specific 1-year return predictions are about as accurate as throwing darts at the Wall Street Journal.

Given the inability to foresee market swings with any degree of certainty, what actions should long term investors take to cope with the inherent volatility? The best and most effective strategy remains having a plan that contemplates inevitable cycles and imposes the discipline to stick to the plan.

“The Federal Reserve is not currently forecasting a recession.” – Ben Bernanke, Federal Reserve Chairman, January 10, 2008

Recessions are an inevitable part of the economic cycle and have occurred 13 times since the end of World War II. Few if any of them have been accurately predicted by the consensus of forecasters, at least with sufficient timeliness to provide actionable information to investors. Chairman Bernanke, who had at his disposal hundreds of Ph.D. economists at the Fed, assured Congress that any impact from subprime mortgages would be “contained”. In fact, the worst economic crisis since the Great Depression had already commenced the month before his comments.

To complicate matters further, stock market cycles do not coincide directly with economic cycles generally lead them. Market peaks typically occur 6 to 8 months before the peak in industrial production and market bottoms lead economic recoveries by 4 months on average. Since professionals have little success in dodging downturns, average investors must accept and even embrace cyclical volatility. Recall that the risk of decline in a well-diversified portfolio is precisely why stocks provide superior returns over time.

“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” – Attributed to Mark Twain

Whether or not uttered by the renowned humorist, this quote succinctly sums up the psychological obstacles to maintaining portfolio discipline.

Investors, being human, respond to several psychological factors in making decisions that are difficult but essential to overcome for long term success. One of these psychological biases is overconfidence: overestimating one’s understanding of the market or ability to predict outcomes or not recognizing what one really doesn’t know. For example, surveys consistently show that over 70% of adults believe they are above average drivers. 

Another common impediment is called recency bias, the tendency to focus more intently on recent events and ignore the bigger picture. This can lead investors to assume either a current bull market or selloff will continue into the future and may cause reactionary moves defeat the overall plan. And many people possess an inherent loss aversion that causes then to fear losses more than they value equivalent gains.

These and other behavioral reactions are hard wired into our brains through instinct and in many cases are modern manifestations of the primitive “fight or flight” response. Combining an inability to predict the future with a psychological instinct to overcorrect can seriously impede investment returns.

According to research firm Dalbar, over past 30 years a passive investment in the S&P 500 returned 10.6% per year, while the typical actual investor in equity funds earned just 7.1%. On an initial $100,000 investment, the average individual would have left over $1.2 million on the table by attempting to time the market.

“By 2005 or so, it will become clear that the Internet’s impact on the economy has been no greater than the fax machine’s.” – Nobel Prize-winning economist Paul Krugman, 1998

If we can’t accurately forecast the market, and if our own biases get in the way in any event, the best course is the time-tested approach of creating a long-term plan when things are calm, and then maintaining the disciple to hold fast to the plan when the going gets tough. Too many retirement investors panicked in March of 2020 and sold when the market had dropped by 25%, only to sit bay and watch as the rapid market recovery passed them by. Instead, investors who stuck to their game plan took the opportunity to rebalance portfolios back to the target and reaped outsized rewards during the rapid recovery. And they slept better.

“It’s tough to make predictions, especially about the future” – Yogi Berra

Until humans develop a much more accurate ability to forecast economic and market swings, timing the market will inevitably fail. Behavior is a much more important determinant of returns than fund performance.

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