Trees Don't Grow to the Sky
Half way through 2017, the economy and the markets remain on solid footing. In fact, the U.S. stock market has not posted an annual loss in 8 years. We all know that both trees and stock markets don't grow forever and at some point (which no one can reliably forecast) the market will decline, and decline enough to enter bear market territory of –20% or more.
Market declines are a fact of life, and their timing and magnitude is beyond our control. The way we react to them, however, is completely in our hands, and it dictates whether or not they have a lasting impact or are a passing storm.
A recent article in the New York Times by psychologist Marty Seligman detailed new thinking about the way our minds work. Specifically, we may be far more forward looking and obsessed with the future than previously thought. Seligman writes that "our emotions are less reactions to the present than guides to the future."
Prior psychological theory explained human behavior as a consequence of each individual's history, of habit and repetition, memory and perception. But it seems this may not be the case, at least not entirely, and it has important implications for our financial lives.
If this is true, why are we obsessed with the future? Are we all just more overwhelmed than we'd like to admit, caught up in the accelerating pace and pressures of modern life? That was the argument made by Alvin Toffler in his famous 1970 book Future Shock.
However, the answer may go back much farther. In his recent bestseller, Sapiens: A Brief History of Humankind, Yuvel Noah Harari argues that this behavior is rooted in our transition from hunter/gatherers to farmers, some 10,000 years ago.
When humans transitioned from a nomadic way of life to farming (the "Agricultural Revolution"), we became dependent on seasonal crops, and forces beyond our control – droughts, floods, pestilence – greatly affected our survival.
As a result, we came increasingly to focus our daily lives on planning for the future. We st
ored grain and seeds, salted and stored meat for the winter, and developed other ways to build up a surplus.
Surplus became a key to survival, and we adapted to pursue and acquire more than we need. This accumulation of excess wasn't greed, it was prudence - those who planned better stood a better chance of surviving. (Sapiens, p.100-101)
Thousands of years later, few of us depend on farming for our daily survival, but we continue to weigh the future heavily. Historically, there has been great reward in looking forward, planning, and acting with foresight. It set us apart thousands of years ago and landed us at the very top of the food chain.
The Lure of Pessimism
Unfortunately, this often leads us to overemphasize the dangers that may lay ahead, and discount potential upside.
Financial columnist Morgan Housel wrote about this in a recent piece titled "The Seduction of Pessimism"
"Tell someone everything will be great, and they're likely to shrug you off…Tell someone you're in danger, and you have their undivided attention."
"Pessimism," he continues, "is often taken more seriously than optimism, which can sound like salesmanship or aloofness." In short, pessimism can sound practical (even when it's not) and optimism can sound foolish or fake, even when it is rational and logical.
He concludes that within investment markets, "the difference between pessimism and optimism often comes down to time horizon. If a recession or downturn is the end of your show, you should be pessimistic. If it’s a bad commercial during an otherwise great episode, you should be optimistic."
Put another way, recessions, market downturns, or good investment decisions that nevertheless get poor results are just chapters. They're not the whole story. Each of us can get through a bad chapter, as we likely have many times before.
The problem comes when we take the current chapter (a market drop) and view it as the final act, or the whole story. A long-term outlook can help properly place a market downturn in context. When the market drops and we see the value of our portfolios decline, that decline is no more permanent than the gains of previous year. But it is difficult convince ourselves, especially when bombarded by news reports, tweets, and articles shared by friends, that the current decline too shall pass, as previous declines have before it.
Planning As a Path to Happiness
There are ways to break out of this trap and alleviate pessimism about the future. To start with, planning helps. Going back to Marty Seligman in the New York Times:
"When making plans, [people] reported higher levels of happiness and lower levels of stress than at other times, presumably because planning turns a chaotic mass of concerns into an organized sequence. Although they sometimes feared what might go wrong, on average there were twice as many thoughts of what they hoped would happen."
The first step, the one that should be taken now, before we're in the midst of a downturn, is a fresh look at your financial plan. This can be as straightforward as a comparison of what you're earning versus what you're spending each year, and setting aside cash for any large expenses looming in the next 12-24 months. Or it can be an in-depth as a comprehensive financial plan projecting decades into retirement and addressing income, tax, retirement, insurance, and estate planning issues.
Planning, in some form, is a key component of long-term financial success, regardless of market conditions. But it is done best and most effectively when the markets are calm and heads are clear.
Visualizing The Next Decline
In addition to tangible financial planning, visualizing what a bear market will look like, and preparing for the media blitz, can lead to better decisions, sounder sleep, and provide surer footing when the seas gets choppy.
A useful analogy, at least for those of us in DC metro area, is the snow storm of the century, which seems occur every 3-5 years. Most of us are well conditioned at this point, as the 6 o'clock news bombards us with dire warnings, and clips of empty supermarket shelves. We've checked our snow shovels or snow throwers come November, we've made sure we have some ice melt on hand, and we might pick up an extra bottle of wine when it looks like a storm is on the horizon. When it comes, we hunker down, ride it out, and move on. A bear market should be no different.
As a helpful, if somewhat uncomfortable exercise, multiply your current portfolio value by 0.8 (or have us do it for you). It's reasonable to expect that at some point your portfolio will be worth that amount, on paper. That number is what the storm might look like. (It's also reasonable to expect it to be higher than the current value at some point in the future, but most of us can live with that.)
Perspective on Bear Markets
A decline of 20% would be normal and healthy. In fact statistically speaking it is already overdue, as declines of 20% typically occur every 3.5 years on the Dow Jones Industrial Average, according to American Funds. (American Funds). The last 20% decline on the Dow occurred in March 2009, almost 8.5 years ago.
Even armed with this knowledge, it can be difficult to remain stoic while watching your portfolio decline. The next bear market will come in a time of unprecedented connectivity and interaction, thanks to the rise of smartphones, social media, streaming video, and instant account access.
At the time of the 2008 crisis, the iPhone was in its infancy, with a mere 13 million phones worldwide, versus 212 million iPhones sold in 2016. It's reasonable to assume that the next bear market may not be of the "slow and steady" variety.
When a bear market does come, we will be bombarded hourly with links, tweets, blogs, and videos, in a way which we never have been before. Words like "plunge," "steep," "sharp," “crisis,” and "plummet" will populate headlines and be repeated ad nauseum.
It will be easy to attribute the day's or week's decline to some bit of recent information – a bad jobs report, higher inflation, or increasing oil prices. But this is a trap, one that psychologists call the "narrative fallacy."
Our brains are wired to piece together explanations after the fact, with nice and tidy causes and effects. We bind facts together with explanations in hindsight, though in many cases those explanations are illusions. Novelist Cormac McCarthy said it more eloquently when he wrote "...the order in creation which you see is that which you have put there, like a string in a maze, so that you shall not lose your way."
Often during the crisis of 2008-2009, the evening headlines would attribute the market decline to a poor economic report released earlier that day. But economic reports are typically released at 8:30am or 10am, depending on the report. A closer look at many of those days with declines showed large declines and the heaviest trading in the 3:30pm –4pm window.
Are we to believe that millions of market participants collectively contemplated the economic report for 5 hours, and then decided to panic? And lest we forget, a large portion of the trading done on the market each day is driven by computers and algorithms, not a do-it-yourself investor panicking about the latest GDP report.
This doesn't mean we're clueless, or that the press is being deceptive. Pessimism, as noted above, gets our attention. Panic attracts viewers and sells ads. While the headlines makes market declines seem like anomalies or mistakes, the result of some particular misdeed or overconfidence, in fact they are quite regular occurrences. Markets are moved not by a single factor but by a complex web of interactions that even now are only partially understood.
Regardless of the root causes, while the next bear market may be unpleasant, it should not be unexpected.
We don’t know when the next bear market will come, but we think it's reasonable to expect one in the next two to three years. Nor do we know what its magnitude will be. A bear market is defined as a decline of 20% or more, and it would not be out of the ordinary to see a market decline of 30% at some point.
A well-diversified portfolio will mitigate risk and should hold up better than the market. A financial plan will provide the context for how a decline affects you and how much cushion you have. Perspective will help properly place the next bear market in historical context as a bad chapter, not the end of the story. Visualization should help lessen the emotional impact of a portfolio decline and influx of negative headlines.
Everyone's situation is different. We work diligently every day to place you in a durable and sustainable financial position regardless of day-to-day market fluctuations. Planning, practice, and perspective help us make the right decisions now and in the future. Please let us know if we can help in any of these areas.
- Christopher Rivers, CFP®