The Cycle of Market Emotions - Where Are We Now?
The Cycle of Market Emotions - Where Are We Now?
Before my current job as a commercial lender, I spent six years as a licensed investment advisor with Ameriprise Financial and then Means Wealth Management, a family-owned firm here in Bangor, Maine. I always felt like being a financial advisor was really two different jobs depending on whether the market was going up or down. In a rising market, everyone is happy and it feels like picking stocks, industries, or funds is easy. Customer calls and quarterly meetings are pleasant because, well, people are generally pretty satisfied when their accounts are rising in value.
When the market is down, however, the role of an investment advisor becomes just as much about managing emotions as it does about choosing investments. Emotional intelligence and the skills of a psychologist are the necessary skills of an advisor as opposed to just the ability to craft a portfolio.
To be a good investor, you often have to do the exact opposite of what your gut is telling you to do. When things are hot and rapidly rising in value, it is usually a time to be more cautious even though it seems in the moment like things are going to continue rising forever. On the other hand, when there is trouble in the markets and the future looks bleak, it is usually the best time to invest. This concept is encapsulated in a famous investment axiom, “Be fearful when others are greedy, and be greedy when others are fearful,” or the more evocative, “The best time to invest is when there’s blood in the streets.”
I have always found the chart below helpful when considering moments in the stock market. An appropriate question to ask when making investment decisions including when to buy, how much to invest, how aggressively to invest, or whether to sell is simply where are we on the cycle of market emotions.
The point of maximum financial risk is at the moment of euphoria. The point of maximum financial opportunity is in the Capitulation/Depression area of the chart. But it certainly does not feel that way at those times, and the mismatches of the emotions people feel with the risk and opportunities that exist very often lead people to make poor financial decisions.
For example, someone might watch a stock they are curious about go up and up in value over the course of several weeks, months, or even years, just watching it and wondering whether to invest in it. Eventually, the positive upward trajectory starts to feel like a never-ending certainty, almost preordained to continue. Plus, investors or would-be investors are also susceptible to healthy doses of FOMO (Fear of Missing Out) and if they see all of their friends, neighbors, and especially Facebook friends making money off something, they will want in on it too. Take the emotions of Thrill and Euphoria on the chart above and throw in some FOMO and you have a pretty toxic emotional stew, which is why 6-12 months ago so many regular Americans were investing in things like Bitcoin and other cryptocurrencies plus stocks like Gamestop and AMC, all of which are down significantly from their meteoric peaks.
The Cycle of Market Emotions in Real Life
All usual disclaimers should apply here about how past performance is not indicative of future results and that each person’s own circumstances should be taken into account when investing (see end of article for a more complete legal disclaimer).
The cycle of investment gains and losses and the emotions that go with them has played itself our repeatedly over history. Consider three of the most notable stock market drops in United States history: the Great Recession, the Dot Com Crash, and the stock market crash that kicked off the Great Depression. Notice how in each of these charts the cycle is basically the same and matches the Cycle of Market Emotions Chart noted above:
The Great Depression (Chart: Dow Jones Industrial Average, 1915-1937)
The Dot Com Bubble (Chart: S&P 500, 1996-2006)
The Great Recession (Chart: S&P 500, 2003-2013)
We are all human beings prone to emotional and irrational decisions, all the more so when it comes to money, so unfortunately we humans often make exactly the wrong decisions by investing when things are already up and selling once they are down. Buy low, sell high is the basic goal of investing, but all too often people buy high and sell low.
So Where Are We Today?
Below is the Cycle of Market Emotions from the top of the article as a reminder followed by the chart of the S&P 500 over the past five years. So where are we?
It is clear that we are not in the area of those positive upside emotions like optimism, thrill, or excitement. And we are not at euphoria. Readers of differing rational viewpoints might fairly put ourselves in different places on the downside. If I had to pinpoint it, however, I would put us at fear, and possibly a notch past fear right between fear and desperation. That leaves the potential for more downside to come, but it also puts us past the stages of anxiety and denial. Although all of these negative emotions are pretty rough, we are also approaching the point of maximum financial opportunity, which is the lowest point of the trough, at which point the drop becomes played out and we will be poised for a rebound.
What Comes Next
In fairness, the cycle only is evident in retrospect and it is difficult (and, in fact, impossible) to perfectly time either the top of the marker or the bottom. I used to compare buying in a falling market to trying to catch a falling knife.
But investors should also take some solace in the fact that markets can rebound pretty quickly following significant drops. In March 2009, for example, the Dow Jones Industrial Average bottomed out at 6469. Two years later the Dow was nearly 13,000, a doubling (or ~100% gain) over the course of 24 months. It would have been very hard to pull the trigger on investing aggressively in March 2009, but for those who did (or who at least didn’t sell), they reaped healthy rewards as the stock market rebounded.
Unfortunately for some investors, not only did they sell during those blood-in-the-streets moments from the end of 2007 through the spring of 2009, they then stayed on the sidelines instead of getting their money back in during the years that followed. So not only did they lock in their losses by selling, but they also missed out on the gains that came over the next several years. In fact, from 2009 onward, despite plenty of blips and dives along the way, the overall stock market had a pretty robust positive run for the next decade.
So What To Do
Again, keeping in mind that everyone is different and has different investment objectives and varying tolerances for risk, at least asking the question of where we are at on the cycle of market emotions can help to frame objectives, risks, and expectations. And you should never invest too aggressively what you cannot afford to lose.
But there are other strategies, too. For example, you can work with a financial advisor. I consider myself a pretty fee-conscious person and any fee you pay to an investment advisor for managing a portfolio is money out of your pocket, but I also fully believe that a good investment advisor will not only earn that fee on a yearly basis, but actually save you tens if not hundreds of thousands of dollars more over the course of a lifetime simply by preventing you from making poor decisions. An advisor who simply said no to a person who wanted to sell in 2009 (and then, of course, explained why and educated their client about the long-term plan), would have profited the investor richly with investment gains that would have continued to compound over time. A good financial advisor with the acumen and emotional equanimity to manage portfolios of investments is generally worth the fees as far as most investors are concerned.
A second strategy is to dollar-cost-average one’s investment dollars over the course of several months or a year or more. If you have $100,000 to invest, for example, you could invest $10,000 per month over the course of ten months to average your way into the market. That puts some of your money to work, allowing you to achieve some gains if the market goes up, but it also protects you on the downside by not only keeping some of your powder dry, but also allowing you to buy more shares with each subsequent purchase as you average you way into a falling market. If the market drops significantly during this dollar-cost-averaging period, you might even consider accelerating your purchases once the market is down.
A third strategy, strange as it may sound, is to stay invested but simply do nothing. Look away. Don’t open your statements. This, of course, is if you are invested long-term in a properly diversified portfolio with an overall risk level that matches your goals. I have long thought that the best investors over the long-term are the ones that follow their investments the least because the more you follow them, the more likely you are to make irrational emotional decisions. Turn off CNBC, close the computer screen, meet with an advisor quarterly or every six months if you have one, and live your life. Because even though the charts above showing the various cycles of gains and losses may be anxiety-inducing, also keep in mind the chart below of the total stock market history:
The macro trend superseding all of these smaller trends is that the overall trajectory of the stock market is up and long-term investors generally win overtime regardless of these shorter term fluctuations along the way even when those fluctuations themselves fear pretty bad. According to Jason Hawthorne at The Motley Fool:
Since 1980, the S&P 500 Index has dropped at least 18% seven times. That means that, on average, about every six years investors experience something close to the definition of a bear market. Yet over that period, someone buying and holding realized a 4,220% gain. Enduring the volatility turned a mere $10,000 into $432,000.
For the year so far in 2022, various stock market indexes are down 14% for the Dow Jones, 21% for the S&P 500, and 31% for the NASDAQ. Those losses hurt, but the chart above should give some solace. Just don’t look at your next quarterly statement too closely.
Ben Sprague lives and works in Bangor, Maine as a Senior V.P./Commercial Lending Officer for Damariscotta-based First National Bank. He previously worked as an investment advisor and graduated from Harvard University in 2006. Ben can be reached at ben.sprague@thefirst.com or bsprague1@gmail.com. Follow Ben on Twitter, Facebook, or Instagram. Opinions and analysis do not represent First National Bank.
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