Why the stock market makes you feel terrible most days?
Money Psychology 101 (3-minute read)
You’ve glanced at the markets, it’s a down day, the third this week, and you’re feeling terrible. Why is this? Last week, the market reached yet another all-time high, making it more than 10 break-throughs alone this year. But we still feel awful this week.
Loss aversion is a behavioral psychology term that explains how humans experience psychological pain twice as much as they experience psychological joy. See this article on Loss Aversion. When we face bad times we tend to forget the good times we just experienced and focus only on our losses. Yet, let’s say next week we have a great week, we will still be reflecting our losses from the week prior. Have you ever heard anyone say “2013, what a great year?” Markets were up over 26% that year. But we all remember 2008-2009.
Now, look at the chart below. You’ll notice that daily swings in the S&P 500 have averaged almost ½ up to ½ down. But, look at the long-term. The up-days outweigh the down-days on both a percentage and total return basis. Look at the rolling 20 years. The S&P 500 never been down on a rolling 20-year period in recorded history. So, even though we have seen over 10 all-time highs this year, and the markets are 20% higher than they were in January 2020 before Covid, we still feel this week’s pain more than last year’s triumph.
Loss aversion, going back to this topic, says we experience pain-to-joy on a factor of 2:1. So, if the markets are up 50% of the time and down 50% of the time, on the daily, then if you look at your portfolio daily, you’re always unhappy. This is because half of the time with a factor of 2:1 markets are down, and this equals a ratio of 1:1. Daily pain.
The prescription for this is 1 of 2 things. Either get used to the gyrations of the stock market and learn to process your emotions (but not act on them), or, stop looking at your portfolio daily.
Reviewing the evidence below, on average, the 1, 3, and 5 year performance of U.S. stocks following a big down quarter has been +25% for the next 1 year, and greater than +90% for the next 5 years. But you’ll see it is not a guarantee every time. However, when excluding the great depression, markets have been up every 5 year period. So, let’s talk about the intelligent investor now.
The intelligent investor recognizes that markets fluctuate and uses this volatility to their advantage. Even though not every 1 year period has recovered from market losses, the majority of them have. And if you as the investor added money into the terrible markets, more times than not, you ended higher than those who did not add new money in the following year. And you always have over the long-term.
So the thing to keep in mind on these down days is to keep investing. And when it hurts, invest more. A good investor will see a bad quarter as an opportunity for a great next year and beyond. But this does not mean that if GME (Gamestop) drops in price by 65%+ this next quarter it is a good investment. I am talking about disciplined, fundamental investing. Not all sold-off stocks are opportunities.
Remember loss aversion in 2021, and whenever we have these down days. Feel free to reach out if you have any questions.