February 22, 2023
In life, few things put us at the mercy of our emotions the way investing can. The last three years in the markets have been especially unnerving, exhibiting the plot elements of a Shakespeare play. We witnessed drama as the world locked down during Covid, a supernatural-like intervention by Congress and the Federal Reserve to bring the economy back to life, and the spectacular fall of many high-flying glamor stocks when the end to economic stimulus brought investors back to reality.
For the markets to experience losses in 2022 isn’t remarkable on its face. After all, volatility is a mainstay of investing. But how the past year unfolded is a sobering reminder that markets rarely follow a prescribed order:
- With risk appetites tumbling, many would have expected government bonds to outperform in a flight to safety. Instead, they had their worst year on record — a byproduct of an unprecedented increase in the federal funds rate (interest rates) to fight inflation.
- If there was a period for gold to triumph, it should have been in 2022 against a backdrop of geopolitical danger and surging prices. Instead, gold lost money on a real return basis (that is, when you adjust for inflation).
- An area of the stock market that did outperform tremendously, the energy sector, did so with the price of crude being flat on the year. And the behavior of crude prices itself was peculiar given the constraints on global supply due to the West’s sanctions against Russia.
Investors have experienced a wide gamut of emotions — among them exhaustion, confusion, and worry — and with those have come ominous predictions of recession. It’s the very kind of malaise that forced a generation of investors to the sideline when the dot-com bubble burst in 2000-2002 and again when the Great Financial crisis struck in 2008-2009.
And on this, behavioral science can be illuminating. It tells us that our emotions can be blunt tools: helpful in real moments of danger yet counterproductive in modern arenas like investing. That’s because in the hundreds of thousands of years man is estimated to have roamed the planet, we have treated threats as more urgent than opportunities. It’s how we survived and reproduced in the face of war, disease, and predators. But even as primitive worries have given way to contemporary ones — like oversleeping on the day of an important exam or losing out on a job promotion — our old emotional circuitry has endured. It’s why consecutive days of losses can feel debilitating and better days feel very far away during a bear market. We’ve become calibrated to over-worry, and in investing, it means the head often loses ground to the heart.
"...our emotions can be blunt tools: helpful in real moments of danger yet counterproductive in modern arenas like investing."
An important part of the solution is to make a habit of studying market history. And that history tells us that business cycles are perfectly natural and even indispensable to growth. In underappreciated ways, downcycles direct our attention and resources towards higher potential pursuits in a process known most simply as innovation. This isn’t to say that we should root actively and often for recessions. But harsh conditions sow the seeds for growth as a scarcity of resources forces businesses to get better and stronger, evidenced by the fact that many of today’s most dominant companies laid the groundwork for success in recessions. Costco, formerly Price Club, was founded during the oil price shocks of the 1970s, which was an extremely challenging time for businesses and families alike. Also consider that, with the bursting of the dot-com bubble in 2001, operators’ only chance at survival was to reconfigure themselves towards profitability, spawning the likes of Amazon, Google, and PayPal. Primed with more focused operating models, they were well-positioned to later capitalize on expansionary business conditions.
"...harsh conditions sow the seeds for growth as a scarcity of resources forces businesses to get better and stronger..."
To be sure, while there is reason to be hopeful about the future, this isn’t a call to throw caution to the wind. In fact, the same emotional machinery that makes market losses so difficult are the very ones that cause us to lose our discipline in better times. A new danger emerges when our brains receive an “all clear” signal and we begin to experience a different kind of worry: that of losing out on experiences as it stirs a primal fear of social ostracism. The fear of missing out, or FOMO, is why investors chase trends to their detriment. It’s what makes us behave as though trees grow to the sky, represented in the most recent market cycle by speculative bets on the blockchain, the green energy revolution, and do-everything-from-home.
"...the same emotional machinery that makes market losses so difficult are the very ones that cause us to lose our discipline in better times."
Looking again at investing through the lens of history, we see that spotting a trend is far easier than identifying the winners of those trends. In the early 1900s, if you guessed correctly that commercial planes would become a fixture in mainstream travel, you might have still lost money on one of many companies in the boneyard of early adopters, among them Air America and Florida Airway, two of the best-regarded operators at one point. Similar lessons follow from the travails of personal computing and countless other promising industries wherein many early movers floundered. There are many reasons for this, including the high costs of scattershot R&D and a regulatory landscape that isn’t yet set (i.e., innovating against a moving target). But the key lesson for investors is that many nascent industries are not worth investing in, and if they are, it may take years before the best ones become investable.
"...spotting a trend is far easier than identifying the winners of those trends."
Becoming better long-term investors doesn’t require that we change our wiring. There’s no hope of that — not when modern living represents an infinitesimal fraction of our existence as a species. Instead, it calls for two things that are far simpler in scope. The first is to develop a better awareness of how we get in our own way and, when we find ourselves in heightened emotional states, to try to delay critical decisions. The second is to build a foundation of knowledge about the things that matter most to investing — business fundamentals and the nature of economic cycles — so that we’re better equipped to see past the fog of our emotions. With these tools in tow, the process of building wealth can feel much more like an enriching and gratifying journey rather than a storm in open waters.
Download Article: The Head and the Heart
The above information is for educational purposes and should not be considered a recommendation or investment advice. Investing in securities can result in loss of capital. Past performance is no guarantee of future performance.