Of Snowstorms and Market Crashes
Here in Freedomville we’re emerging from the snowstorm-of-the-century-of-the-week that wasn’t. Weather forecasts in the mid-part of last week predicted 2-4 inches of snow accumulation last Friday night into Saturday morning, and for us that would have been a significant amount. The forecasts led to a familiar phenomenon: panicked masses flooding the grocery stores on Thursday into Friday to clear the shelves of staples like bread and milk. One of my neighbors reported seeing a woman exit the local grocery store with eight gallons of milk. Eight. The bread aisle looked like a stampede had proceeded through the area. By late Friday night this frenzied behavior had created something approaching a local shortage of bread and milk.
I did not go to the grocery store on Thursday or Friday as the projected snow volume moved higher. My routine is to hit the grocery store on Mondays. I like routines. So I had a little extra time to consider the psychology that compels an individual to light their hair on fire and speed to the store to throw some elbows and thereby ensure their right to buy more milk than any normal sized family could possibly consume in three weeks, let alone three days. Here in Freedomville we get a storm forecast like this one about once a year, and every now and again it actually materializes. Whether it does or not, each year I get an opportunity to marvel at the resulting irrational behavior. Action bias—the unfounded conclusion that taking any action, no matter how irrational, must be better than taking no action in the face of adverse circumstances—prompts many to move aggressively toward the bread aisle. The remainder of the throngs are driven by herd mentality; “my neighbor said he’s running to the store to buy up staples so I should too!” In the end this irrational behavior creates the bad outcome that the herd was attempting to avoid.
A similar set of psychological factors drive behaviors that lead to market crashes. The same irrational impulses that lead someone to rush to the store to buy milk that they don’t need can lead them to sell public equity shares during market downturns even though they don’t need or intend to access the invested capital for years if not decades. In both cases, even though the bread (invested capital) is not needed this weekend (or this decade), the fear that I could not buy it (or sell it) tomorrow if I wanted to compels me to do it now. Because I can’t just sit here and be content with the milk and bread that I know will last me through this storm, can I? Certainly not when I see everyone else on the local news rushing to buy it up … right? This bias toward action also adversely affects our investment returns—whether it prompts selling in the trough of a downturn, or just simply churning supposed long-term investments in a frenzied attempt to stay ahead of the market. (Read here for an entertaining analysis of the action-bias principle in the context of soccer penalty kicks and investing.)
The projected 2-4 inches of snow did not materialize here in Freedomville. We received a very light dusting. That may be over-stating it. Late on Monday afternoon, three days after the lines of frantic consumers at my grocery store checkout had burned off, I sashayed my pretty self into the market and leisurely selected my bread and milk for the week. (Note here: if Snowmageddon 2017 had actually materialized, we had enough in reserve to last us well beyond any conceivable period of snow-in and/or supply-chain disruption.) As I walked through the aisles I entertained myself by contemplating whether I could buy a few of Mrs. 8-Gallon’s containers for pennies on the dollar. I concluded that I surely could. A lot of bread and milk will be at the curbside for next week’s garbage pickup.
I doubt that the $25 or so that Mrs. 8-Gallon burned buying up perishable goods that she clearly did not need will bankrupt her family’s finances. “It was good to be prepared!” she will undoubtedly declare as she heaves them into the big green trash bin to roll to the street. No problem! But when the mistake is the sale of her portfolio of equity stocks at fire-sale prices during the next market correction … problem. And what’s even harder for me to understand is that she’ll do it all over again next year (or next market correction)! It is an absolute truism that those that do not learn (and learn from) their history are destined (or doomed) to repeat it.
Now let me take a few moments to clarify a couple of points and objections. I am not saying that there is never any rational urgent action to be taken in the face of potentially dire circumstances like severe storms or market downturns. If you usually buy bread and milk on Saturday, you need it this Saturday, and the forecast is for a snowstorm to hit on Saturday—buy before Saturday! Similarly, if you need to sell securities in the next year to fund living expenses or to re-balance to a desired portfolio allocation, and you subscribe to the view that US equity markets are over-heated, then adjust now. (But prudent and thoughtful portfolio allocation should prevent you from ever being in a situation where movements in the equity markets in one day or one week demand that you sell equity positions. Short-term spending needs should be covered by capital drawn from less volatile asset classes like, ahem, bonds … Ok, so maybe everything is volatile these days.) The harm is self-imposed by all of the other people that take action but don’t need to. Irrational and unnecessary action in the face of perceived risk leads to moldy bread and the so-called “behavior gap”—or the phenomenon where the S&P 500 (or other investment index, mutual fund, or vehicle) generates a return of say 8% in a given year, but the return for the “average investor” in the security was something less, say only 5%. (Read here for an excellent explanation of the behavior gap by Harry Sit, as well as an argument for why the Dalbar report overstates it). I’m reminded here of Charles Ellis’s analogy in his classic book Winning the Loser’s Game where he compares investing to amateur tennis, and concludes that in both cases the secret to success is to avoid unforced errors—that is, don’t beat yourself.
In these situations it is the superfluous action that compulsively seeks to avoid harm that—paradoxically—brings about the feared undesirable result (either scarcity of staples during a storm or loss of portfolio value during a correction or crash). Freedomville is an affluent suburban community—grocery stores here don’t run out of milk and bread. Ever. Except of course when people panic during storms. Rational and efficient markets should not lose 15-plus percent of their value overnight (literally or figuratively). Ever. Except when people panic during storms. (And note here that irrational behavior affects market values on the way up as well as the way down, thereby exacerbating the volatility.)
Avoiding Unnecessary Waste and Loss
A fundamental tenet that undergirds the FI philosophy and community is that we think differently than the herd, and that philosophy has served me well in dealing with snowstorm forecasts as well as market corrections and crashes. The best practice is to develop a solid plan before the perceived crisis arises—one that is based on sound reason, logic, and a knowledge and understanding of relevant history. And then stick with it come hell or high snowfall—no matter how loud the hue and cry from the herd becomes. To achieve this objective you must be confident in the thoughtful and informed decisions that you have made. I am not advocating never re-evaluating your decisions. To the contrary—important and weighty decisions should always be stress-tested and re-evaluated. But if the decision was sound and reasonable in the first instance, and if you keep your cool and re-evaluate it using reason and logic—not emotion driven by the adverse circumstances—you’re likely to re-confirm the decision fairly easily upon revisitation. And a good working knowledge and recollection of history will help build confidence in the decision. I’ve been to the grocery store enough to know that there is always milk and bread a-plenty on Monday when I typically need it, and that storms in our area just don’t keep us locked up that long. I’ve also lived through enough market corrections to identify the big patterns—the market will always be over-bought on the way up, and always over-sold on the way down. And any time you hear the guy bagging your groceries tell you that “I’m never investing in foreign stocks again … I’m just making too much in the US!” … you know that you likely have an opportunity to be greedy.
So get ready. More storms are coming. Winter isn’t over yet here in Freedomville. Market corrections are also coming. I don’t know when, and I don’t really care. I just know that they do eventually come. Let’s prepare our psychology to weather the next storm, no matter what the herd does.