A ‘bull market’ is a financial market in which prices are rising or are expected to rise. We’ve been in our current stock fueled bull market for almost 9 years, since the great recession officially ended in March 2009. The advance of stocks we are experiencing now is the second longest on record without at least a 20% drop in the S&P 500.  And it appears there are not many worrisome stresses in the capital markets at the moment. All asset classes appear similarly stretched in valuation – yet rationally valued in relation to one another. Positive corporate earnings, healthy unemployment, and growing, albeit slowly, GDP.

Each stock bull market seems to reinforce our faith in equities as the road to riches. And with each new rally, stock purchasing in 401(k), IRAs, and online brokerages grows exponentially.

So how can a bull market seduce us? Let’s look at three facts of behavioral psychology.

  1. Optimism
  2. Short term memory
  3. Emotion

Firstly, we tend to be optimistic thinkers when it comes to our futures and having successful outcomes of things. Optimism can be a great motivator, but when it comes to investing, optimism can lead to overestimating our own abilities (especially when times are good) and underestimating or altogether ignoring the risks.

Secondly, we tend to have short memories regarding the information and data we use to make decisions, overweighting current events (good corporate earnings, market growth, and low unemployment) and underestimating or ignoring the more distant past (like how well the economy appeared to be doing just prior to the last major market correction).  In early 2007, I was feeling confident enough to quit a high paying job, move my family all the way across the country and take a new commissioned based job in the financial services industry. (Hint: the company experienced massive workforce reduction just 12 months later.)

This combination of over-confidence and short-term thinking, often results in being overweight in stocks and overexposed to market shocks and surprises. This leads to the third area of behavioral psychology which is the two parts of our brains that make decisions: (1) the intuitive (emotional) side and the (2) logical side. But this is not a 50/50 partnership, because when confronted with danger, stress or surprise, guess which side takes over?  The emotional side is correct.

Emotional decision making can lead to some common mistakes many investors make during a market downturn:

  • Moving to cash – The first reaction of many investors during a downturn is to sell their investments and remain in cash until things return to normal. The problem with this strategy is that volatility and uncertainty are normal for the stock market and by moving to cash you turn your paper losses into real ones. Also, by waiting until things seem ‘normal’ you are typically missing the bulk of the recovery. Selling low and buying back high is not going to get you very far.
  • Not continuing to invest – Even if investors avoid the mistake of moving current investments to cash, many investors stop making additional contributions to investments when the market drops. Frankly, if you have not finished building your nest egg you should look forward to market drops as opportunities to double down and invest in good companies at discount prices.

Here is a strategy you can employ today to prepare yourself and your portfolio for the next market correction.  And why should you do this now? Because most likely your account balance is the highest it’s ever been and because none of us will know when the next correction is happening until we are all part of it.

Find out the answer to the following three questions: A competent financial advisor can help.

  1. What is my financial risk tolerance?
  2. How much financial risk (return) do I need to achieve my goal?
  3. What is my ‘risk capacity’? How much can I afford to lose and still achieve my goals?

Answering these three questions and adjusting your portfolio now will give you the knowledge and courage to know you are doing the right thing while you are weathering the next market reset.

 

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