(This is a reprint from October 2017)
A bull market is one in which major stock indices (i.e. S&P 500) are rising or are expected to rise. We’ve been in our current stock-fueled, bull market for nearly 10 years. The second longest on record, after the dot-com bubble of 1990-2000. So how can a bull market seduce us, again and again? Let’s look at three facets of behavioral psychology:
We’re too optimistic during good times.
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 (like bear markets).
We have short-term memories.
Secondly, we tend to have short memories regarding the information and data we use to make decisions, like current events (i.e low unemployment) and underestimating or ignoring the more distant past (i.e how well the economy appeared to be doing just before the great recession of 2009).
We make emotional (bad) decisions when we are scared.
This combination of optimism & short-term memory often results in us being caught 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? You guessed it, the emotional side.
Emotional decision making can lead to 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.
Ask yourself the following three questions:
- What is my financial risk tolerance?
- How much financial risk (return) do I need to achieve my goal?
- How much can I afford to lose and still achieve my goals?
If you need help, ask a professional.