The stock market has been soaring. Both the Dow Jones Industrial and S&P 500 indexes have more than doubled since their lows during the 2008-2009 financial crisis and are now approaching their all-time record highs. Understandably many investors are beginning to feel more optimistic about their financial futures. For some, the financial and emotional damage unleashed by the crisis has receded into distant memory. However, for those of you considering increasing exposure to stocks, make sure you are doing it for the right reasons, not simply because you “feel” more confident about the future of the markets.
Behavioral finance is the area of economics that studies how the financial decisions we make are influenced by our biases and emotions. Perhaps nowhere is this more evident than in the area of investing. The 2008–2009 bear market instilled fear in individual and institutional investors worldwide. That fear was well founded as the meltdown in the U.S. financial system spread across the globe and dragged the U.S. and world economy into a deep and frightening recession. Unfortunately, those investors who fled the markets forfeited the chance to participate in the dramatic reversal from the lows of March 2009 to today. There are two important lessons to be learned from this experience. One pertains to the investments and the other to the investor.
First, financial markets can change direction quickly and the timing and magnitude of those changes are unpredictable. We only know what the best course of action is when we view it in hindsight. Why can’t we do a better job forecasting market direction? Because there is no indicator, combination of indicators, or financial model that is a reliable predictor of what is to come. Entering the markets as they begin to rise and exiting before they decline would be a profitable strategy if it could be executed consistently. Unfortunately, for those who have attempted to time the markets, including some of the most sophisticated investors with enormous resources, the results have been disappointing.
Second, investors sabotage their own success by allowing their emotions to drive their decisions. Instead of developing a sensible long-term investing program consistent with their emotional and financial ability to handle market volatility, they panic during times of financial crisis abandoning their investments only to jump back in after the markets recover significantly and they have determined that “the coast is clear”. Not surprisingly this behavior inflicts permanent damage to an investor’s portfolio.
The conclusion of various behavioral research studies is clear. An extended market rally leads investors to believe that prices will continue to rise and so they accelerate their share purchases. Furthermore, the good times provide a false sense of security so they believe they have a greater tolerance to handle investment losses than they actually have. Unfortunately, for many investors, it is during a prolonged and painful bear market that they recognize their true risk tolerance.
Investing involves risk. The most important decision an investor can make is how much of an investment loss they are willing and able to handle. The time to make this assessment is before you begin your investment program rather than during times of euphoria when the markets are soaring or despair when they are declining.