Bear Hugs For Nervous Investors Investor Psychology 101

About the author:
John W. Schott, M.D. serves on the faculty at Harvard Medical School. Dr. Schott received his B.A. from Johns Hopkins (summa cum laude and Phi Beta Kappa) and his M.D. from Harvard Medical School. He did a medical internship at the Mayo Graduate School at the University of Minnesota and completed psychiatry training at the Massachusetts Mental Health Center. He is also a graduate of the Boston Psychoanalytic Institute and Society. His major area of research is in behavioral finance with special interest in the relationship between personality and investment decisions.

Dr. Schott, as well as others, will be writing more articles for AIC in the future, all of which will be available on our website at www.aic.com – check in and check them out.

Investor Emotions Experienced During Bear Markets

In contrast to the greed and excitement characterizing bull markets, investors experience fear, anxiety, and depression during bear markets.

What defines a bear market? There is some difference of opinion about this, but the generally accepted definition of a bear market is a drop of 20% or more in the broad indices of the market.

A bear market usually, but not always, begins slowly with a steady pattern of declines occurring among the market's most speculative stocks and those with the most over-valued metrics, e.g. high P/E ratios, high price/book ratios and high price-to-sale ratios.

An astute investor may spot this and institute defensive measures such as reducing the equities held in favor of purchasing more fixed income investments.

If you are a long-term investor determined to hold through" thick and thin", be prepared to recognize that "thin" is approaching. All investors should understand that 20% + market drops are to be expected periodically to correct the excesses found in the late stages of every bull market. This is the human nature of greed and always occurs.

The natural history of emotions found during bear markets starts as a market decline approaches the 10% market. Lesser declines are generally rationalized as minor corrections. However, at the 10% mark, anxiety and subtle signs of panic begin to set in. Most investors employ denial as their first line of defense. Examples are "This can't be happening" or "This is only a minor correction". As the market continues its decline, investors begin to feel overwhelmed, discouraged, and depressed. Denial gives way to emotions similar to those seen in clinical depressions, including sad mood, anxiety, irritability, insomnia, and such physical complaints as tension, muscle aches and pains, and GI irritability. I dub this the Bear Market Depressive Syndrome or BMDS for short.

BMDS inevitably leads to a degree of cognitive distortion. As Yale professor Robert Shiller coined the term "Irrational Exuberance" to describe the late phase of the late '90s bull market, I call the opposite side of that coin describing a bear market as "Irrational Fear".

When this happens, it is extremely important to understand that you are not a weak person. What you are experiencing is the conscious manifestation of a whole host of underlying negative emotions. In an established bear market, investors must cope with BMDS emotions, which are as painful as a clinical depression.

The typical BMDS causes investors to feel some of the following symptoms:

1. A feeling of loss of control – accompanied by the fear that this will become a total loss of control.
   This is the reverse of the illusion that people feel in a bull market when their fantasy is that it is their skill driving the market upward. In a bear market the illusion is that it is something you are doing or not doing that is causing the losses.
2. Guilt – Following the line of thinking in the belief that one is losing control, investors blame themselves for the bear market and feel very guilty about their losses and poor judgment. This is very irrational and needs to be combated by reality testing.
3. Shame – Shame is the more primitive sister of guilt psychologically speaking. When we feel ashamed, we question our basic worth as an individual. It is our sense of self that is threatened. We feel ashamed that our losses have let our family down. We think our loved ones will stop loving us. Once again this is highly irrational and can be reality tested by talking to those most important to us.
4. Decreased self-esteem – The end result of this process is as suggested above a serious loss of self-esteem, usually related to the size of the loss in the market. The investor becomes the victim of his or her conscience or super-ego.
   This creates a special investment problem because the best investment opportunities happen in a bear market. Just when it is the time to buy, the individual suffering from guilt and shame is paralyzed in decision-making.

How to Control BMDS

You cannot see reality, you cannot embrace opportunity when you are under the sway of BMDS. You will find it very difficult to achieve long-term wealth if you do not overcome BMDS.

 Here are some very simple rules and tools to help you through a bear market.

1. Remember the market is cyclical. No matter how severe or how long a bear market lasts, the market is eventually going to recover and when it does a new bull market will begin. Remember the market is cyclical. It is human nature and will be that way for the rest of your investing life.
2. Think dollar-cost-averaging! It may not feel like it at the time, but market drops are your friends in the long run. A market drop of 20% or more is a buying opportunity, not a reason to sell.
3. Expect market drops of 20% or more. Bull markets always go to excess and need to be corrected. Sometimes bear markets correct these excesses. Sometimes they too go to excess. These occurrences give you a chance to buy at a bargain.
4. Maintain a wish list. Sir John Templeton, one of the greatest investors of all time, maintained a wish list of companies he would like to own stock in, but were over-valued. When the market dropped, he hoped to buy these stocks at bargain levels.
   If Sir John did this, why not you? List some of your favorite stocks and then review them with an eye to selecting the five or six you think are the very best businesses. Then decide the price you regard as a bargain and be prepared to buy if and when the market slides to that price. Do not be greedy waiting for lower prices. Buy as soon as your desired price is reached.
5. Have heroes. Every investor should have investment heroes, those people who are your ego ideals of investing. My two are Warren Buffett and his mentor, Ben Graham. When the market starts to go sour and I begin to have self-doubts, I re-read Buffett and Graham, thereby feeling reassured that all will be well if I just maintain my discipline.
6. Seek support from like-minded investors. If you have friends who invest using a style similar to yours, talk to them frequently. You will feel comforted and reassured that they are experiencing feelings and thoughts very much like yours. These are techniques to use all the time, but investors seldom do during bull markets because they are usually content with the status quo at those times. A bear market is painful but if it forces you to do some valuable planning, the ultimate outcome will surely be in your favor.

This is also the time to contact your financial adviser for support. Discuss with him or her, your goals and your plans. Does he or she think you are on target with your investment plan?

About the author:
John W. Schott, M.D. serves on the faculty at Harvard Medical School. Dr. Schott received his B.A. from Johns Hopkins (summa cum laude and Phi Beta Kappa) and his M.D. from Harvard Medical School. He did a medical internship at the Mayo Graduate School at the University of Minnesota and completed psychiatry training at the Massachusetts Mental Health Center. He is also a graduate of the Boston Psychoanalytic Institute and Society. His major area of research is in behavioral finance with special interest in the relationship between personality and investment decisions.

Dr. Schott, as well as others, will be writing more articles for AIC in the future, all of which will be available on our website at www.aic.com – check in and check them out.

The Pain of a Bear Market

Almost every investor has heard the cautionary statement, "Beware of greed in a bull market and fear in a bear market "This interdiction is a valuable one. We want to take you to a higher level of understanding about this statement especially as it applies to emotions felt in down ("bear") markets.

Let's begin with the happier days of up or bull markets. Most investors during a bull market (the exception being traders) don't so much experience greed as they do marked happiness or excitement. Rising markets stimulate ideas of retirement and the fulfillment of dreams. The higher the market goes, the more extreme the hopes become. Remember back in 1998 and 1999, how many people were going to, or in some cases actually did, leave excellent jobs and professions to "play" the market full time. How many friends and acquaintances were planning to retire at age 55?

The significant fact about this kind of euphoria is that it means that the person has become grandiose. Grandiosity is a stage gone through in early childhood, which can easily be rekindled. The easy money of the late '90s came from being a participant in a market mania or market bubble. However, the exuberant investors believed that it was their skill that led them to a sense of grandiosity. They had never heard the sage Wall Street saying, "Never confuse genius with a bull market." Wise investors in the late '90s made some easy money and then battened down the hatches even if meant being on the sidelines during the latter part of the bubble.

The same grandiose aspect of the personality is at play in bear markets, but in reverse. Having taken a huge amount of undue credit for itself in the bull market, the mind now blames itself for the failures in a bear market. The combined pain of loss of self esteem and loss of money damages an investor's narcissism in a severe way, sometimes even to the point of an actual depression or at least a mental state highly similar to a depression which I call the Bear Market Depressive Syndrome or BMDS for short. The rational person would say to himself, "I know markets are cyclical. I know a market bubble must be followed by a severe correction to get values back to normal." In fact, rational and experienced investors know that while a bear market may be painful, it affords the opportunity to buy good stocks at bargain prices. For the mutual fund buyer, he or she knows that dips provide a useful way to dollar-cost-average and ultimately give superior results.

The very important lesson for all investors is to appreciate that every investment carries risk, some greater than others. U.S. and Canadian government bonds (as well as those of other developed nations) are sometimes perceived of as risk-less. However as buyers of U.S.T-bonds have learned in recent years, currency and interest rate risks are associated with government bonds and can be fairly severe. Therefore, remember every investment carries risk and it is not always possible to tell in advance what the risk will be.

Before investing think about risk and consider it in two dimensions. First, calculate the risk in the usual ways. Be cognizant that most investments carry both market risk and company specific risk. By market risk, I mean interest rate risks, wars, political risks, acts of God, and broad market declines, and others too numerous to mention. Company specific risks mean management skills, management honesty, product problems, lawsuits, and whatever competition can throw at the Company. When assessing these risks, be sure to discuss them with your broker or representative. You will gain valuable insight and it will give him or her the opportunity to learn your needs better. Be warned that Wall Street and academia have a different definition of risk than you do. To them, risk is volatility. It is measured by beta, the measurement of how closely an investment mimics the market as a whole. A beta of one means that stock rises and falls exactly with the market, generally the S&P 500, but beta could be calculated against any customary bogey, other common examples are the Dow-Jones Industrials or the NASDAQ 100. A beta of less that 1.0 indicates low volatility and a beta of greater than 1.0 indicates high volatility, but remember volatility and risk are not at all the same thing.

The second aspect of risk is equally if not more important which is the psychology of risk and what it means to you individually. People differ widely from each other in this important dimension. Certain reality factors will bear on this. They include your age, your earnings, your inheritances and expected inheritances, your health, and whether or not you are married and have children. In addition, your attitudes about risk will be shaped consciously and unconsciously by your genes, by your parents attitudes toward risk, by your feelings about money, by your confidence, and by your past experiences with losses. If you are a person who has experienced many painful losses in your life, you may be very loss averse. Yet this is a highly personal quality, because some people with a history of many painful losses are driven to repeat them in an attempt to gain mastery. This is called repetition compulsion.

At first glance this may seem very daunting. It is truly complicated, but be assured most people can invest very successfully. Be aware as you begin to think about risk and how to manage it, that research has shown we tend to overestimate our capacity to tolerate loss. Danny Kahneman, a psychologist at Princeton University who shared the Nobel Prize in Economics for his work in behavioral finance, and his mentor Amos Tversky demonstrated that the average individual believed he could tolerate twice as big a loss as he actually could. In other words, if you believe you can tolerate a 20% decline in the market value of your investments without feeling much pain, you would actually begin to panic at 10% decline.

What can you do with all this knowledge to become a better investor?

1. Consider being a dollar-cost averaging investor. Select good mutual funds or stocks that you regard as excellent long-term investments and systematically invest the same dollar amount at fixed time intervals, e.g. quarterly.
2. Diversify your investments. If you have all growth funds, add some value funds or vice-versa. If you buy individual stocks, diversify by always investing in many sectors. They tend to perform differently at different times. Therefore your results may be smoother causing you less anxiety. Beware of "di-worsifying". Don't make a bad investment for the sake of diversification. Incidentally, 17 stocks, if chosen from different sectors, will give 90% of the diversity of the market. 30 stocks will give you 98.6% of market diversity.
3. Emulate the great investors. First, these investors know they will make errors. In fact it may not even be their error. Remember no one can accurately predict the future. If 60% of your investments turn out to be successful, you will do well. If your batting average is higher, you will do really well. Second, concentrate on your investments as businesses. Follow the company’s business results more than you follow the share price. If the business is doing well ultimately the stock price will follow. Third, my colleague Dick Geist has observed that many of the greatest investors have had a friend or partner on whom ideas could be tried out. Warren Buffett and Charley Munger are the most famous example of this. At first glance, they seem like an odd couple, but their differences apparently complement each other. Certainly no one could challenge the results. So if you have a friend whose input you value, try running investment ideas by him or her. Absent such a person in your life, try to utilize your broker or representative this way. Direct him or her that you want frank feedback.
4. Repeat to yourself every day that this is the kind of market Warren Buffett and the other truly great investors relish. Maintain the wish list mentioned in the previous article. A wish list is a list of the companies that you consider the greatest investments and at what price you would like to buy them. If the share price is reached, buy the stock without trying to get it more cheaply.
5. Time is your friend. In growing economies like the U.S. and Canada, the long-term trend of the market is almost always up. If you have shares in a good business, even if the price drops, your odds of doing well in time are very good.

Market Cycles and Investor Emotions Move In Tandem

Stock markets move in cycles and investors are pulled through a range of emotions as the market goes through its routine of ups and downs. The following chart illustrates this point very well.

Starting in February 1999, as the market moved higher, investors were optimistic. As time went on, optimism moved to excitement and by July 2000, investors were elated as their investments doubled in value and the bull market charged ahead. They began to believe, “Wow this is easy.” It was at this point that they were at the greatest financial peril as they began to take more risks and greed dictated their investment decisions. By this time however, the market began to turn.

By October 2000, investors began to worry about their investments. As the market slide continued into 2001, anxiety was the emotion of the day. Investors hoped things would turn around in 2002, but as the bear market took hold, fear, desperation and panic set in until finally investors felt defeated and sold.

Selling is the worst thing an investor could do at this point. This is the point of maximum financial opportunity – the time of deepest gloom.

Don’t ride the emotion cycle
You don’t need to ride this cycle of emotion with the market. It is inevitable that markets move in cycles; the key is to not get caught up in it. By sticking to a sound intellectual framework for investing, you remove the emotion from your investment decisions. You need to ride out the ups and downs of the market and view the downs for what they really are – great buying opportunities.

Now is the time to buy
History has proven that the best time to buy stocks is at the deepest point of gloom. Buying at or near the bottom of a bear market is a wealth-creating opportunity. Looking back over the past 25 years, when were these opportunities available?

1982	Debt crisis – worst recession in 40 years
1987	Market crash
1990	Gulf war
1994	Quebec referendum
1998	Asian crisis
1999	Y2K
2001	Tech bubble bursts
2002	Corporate scandals
2008	Sub-prime mortgage crisis

Six to 12 months after each of these events, the market reversed and returned to positive territory. Had investors bought after each bear market ended, they would have enjoyed stellar returns in the subsequent months. Today, we may be at a similar point of opportunity.

While no one knows if the market will drop further or take off to new highs tomorrow, we do know that, as history has demonstrated, five to 10 years from now things could look much better. Stop riding the cycle and start believing in the long term. Contact your financial advisor to discuss this opportunity.

Investor Behaviour vs Fund Performance - Which Wins?

The S&P 500 delivered 11.81% over the past 20 years but the average equity mutual fund investor only earned 4.48%.*

Just as puzzling, over 20 years, the average fixed income mutual fund investor only earned 1.55% while investors in asset allocation portfolios only earned 3.45%.*

Why?

Investor Behaviour.

DALBAR, a Boston-based financial research firm, has been measuring the effects of investor decisions to buy, sell and switch into and out of mutual funds since 1984. According to the 2008 Quantitative Analysis of Investor Behaviour study conducted by DALBAR, one of the principal reasons why the average investor has earned significantly less than the mutual fund performance is because...

Investment return is far more dependent upon investor behaviour than on fund performance – some investors make investment decisions based on emotions rather than sound investment practices.

Close examination of investor behaviour reveals that, as markets rise after a decline, investors pour cash into mutual funds, and a selling frenzy begins. Tracking dollars going in and out of mutual funds over a given month compared to market performance proves the correlation: As markets go up, cash flows swell; as markets go down, cash flows deflate. According to DALBAR, poor longer-term investor performance is also due to investors holding their mutual funds for a short period of less than four years.

This research study also shows that mutual fund investors who hold their investments are more successful in the long run than those who try to time the market.

THE POWER OF DOLLAR-COST-AVERAGING

Rather than attempting to time your investment or redemption to beat the market, consider this suggestion: start early, keep contributing and don’t panic when the markets fluctuate. How? Establish a regular program of systematic investing; for example, use dollar-cost-averaging.

As the bar chart indicates, in all three types of mutual funds (whether equities, fixed income or asset allocation), the dollar cost averaging (or “systematic”) investor would have fared better than the average mutual fund investor, according to Dalbar research:

• For equity investors, the increase in appreciation would have been more than 50%.
• For fixed income investors, the increase would have been 196%;
• And, for asset allocation investors, the difference in return would have been 116%.

All examples, assume a total of $10,000 is invested over 20 years. As Dalbar research points out, the illustrations demonstrate the importance of consistency in wealth building. Moreover, the benefit of dollar cost averaging can potentially be dramatically improved by increasing contributions over time.

According to Dalbar research, the principles of behavioural finance help to explain why investors often make buy/sell decisions that may not be in their best interests.

Behavioural finance hurdles include the following:

Central to improving investor behaviour is correcting the irrational actions that are driven by the behavioral finance factors of:

Loss aversion – expecting to find high returns with low risk
Narrow framing – making decisions without considering all implications
Anchoring – relating to the familiar experiences, even when inappropriate
Mental accounting – taking undue risk in one area and avoiding rational risk in others
Diversification – seeking to reduce risk, but simply using different sources
Herding – copying others even in the face of unfavourable outcomes
Regret – treating errors of commission more seriously than errors of omission
Media response – tendency to react to new without reasonable examination
Optimism – belief that good things happen to me, bad things happen to others

While many investors can overcome these hurdles above on their own, most need the support of a financial advisor to supply the required discipline and encourage the necessary patience.

Contact your financial advisor today.

*Source: Dalbar 2008 Quantitative Analysis of Investor Behaviour