3 Reasons The Market Is Exhibiting Extreme Fear
How psychology turns us into poor investors during market downturns
I think psychology is arguably the most important aspect of market sentiment and your investing success. Because of that, I think it’s important to do some research into what Charlie Munger calls the Psychology of Human Misjudgement. We make misjudgments all the time, but if we want to improve, we should strive to reduce these misjudgments.
I like looking at each of Charlie’s misjudgments and then applying them to what I’ve done in my life. Then seeing where I made errors, as well as looking at other people or current/historical events and trying to find errors in their thought processes. If you aren’t constantly challenging yourself to adopt new mental models in your thinking, you get stuck thinking as a man with a hammer (that every problem is a nail)!
We will apply some of these psychological misjudgments to the current market. We will identify some common errors the market is making in order to arrive at its current mental state. This will be discussed in the context of understanding what money-losing mistakes the market is causing people to make. If you can invert, and avoid these mistakes, you should be able to reap the rewards by thinking long-term and rationally.
Deprivation Super-Reaction Tendency
This term is also known as loss aversion. A lot has been written on the topic of loss aversion but I’m most interested in how I can apply it to my own investing, to minimize costly mistakes. The simplest way to describe Deprivation Super-Reaction (DSRT) is by the definition written by Kahneman & Tversky “losses loom larger than gains.”
All market participants love it when the market goes up. We feel happy, cheerful, and euphoric during these times. But what happens to our emotional state during the times we are currently living in? We let fear and irrationality cloud our judgment. When the market exhibits these emotions you see the results in the prices of the market as a whole.
Why is it that when we are fearful, we’re more likely to sell our assets at a loss? Rather than hold them during the temporary downturns that are completely inevitable in markets? Loss aversion is one of the major culprits. As the quote above says, we overweight losses compared to gains. In fact, Kahneman & Tversky have mentioned that losses can be twice as powerful psychologically, as gains.
Let’s go over a quick example using a current stock with a 5+ year track record, Alibaba will be a good choice. Here is how the stock has moved each year, either up or down:
If we experience losses twice as powerful as gains the overall psychological impact would be equal to years where the price is up, minus years the price is down (multiplied by a factor of 2 as losses hit harder than gains). The equation would be: 4 - 4(2) = -4. So owning Alibaba has a negative psychological toll on shareholders.
This is one of my holdings, and I still haven’t sold it because I am aware of this tendency and look at metrics other than price to determine the performance of my holdings.
In terms of using the prospect theory equation above, I don’t think it’s useful for identifying winners. There was a 10-year period where Buffet held Coke and it had a negative score as well, but his investment went up by some absurd multiple. You can use this as a way to show how hard it is to hold onto an asset when we experience negative psychological impacts.
The most important thing to combat this tendency is to be aware of being under its influence. If we are starting to get fearful because the market is going down, are we thinking rationally about our assets? If you hold a stock that is inflation and recession-proof, the fact that we are experiencing inflation and a recession does not mean our business has fundamentally changed. So why act on this fear if nothing has changed? A falling price of your asset does not change the forecasted outlook if you know it’s immune to the current environment!
This quote, straight from Poor Charlie’s Almanack, defines this tendency perfectly: “This mental tendency echoes the words of the song: “When I’m not near the girl I love, I love the girl I’m near.” Man’s imperfect, limited-capacity brain easily drifts into working with what’s easily available to it.” This is also known as availability bias.
It’s easy to be constantly bombarded with positive and negative information in this day of information overload, social media, and mobile notifications. A large part of our mental energy is going into thinking negatively about things that are happening now:
The war in Ukraine
The supply chain issues from Covid
Commodity shortage from sanctions on Russia and Covid
Rising interest rates
I’m sure you can add to this list, but you get the picture. The general outlook isn’t particularly cheery and negativity is easier for our brains to grasp. Once our sources of media begin “reporting” on more positive things, sentiment will change. When that will be is anyone's guess!
How do we combat availability bias? Like the first example, we have to be aware when we are beginning to feel fearful. Slow down, and use your system 2 thinking to understand how it will affect your assets. If you are a long-term investor, you must realize that stock will go down at regular intervals.
From 1928 to 1943 the S&P 500 experienced an intra-year drawdown of -10% or worse every year. From 1946 to 2022, there have been 45 intra-year drawdowns of at least -10%. So from 1928 to 2022, we have had intra-year drawdowns of -10% or more in 61 of those years.
This is a ~65% chance of a -10% drawdown every year. Or in every 10-year period, you will experience on average 6-7 -10% drawdowns. If you can’t stomach this fact of the stock market, you shouldn’t be playing the game. If you can think long-term and understand that the stock market has gone up after every single drawdown, you will be better prepared mentally when the next inevitable drawdown occurs.
This is a reminder that just because we have easy access to current information, it doesn’t mean that negativity and positivity will persist indefinitely. It moves in cycles. Act accordingly.
Reason Respecting Tendency is “where people want the answers to something but don't care to know the background information or reasoning to gain a better understanding.” In short, we are lazy thinkers. When someone else gives us a reason for doing something, we automatically default to respecting that reason, rather than thinking for ourselves, if that reason is rational.
For instance, there is an often-quoted study from the 1970s where people asked to budge the line of xerox copiers because they “had to make copies.” Thinking rationally, every person is waiting in line to do just that, so why would we allow someone to get in front of us to do the exact same thing we are doing? The reason-respecting tendency is the culprit!
When people give reasons for a specific action, we default to respecting the reason without rationally thinking if the reasoning is valid. So when you see a talking head discussing the next hot stock, think rationally about what they are saying. Do your own homework to try and figure out if what they are saying is actually valid. The same goes for hot tips from random cab/Uber drivers and barbers. Chances are they aren’t in their professions due to their exquisite stock-picking prowess.
This comes down to doing your homework and getting a firm understanding of what you are buying. When people are looking to drop $2,000 on new car tires, they’ll shop around, read reviews, and ask friends what they like. These same people will spend $10,000 on an investment tip in an instant without doing any work because their Uber driver told them about it. Is that rational?
If there is one takeaway, it’s that you should try and think rationally when you are in a heightened emotional state. This goes for both emotional lows and highs. Our decision-making when emotional and uncertain is poor. If you sit back, wait for emotions to subside, and think about your financial decisions, you’ll be less error-prone. You know yourself better than anyone else, so you must design your environment to minimize mistakes and amplify your successes!