How to beat the bear market blues

Bear markets are the ultimate behavioural test for investors; the outcome of this test says more about their likelihood of success in building wealth over the long run than does the direction of financial markets. Investors will either stay smart, or yield to emotion, which can ruin the potential for gains.

In the current scenario of volatile markets, the wildcard is the human mind, not the movements in asset prices. Not one investor is immune to systemic risks, but all investors will need to resist their emotions to act as prices fall during the current bear market. The euphoric phase of bull markets fuelled by cheap money has ended; as fear of losses grips some investors, they need to be careful to stay calm and stick to their long term investment plans and avoid emotional decision-making panic. 

In reality, emotions can compound in bear markets. To add fuel to these fears of losses, stagflation has become the topic du jour. With the US Federal Reserve raising interest rates this year, and inflation rising worldwide, equity rotations have started from meme stocks, non-profitable technology shares and other growth companies into value shares. Behavioural finance theory has been well documented by the likes of Daniel Kahneman and Richard Thaler. Prospect Theory and Aversion to Losses emphasise that investors perceive asset gains and losses differently, they place more weight on perceived gains than losses, but losses cause a greater emotional impact - and with that comes a desire to act to alleviate loss.

To avoid emotion, investors need to understand what the fundamentals of their portfolios are and how asset prices will behave now that we are in an inflationary regime and central banks are on the offensive. We are seeing a widening divergence around the world in both monetary and fiscal policy and the fracturing of globalisation as the rift between the US and China widens. At the same time, Russia’s relations with the US and Europe have frozen. The times are extremely uncertain; with war in Europe, sharply higher food and energy prices and a concerted effort towards a path to decarbonisation, caution is needed - and patience.

The risk for portfolios in this scenario is that risk averse investors will become overwhelmed by their anxiety and fears and sell down riskier assets such as shares. Investors who act rashly in response to nightmarish headlines and sell quality companies may be compromising their long-term investment outcomes. The rational investor, on the other hand, will stay calm and even become excited by the falls in share prices and see opportunities rather than losses. That goes against Prospect Theory but it will help investors hold onto their wealth.

Given the current market conditions, investors need to focus on fundamentally sound assets to strengthen their portfolios. Investors should stick to the decisions that they have already made with their financial advisors when they were in a calm and rational state, and not deviate from their agreed portfolio mix. Now is not a good time to change the asset mix in your portfolio when you become overwhelmed by emotion.

Ideally, you have a portfolio that takes into account your financial needs now, and well into the future. You need to stick to your financial plan and stay rational with a clear head despite all the bad news we are hearing. If you need to transact, don't read the headlines before you trade. Instead, imagine what your portfolio should look like in 10 years and what you need to do now to see that future happen. That is a better guide than listening to the noise being reported in the media, which automatically focuses on bad news.

Investors must expect the ups and downs but they must remain patient. Share markets move in cycle. During the ride, no investor is impervious to systemic risks. Markets rise, markets fall. Unpredictability is the only constant. As Mark Twain once said, “History never repeats itself, but it does often rhyme.”  No bull market endures forever; neither does a bear market. Historically, the upside in markets – bull markets – lasts longer than the downside, or bear markets. So, over time, the gains may well outweigh the losses.

According to billionaire hedge fund investor Howard Marks the biggest investment errors come not from factors that are informational or that are analytical but come from psychological factors. Our body is wired to act impulsively when faced with fears, but our brain needs to remind us, over and again, to stay level headed, stay patient and stick to your investment plan. After all the human mind is the ultimate black box. If you don’t trust yourself, see a financial adviser.


A version of this article originally appeared on The Australian Financial Review website here.