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20 May 2020

What sort of behavior should we adopt in adverse markets? Here is a mini-guide of seven rules for investors to help you avoid panic in turbulent times.

Author: Luigi Compopiano


Pandemic. Lockdown. Crisis. Drawdown. Downgrading. The path of a market after a shock, whether provoked by endogenous or exogenous factors, tends to trace the movements registered in the past. As losing a point is always more painful than gaining one, it is also true that investors must not act by chance, and must avoid at all costs acting because of their bellyache, adopting instead a strong model of risk management. The only valid strategy to avoid irrational and emotional behaviour is to work on a plan, shorn of emotive impulses, with a medium-long term perspective. Here are seven rules that an investor can follow to help him or her face the ups-and-downs of the markets with equanimity.
1) Reason vs gut feel
Fear can provoke impulse responses like selling on market falls and conversely buying near highs. The risk is clear: selling at market bottoms and buying at market peaks. Investing does not mean speculating on short-term rebounds but means planning for a future yield. As Mark Twain would say “There are two times in a man's life when he should not speculate: when he can't afford it and when he can.” As neuroscience teaches us the brain is made of two parts: the neocortex where slow pondered thought occurs, the origin of rational thought, and the other, the so called limbic system, that is quick and rapid and emotional, where irrational fast responses occur and, in conjunction with the amygdala, allow our fear fight or flight mode.

2) Limit emotion, silence the background noise
How can we overcome panic reaction? Only by overcoming short-term emotivism by concentrating on facts, with reliable analysis of data, good research and predefined strategies. Our natural instincts do not help us manage our money in a cautious way, but rather push us to fragmented actions taken on the spur of the moment. Gut reactions are human, but unfortunately, they are not well attuned to good investment performance. To quote from Daniel Kahneman, 2012 Nobel economics prize “People are very sensitive to pressure and its immediate consequences. Long-term effects are more abstract and difficult to gauge. Take global warming as an example. By the time the menace is pressing it will be too late to act.” 

3) Take declines into account, they are an inevitable part of investing
Correction = a fall in up to 10% of market prices. Downtrend = prolonged decline of up to 20 % or more from initial prices. Collapse = sudden fall in prices, often with subsequent rebound, following some sort of market shock, endogenous or exogenous, as in the case of coronavirus. Irrespective of the type of shock, instability does not last forever. Each and every decline is followed by an uptrend equal or greater than the fall. Why then do we remember the bear markets more than the bull markets. Each unit of loss brings with it a sense of discomfort that is considerably higher than the pleasure associated with a unit of gain. To be able to invest serenely we must get out of this mind-set, taking into more consideration the risks than the potential gains, and diversifying ones portfolio. “Everyone knows that prevention is better than cure” remarks Nassim Nicholas Taleb, the Lebanese economist of Black Swan fame, “but few prize prevention itself.”

4) Accept volatility as a temporary phenomenon
Recently asset managers use a metaphor that compares their trade with the song of the siren: to be able to reach your objective you have to “tie yourself to the mast” like Ulysses did in the Odyssey to resist the siren song. This is the only way an investor can overcome the adversities in his path and pursue longer-term objectives. Even if you cannot exclude the fact that a dip in the market will not prolong into a full-blown bear market, it is also true that 30%, or more, declines are not all that common.  As behavioural science points out, recent events influence operators’ perception disproportionately and so they must be capable of prudent decisions.  “The four most dangerous words in investing are: this time it’s different.” The founder of Franklin Templeton Sir John Templeton said this, insisting on the importance of not being carried away by a wave of short-term enthusiasm and attempt to “beat” the market, but to have a well-balanced position within a defined strategy with set goals.

5) Time not timing
The aversion to loss bias often induces investors to sell their positions for fear of further declines, causing, with the exit from the market, the consequent impossibility to recoup the losses incurred. Losses are never real until they are taken, but on the other hand, it may also be necessary to accept a loss and carry on rather than insist on an unfortunate investment and worsen the situation further. Setting apart volatility and shocks, markets tend to reward investors who look forward and remain coherent with their long-term objectives, marginally adjusting their positions for changes in basic conditions and according to specific needs. As John Maynard Keynes said, “the importance of money fundamentally derives from it being a link between past and future”, but he also, famously, drew a limit to the time frame saying “In the long term we are all dead”.  

6) Weigh risks, diversify  
Keeping on the side-lines of a volatile market guarantees one thing: you are out and therefore you cannot benefit from the uptrends that follow the declines. Two suggestions could be useful here to overcome the fear of staying invested. The first, stay anchored to the long-term view, especially in falling markets: the second, a diversified portfolio cannot ensure gains nor protect you from losses, but it can certainly lower the overall risk considerably. By distributing investment over several classes of assets, an investor lowers potential swings and therefore reduces the stress that accompanies downtrends. As the Oracle of Omaha, Warren Buffett, a long-term investor by definition likes to remind us, "Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1.”  

7) Stay focused on your objective (better if sustainable)   If your investment plan reflects your risk aversion level, your near and medium term expectations and the immediate surroundings, then stick to it as closely as possible, as this can avoid taking hasty and ill-advised decisions in negative markets. Rather than trying to guess and outsmart the market, investors should move according to their risk propensity and stay invested in downturns possibly modifying asset allocation to better face crises.    

William Forsyth Sharpe, Nobel prize 1990, inventor of the Sharpe indicator that measures the higher expected returns of a portfolio with respect to the risk free rate.  “The nature of risk may be the single most important argument for the use of quantitative analysis in investment management”. “What if your advisor talks only about returns, not risk? ... It's his job to take risk into account by telling you the range of possible outcomes you face. If he won't, go to a new planner, someone who will get real.”

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