Experts of varying persuasions are lining up to explain the misfortunes of the local stock market. Everyone is long on commentary and suggestions, but short on practicality. Failed experiments have included firing unpalatable regulators (in the eyes of brokers) and easing credit to revamp animal spirits. The failure is as much one of imagination as it is of misdiagnosis.
The domestic market had two stellar years prior to the last. Shares are expected to return 9-12% per annum (including dividends) when measured over a meaningful period of time. The above figure comes from the longest running data set collected on shares spanning two centuries across 25 countries by Professor Elroy Dimson and his team at the London Business School. Given the strength of share price growth in 2009 and 2010, they’re now well and truly in line for a correction and possibly a bear market.
The mental barriers to effective decision-making in bear markets are as many and varied as those that plague rationality during bull markets. However, in bear markets the primary role of emotion is particularly pronounced as the resulting fear and shock short-circuit more logical analysis. Experiments have shown that those that can’t feel fear behave more rationally in the face of loss than those who can. Perhaps many of the extremes we experience during our moments of both euphoria and revulsion could be avoided if only we understood human psychology better.
It is a cliché that markets are driven by fear and greed. However, it is also disturbingly close to the truth. Having spent the middle part of last decade exploring the psychology of bull markets, it makes a refreshing change to examine the drivers of bear market behaviour. Fear seems to lie at the heart of the psychology of bear markets. The bad news for us humans is that within the brain emotion appears to have primacy over cognitive functions.
Our brains consist of two different (although interconnected) systems. One is a fast and dirty decision-maker (System 1), the other is more logical but slower (System 2). System 1 (fast thinking) is the mental state in which you probably drive a car or buy groceries. It relies heavily on intuition and is amazingly capable of misleading and also of being misled. The slow-thinking System 2 is the mental state that understands how System 1 might be misled and steps in to try to prevent it from happening. The most important quality of System 2 is that it is lazy; the most important quality of System 1 is that it can’t be turned off. We pass through this life on the receiving end of a steady signal of partially reliable information that we only occasionally, and under duress, evaluate thoroughly.
System 1’s output is often unchecked (or at least checked only too late) by System 2. For instance, if I were to place a glass box containing a snake on the table in front of you, and asked you to move as close as you could to the box, if the snake reared up, you would jump backwards – even if you aren’t afraid of snakes. The reason for this is that System 1 ‘recognised’ a threat and forced the body to react, all of which was done before the System 2 had a chance to point out the protection offered by the glass box. Effectively from an evolutionary standpoint a rapid response to fear carried a very low cost to a false positive, relative to the potentially fatal cost of a false negative. Whilst such an approach may have kept us alive, it doesn’t necessarily work in our favour when thinking about financial markets.
In a fascinating experiment Professor Baba Shiv and colleagues show that when taking risk is rewarded over the long-term, players who can’t feel fear (due to a very specific form of brain damage) perform much better than the rest of us. Prof. Shiv also show that the longer the game goes on, the worse people's performance becomes. The parallels of Prof Shiv’s game with bear markets are (I hope) obvious. The evidence suggests that it is outright fear that drives people to ignore bargains when they are available in the market, if they have previously suffered a loss. The longer they find themselves in this position the worse their decision-making appears to come.
This is in no way to suggest local shares are a bargain at the moment. Given how far markets have gone up, it’s fair to assume that global macro events will dictate another subdued 2012. Given our inclination to herd it is possible that individual bargains may start to appear in the event of a complete stampede out of local shares.
Investors should consider the Buddhist approach to time. That is to say, the past is history and the future is a mystery, and so we must focus on the present. The decision to invest or not should be a function of the current situation (the value on offer) and not governed by prior experiences (or indeed our future hopes). Perhaps we would all do well to remember the sage words of King Solomon’s advisors when charged to find an expression that would be true and appropriate in all times and situations, that ‘This too, shall pass’. Buddhists believe that ‘all things must come to an end’. That goes for both bull markets and bear markets in equal measure.
(Kajanga, an Investment Specialist based in Sydney, Australia, and is the Business Times’ regular columnist on investment issues. You can write to him at firstname.lastname@example.org).