How to Handle a Market Gone Mad

Posted by jasonzweig on Sep 19, 2008 in Articles & Advice, Blog, Columns, Featured |

Image Credit: “Mouth of Hell,” detail from the Hours of Catherine of Cleves, Dutch, ca. 1440, The Morgan Library

By Jason Zweig | Sept. 16, 2008 12:01 a.m. ET

If you learn nothing else from the last few harrowing days, you should learn the difference between what is obvious and what is inevitable.

In the heat of the moment, the two perceptions seem identical. It was obvious that investors would panic as they absorbed the news about Bloody Sunday on Wall Street, so it was inevitable that the market would take a slashing. It was obvious that Lehman Brothers had to go bust, so a bankruptcy filing was inevitable. It was obvious that Merrill Lynch could no longer make it on its own, so it was inevitable that a bigger institution like Bank of America would take it over.

But investors — at least individual investors — don’t actually panic in times like these. Instead, they freeze. In July (the latest month for which final numbers are available), mutual-fund investors pulled out just $2.62 of every $100 they had invested in stock funds. That was less than they took out of bond funds, even though the stock market had just gone through a nauseating summer swoon.

According to researchers at Strategic Insight, who have studied decades’ worth of data on how fund investors behave, this inertia is typical. Tim Buckley, who oversees retail investor operations at Vanguard Group, says the giant fund company had only 10% to 15% more phone calls and online inquiries yesterday than on a typical Monday in September. “However much panic there might have been on Wall Street,” said Mr. Buckley, “there [was] no panic on Main Street.”

Scott Jaffa, a 25-year-old systems administrator in Silver Spring, Md., called yesterday’s plunge “as much a test of my psychology as anything else.” Because he does not need the money “for another 30 to 40 years,” he asked rhetorically, “why should I worry myself about its performance over a period of days or weeks or even months?”

Mr. Jaffa is already developing what the ancient Stoics and the great Danish philosopher Soren Kierkegaard called ataraxia, or imperturbability. But he knows that ataraxia does not come naturally; it takes work. A year and a half ago, Mr. Jaffa destroyed the online access code for his 401(k) so he could no longer have instant access to his retirement accounts. His goal was to make it “significantly harder” and to require “human interaction” before he could trade on his own emotions. That enabled him to watch Monday’s decline without acting on it.

Here, then, is one way the obvious is not inevitable. It may be “obvious” to professional money managers that small investors are the problem in turbulent markets. But it’s not individual investors who cause (or even widely participate in) a selling frenzy. It is, instead, the “smart money” that tends to panic.

But the differences between obvious and inevitable run much deeper than this, all the way down into the biological bedrock of our minds. The investing brain is bad at some things and good at many others, but above all else, it has a remarkable capacity for fooling itself. What seemed so obvious and inevitable Monday had, less than 24 hours earlier, struck nearly all of us as impossible.

Before Sunday, not even most people on Wall Street really believed that Lehman would go bust. The stock finished last week with a market value of $2.5 billion, showing that investors as a group simply did not believe that Lehman would go under.

But by Monday morning, everyone’s beliefs had already been retroactively revised; suddenly, Lehman’s bankruptcy had been “inevitable.” Psychologists call this hindsight bias — the uncanny feeling that “I knew it all along.”

History is full of such instances. The O.J. Simpson verdict, for example, convinced people that they had predicted he would be found innocent (regardless of what they actually said before the jury made its decision).

Once Lehman went bust, none of us could remember how surprised we were when we first heard that it might. As Princeton University psychologist Daniel Kahneman says, “Hindsight bias makes surprises vanish.” And therein lies its extreme danger for investors. By retroactively fooling us into thinking that we knew how the past would unfold, hindsight bias tricks us into thinking we know how the future will unfold. But if the past took you by surprise, why should you believe you can decipher the future?

The question answers itself. It also points the way toward a sane course of action even as the markets seem to have gone mad.

Be a contrarian. The late Sir John Templeton preached that investors should buy at the “point of maximum pessimism,” when market sentiment stinks and no one wants to hold anything but cash. Adds Daniel Fuss, vice chairman at money manager Loomis Sayles & Co. in Boston: “It’s not a point, it’s a period.” No one can find the point or moment at which pessimism hits its exact zenith. But it’s not hard to identify a period in which pessimism is extreme — like right now. When I spoke to him yesterday, Mr. Fuss called this market “the best opportunity to buy corporate bonds at phenomenal prices since September 1974.” Risk takers might take a look at real-estate-related stocks; extreme risk takers might even consider a small allocation to financial stocks.

Take an inventory. “Instead of just saying, ‘Everything’s going down, everything’s going down’,” says Gary Schatsky, a financial planner in New York City, “write down on a piece of paper everything you own and everything you owe.” Then go through each of your assets and liabilities to see how you might improve your position. In a period when stocks and bonds and mutual funds are not delivering positive short-term returns, you can probably add the most to your net worth by turning your attention to paying down or consolidating your high-cost debt.

Take baby steps. If you truly cannot sleep at night, sell off some stocks, or move some of your money to bonds or cash. But do so a little bit at a time, and talk to your tax adviser first in order to maximize the considerable tax benefits you may be able to get out these incremental moves. By the time you get any money moving, the panic may already have passed.

Question authority. If the financial world really were coming to an end, nobody would know it — least of all the pundits who are currently crying doom. In 1929, experts ranging from the legendary trader Jesse Livermore to John D. Rockefeller and Treasury Secretary Andrew Mellon all declared that falling stock prices were nothing to worry about. They were wrong. The lesson is not that it’s a mistake to be an optimist in falling markets, but rather that it’s a mistake to trust the consensus view of the experts. With the mood on Wall Street now as dark as a mushroom farm, optimists are much more likely than pessimists to be proven right in the end.

Source: The Wall Street Journal

http://www.wsj.com/articles/SB122152121190739301

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