It’s not brains that will help you beat the stock market, it’s your stomach.
Peter Lynch once said that you can be the world’s greatest expert in financial statements but without a strong stomach, you will succumb to the negative headlines, and sell in panic when share prices go down.
That is what’s happening today.
With dark clouds gathering around the global economy, stocks are generally cheaper today compared to the past two years.
Yet, many are not won over by the lower valuations.
It’s not for the lack of data or analysis. There is more information readily available today than there has ever been.
Instead, the root of the problem is something simpler — FEAR.
When fear overcomes reason
When it comes to investing, many picture themselves making rational, well thought-out decisions.
However, in reality, this same group is prone to reacting poorly to stock market moves.
This disconnect is down to the way we process information, says Daniel Kahneman, who is considered to be one of the fathers of behavioural finance.
In his book “Thinking, Fast and Slow”, Kahneman describes two general modes of thinking: System 1 (reflexive) and System 2 (reflective).
Where System 1 is built for intuitive, snap decisions, System 2 is primed for untangling complex problems which require time.
Under this framework, most investors consider themselves as System 2 thinkers, tapping on the analytical side of their brain to process data, deliberate over the pros and cons, and come up with a rational investment decision.
Yet, in practice, System 1 often overwhelms System 2 before the latter has a chance to act.
It’s not a matter of choice.
According to Kahneman, most of the time, we function based on System 1.
Our reflexive mode is useful for daily routines and recognising familiar situations, and it does a good job in prompting the appropriate reaction.
In addition, because System 1 is adept at processing similarities, it will alert us when there is a deviation from the norm.
For instance, if you step onto the road and there’s a car speeding towards you, you will sense danger and move out of the way. Here, System 1 kicks in automatically without deliberation, saving your skin.
Therein lies a wrinkle.
What’s good for avoiding danger is not always helpful when it comes to investing.
In particular, watching the stock market fall day by day, month after month, is enough to send investors’ System 1 into overdrive, overwhelm their System 2 mode, and cause them to panic sell.
The result is what we see today: few takers despite the lower stock valuations.
The everlasting effects of fear
Amid the doom and gloom, it’s easier to be a pessimist today than it is to be an optimist.
After all, Singapore is facing a long list of challenges, ranging from disrupted supply chains, protectionism among trade partners, higher cost of living, and rising interest rates.
Unfortunately, the insistent drone of negative headlines can also alter the way we think about the future.
Why is that the case?
Journalist and author Jason Zweig has the answer.
In his book Your Money and Your Brain, Zweig says that predictions of the future often fall prey to relying too heavily on the short-term past to forecast the long-term future.
If we apply this behaviour to the current context, it would be akin to taking all of today’s worst problems and projecting these worries indefinitely into the future.
Faced with nothing but gloom, it’s no wonder fearful investors are sitting out.
Under the circumstances, it is helpful to remember that the stock market has undergone worse situations before.
Tellingly, not all predictions of doom turned out to be true.
Fearful prophecies gone wrong
In 2014, a former Harvard economist withdrew almost US$1 million of his own money, speculating that cash will lose almost all its value due to the US Federal Reserve’s zero-interest rate policy.
Yet, in today’s rising interest rate environment, the US dollar has gained ground over almost every major currency.
That’s not the only prediction that didn’t pan out.
Two years earlier, around 2012, a high-profile investment advisor suggested that investors should dump most of their US stocks in favour of gold.
With the benefit of hindsight, we can now say that it was a terrible idea.
Over the past decade, the value of the S&P 500 index, which represents 500 of the largest US companies, has almost tripled, during the time when the value of gold fell by 3%.
The lesson here is to be aware of undue influence of the current problems we see today.
To be clear, it’s not about being blind to the real issues that we have to deal with in our day-to-day life. But to assume that the challenges of today will persist unfettered for the long-term would be an incomplete approach.
As history has shown in the two examples above, positive scenarios are possible too.
Finding courage in fearful times
Avoiding predictions is one thing, but what about our inherent System 1 biases?
Here, we have to accept that we can never fully get rid of our innate tendencies, nor can we control them on demand.
All is not lost.
There are simple things we can do to lessen their negative effects.
Firstly, we can remove the column which shows the daily stock movements from our portfolio trackers.
Think about it, whether a stock is up or down in a single day should play no part in your investment decisions and only serves to inflame our System 1 biases, potentially triggering the wrong reaction.
Secondly, setting up simple guard rails can moderate our buying and selling when investing.
For instance, we can earmark a specific amount of cash to invest at every decline interval in the S&P 500.
That way, we will be more disciplined in how we put our money to work and be prevented from going overboard in buying too much of a stock as the stock market falls.
The third action is to start writing an investing journal.
You can start by writing down the reasons why you bought a stock, its valuation, and the risks you see.
Doing so will help you become more objective in judging the performance of the underlying business in the future, lessening the impact of recent events around the business.
Writing a journal will also help you figure out your past tendencies in different stages of the stock market which can then become a blueprint for guard rails against your own behaviour in the future.
Get Smart: The Even Bigger Picture
Keeping the faith and stockpicking should go hand in hand, says Peter Lynch, as success in the latter depends on the former.
When confronted with doubts and despair about the current big picture, Lynch suggests that we concentrate on what he calls the Even Bigger Picture.
In his book Beating the Street, Lynch says that stocks have provided patient owners with gains of 11 per cent per year, on average, while other instruments such as treasury bills, bonds, and certificate of deposits have returned less than half that amount.
Now, that’s a useful picture to have in mind.
With the right measures in place, we can emerge with a stronger stomach, and hopefully, some satisfying gains in the stock market.
But only when we keep faith and stay invested for the long term.
Note: An earlier version of this article appeared in The Business Times.
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Disclosure: Chin Hui Leong does not own any of the shares mentioned.
