Three ways to keep cool during market downturns
Mitchell Barr, Client Associate
What are you afraid of?
Take a minute to think about your top three fears. Why are you afraid of those things? Let’s say your number one fear is snakes. Snakes are slimy and ugly, but that’s not why people are afraid of them. Some snakes are venomous and can kill you. The bushmaster is one of the most venomous snakes in the world. A bite can kill you in twenty minutes, with 80 percent of cases ending in fatality. A Costa Rican tour guide once told me he always carries a machete because the only chance of someone surviving a bushmaster bite is to hack off the affected limb immediately (Yikes!).
It would seem that we fear snakes because we fear death, but that’s just on the surface. Our deepest emotional connections are driven by fear. We want to be strong for our spouse, provide for our children, and feel validated by our peers. Death is certainly a fear, and not just because it means the end of us, but also because those emotional connections will also be affected.
Fear is a primal response, meaning you don’t have to consciously conjure it. If you saw a bushmaster snake on a hike in Costa Rica, you’d probably take off running before you could even comprehend the situation. This reaction creates a problem for those of us who like to think we are making decisions of our own free will. Our brain overrides conscious thinking when we find ourselves in times of distress. We are protecting ourselves from our fears.
Most of the time this mechanism works well. The fact that you are reading this means you have avoided deadly snake bites to this point in your life. But there are decisions that we don’t want to be driven by fear. We know that many bad investment decisions are made because we give in to fear. It’s tremendously difficult to keep your wits about you when you are afraid that your life savings are at risk. It’s not about the money, but rather how losing it will affect those same emotional connections that cause us to fear snakes. This can often lead to selling investments at their lowest point, just when the pain is at its worst.
Because we know that we will be weak when fear strikes, it’s important to have fail-safes in place before our brains run away without us. We want to be able to charm the snake to back down when it rears its ugly head.
Three ways to overcome fear as an investor
- The Reality Check – A 20 percent stock market decline has historically occurred about once a decade. However, the average time the market takes to recover is only about 14 months.1 Keeping this perspective in your back pocket as a long-term investor can reduce the shock associated with declines when they happen (and they will happen). Losses are only on paper unless you sell at the bottom in a panic and realize them. Remember that it’s only temporary, and the market will correct itself if you hold tight.
- The Lifeboat Test – We know that market declines happen, but we often don’t think about how it will affect our assets in dollars. It helps to actually calculate these dollar amounts ahead of time so our fear gauge doesn’t explode when we see the number. Do some napkin math to figure out what the dollar loss would be for a 20, 30 or 40 percent market decline. Such stock market declines are possible (there have been three declines of 40 percent or greater since 1945)1, so you have to be comfortable with what the potential losses are when determining how much of your money to invest.
- The Commitment Device – A common reason people make emotional investment decisions is because they don’t have a plan. Create an investment policy statement that details your long-term investment allocation and refer back to it in times of distress. If you have the discipline, impose a waiting period of several days before making any trades in your accounts. If you lack discipline, hire a fiduciary financial advisor who will stick to the policy for you.
Fear is one of our brain’s strongest tools for survival. It is so ingrained in our DNA that we usually can’t control it. Addressing fear head-on is the only way to prepare for market declines that are not just probable, but mathematically inevitable.
Mitch writes the popular blog, The Money Monkey, where he focuses on common mental mistakes made by investors, how to avoid being your own worst financial enemy, and thinking about investing in new ways.