This is your Investment Brain on Pessimism

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By Steve Lowrie, CFA

Special to the Financial Independence Hub

I’m no psychic. But I bet I can still correctly divine what’s on most investors’ minds these days.

Pessimism, bordering on despair …

Have you been reading the headlines, viewing your investment portfolio, and assuming the worst is yet to come? Welcome to your painful crash course on what market risk really looks like—and more importantly, how it feels.

Most investors say they’re ok living with periodic market risk, as long as it helps them achieve better returns over the long run. We accept (in theory) that tolerating the interim damage done to our own investment portfolios will help us meet our long-term financial goals.

But that’s investment risk in theory. Since it’s been a long time since we’ve encountered an extended bear market climate, you may have forgotten or never known the reality of it. It may not have clicked then, when significant market declines happen, it is usually due to despairingly bad news … amplified by headlines screaming how things are only going to get worse from here.

The reality is, when we’re in the middle of a storm of stuff, our behavioural biases make it very difficult to believe we’ll ever see better days.

Now and Then Investment News

History informs us otherwise. Even in the current climate, there have been plenty of days when stock markets have delivered positive outcomes. Some days, it’s even been very positive.

How does the popular financial media (aka, “group think central”) report the good news? They have a gloomy story to tell, because that’s what’s been selling lately. So, they dig up market pundits who downplay the uptick. They discount the event as being a “short covering,” “relief rally,” “dead cat bounce,” or some other meaningless adage, rather than accurately reporting that this is just how efficient markets operate every day. Without a scrap of plausible evidence, their confident conclusion is that the markets must soon continue their downward spiral.

A relevant question is: What is the pundit’s track record? You have to dig hard to find the data, but even those with the best reputation score less than a coin flip across their body of forecasts. (Actually only 46.9% accurate according to this study.)

On the subject of forecasting generally, David Booth, the co-founder of Dimensional Fund Advisors, recently offered this very practical insight:

Do you really want to invest your hard-earned savings—the money you’ll need for your kids’ college or your own retirement—based on someone’s hunch or wish?

What Goes Down …

From an analytic perspective, the general economy does have its work cut out for it over the foreseeable future. But, believe it or not, I remain optimistic about staying invested in our financial markets, and I think you should be too.

While I’m admittedly an optimist by nature, I’m also evidence-based. So, let’s look at what we know, and how it shapes what to prepare for—i.e., financial markets that should continue to deliver solid rewards to patient investors in the years ahead.

Let’s start with one of those pictures to replace a thousand words. Compliments of our friends at Dimensional Fund Advisors, here’s what U.S. stock and bond markets have done in the past after stumbling into bear market territories. Defying gravity, it would seem what goes down in financial markets has typically gone back up — and kept going over time.

lowrie dimensional equity returns to 2021
*Dimensional Fund Advisors LLP – Past performance, including hypothetical performance is not a guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. In USD. Market declines or downturns are defined periods in which the cumulative return from an a peak is -20% or lower for equities and -2% or lower for fixed income. Returns are calculated for the 1-, 3-, and 5 year look-ahead periods beginning the day after the respective downturn thresholds are exceeded. The bar chart shows the average returns for the 1-, 3-, and 5-year periods following the 20% for equities and 2% for fixed income thresholds. For the 20% threshold, there are 15 observations for 1-year look-ahead, 14 observations for 3-year look-ahead, and 13 observations for 5-year look-ahead. For the 2% threshold, there are 29 observations for 1-year look-ahead, 26 observations for 3-year look-ahead, and 25 observations for 5-year look-ahead. See “Index Descriptions” in the appendix for descriptions of Fama/French index data. Eugene Fama and Ken French are members of the Board of Directions of the general partner of, and provide consulting services to, Dimensional Fund Advisors SP. Bloomberg data provided by Bloomberg.

As always, we can’t guarantee that’s what will happen this time. Nor is it going to be pleasant to wait for markets to likely do what they’ve done before. But one thing is for sure: If you sell out of today’s markets or make significant changes, you’ll lock in at today’s lows, despite the logic and data that suggests we should expect above-average returns over the next few years. In past posts, I’ve referred to this as one of the Big Mistakes in investing.

Markets, Economies, and Different Drummers

You may also have noticed that financial market pricing is often quite out of sync with economic indicators, especially in more volatile markets. The economy will stumble … and markets will end higher for the day. Or the economy will catch a break, and stock prices drop.

This isn’t because markets are insane. It’s because they generally lead (or look ahead of) the real economy by about 6–12 months, while economic indicators are lagged, and backward-looking to whatever just happened. As an investor, it’s helpful to remember that the market’s expectations are constantly being priced in long before the economic indicators have caught up.

Ditto for Bonds

All of the above can also be said about bond markets. However, there are some logistical differences on how bond prices are set. Without diving too deep, current stock prices are estimated as the aggregate best guess from all market players combined. Bond (and GIC) pricing is done differently, since we can look at specific issues with specific maturities and calculate their known return if held to maturity. Put another way, expected bond returns are observable.

Either way, the conclusions remain similar: Thanks to lower prices on existing bonds, future expected returns have increased dramatically across nearly all bond portfolios. In all, current nominal and real (return above inflation) yields look more attractive now than they have over the previous 10 years.

Next Steps

By now, I hope you’re feeling better about your investment prospects. If you can sit tight (if you don’t have to sell holdings for retirement or other cash flow needs), the odds are pretty high that your existing portfolio will eventually recover and grow. However, if you instead sell and move to cash or other guaranteed assets during a bear market, there’s no way your former investments can ever recover. This, by extension, places a drag on the rest of your portfolio in the form of a significant lost opportunity cost.

This does not mean there’s nothing you can do but grin and bear a bear market. There are a number of other steps you can take, such as:

During your accumulation phase: Continue with regular, systematic investing, knowing you’re buying low and likely eventually selling high. You can even consider accelerating your future possibilities with cash injections or more aggressive investments if you’re able. Contrary to conventional (albeit incorrect) wisdom, the risk of holding cash goes up, not down, during periods of market weakness.

During your decumulation/retirement phase: Sit tight if possible; avoid selling low. Slightly reducing your spending is preferable to selling and withdrawing investments at this time.

Across all phases: Note that in both accumulation and decumulation phases, it is never advisable to make unplanned, lump sum withdrawals, even briefly. The potential lost opportunity cost can be significant. Sometimes this is unavoidable, but it’s worth looking at various options before committing to sudden capital withdrawals.

Moving forward: If you feel you need to reallocate toward “safer” ground, try to stay put for now, and consider how to revisit those plans under better conditions.

The Bottom Line

Even though it’s unusual for stock and bond prices to both be down at the same time, it’s not the first time it’s happened. It probably won’t be the last. But when prices are down, future expected returns are higher, despite what the media pundits may say. To counteract the current excess of gloom and doom, I permit you to remain optimistic, especially if you’re a “glass half full” type like me.

Please get in touch with us for a conversation if you’d like to know more about the evidence behind our approach.

Steve Lowrie holds the CFA designation and has 25 years of experience dealing with individual investors. Before creating Lowrie Financial in 2009, he worked at various Bay Street brokerage firms both as an advisor and in management. “I help investors ignore the Wall and Bay Street hype and hysteria, and focus on what’s best for themselves.” This blog originally appeared on his site on Oct. 21, 2022  and is republished here with permission.

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