Meir Statman, Ph.D.
Consultant to Avantis Investors®
A TV commercial from the exuberant tech days of the late 1990s shows a young man at his office computer while a Grafware Tech stock chart shows an immense rise in its price. The man darts up the stairs with glee, hugging co-workers and toppling a tower of Styrofoam cups. He throws open the door of his boss’s office and announces smugly, “Mr. Dinky, I quit!” The man then runs downstairs, only to find that Grafware Tech’s stock price has collapsed. “Oh no!” he shouts in panic and runs back to his boss’s office— “Mr. Dinky, I’m not quitting, that was a joke, sir!"
Hope is a useful emotion and so is fear. Hope gives us the wisdom to accept reasonable risks and the power to persist in the face of adversity. Fear guides us away from unreasonable risks and urges us to slam the brakes when the car in front of us suddenly stops. Unfortunately, hope often becomes exaggerated and turns into exuberance, while fear becomes exaggerated and turns into panic.
We cannot set emotions aside, but we can step away from our emotions and examine them with reason. This is an important lesson we learned from our parents and teach to our children. “When angry,” my mother said, “count to 10 before you open your mouth.” Unwise words we say in the heat of anger might feel good for a moment, but words cannot be retrieved, and they can come back to bite us. The same is true for words spoken and actions taken when hope turns into exuberance and fear turns into panic. The exuberant young man in the commercial must have felt smug when he said, “I quit,” but now his days at the company are numbered.
Fear is a negative emotion arising in response to danger, whereas hope is a positive one in anticipation of reward. But the two are similar in that control is in the hands of others, whether other people or situations. We fear the danger of a stock market crash but can’t control the outcome. We hope for a stock market boom but can’t control the outcome.
Exaggerated fear inclines investors to expect low returns with high risk, whereas exaggerated hope inclines them to expect high returns with low risk. A Gallup survey of investors asked: "Do you think that now is a good time to invest in the financial markets?" Answers reveal that high recent returns lead investors to believe that now is a good time to invest, and low recent returns lead investors to believe that now is not a good time to invest. Evidence, however, indicates these beliefs are without foundation.
Gallup also asked investors if they believe the market is now overvalued or undervalued. Answers reveal that the months when large proportions of investors believed the stock market was overvalued were also the months when they thought now is a good time to invest in the financial markets.1
Fear prods investors to fly to safety. The VIX Index is a risk gauge known as the fear index. It measures expectations of future risk by measuring the expectation of future volatility of stock returns. Flight-to-safety periods coincide with increases in the VIX, bearish consumer sentiment, and bond returns that exceed stock returns.2
Fear increases risk aversion even among financial professionals, whose risk aversion rises after financial busts. Financial professionals who read a story about a financial bust became more fearful than those who read a story about a financial boom and fear led to less risky investments.3
We are right to fear the coronavirus, and we are right to fear stock market volatility and losses. But we should not let fear turn into panic. We can’t set aside our fear of the coronavirus, and we can’t set aside our fear of stock market volatility and losses. But we can step away from our fear and examine it with reason.
Reason in the face of the coronavirus calls for applying some simple rules. If you have flu-like symptoms such as a fever, cough or sore throat, stay home and consult a physician.
Reason in the face of stock market volatility and losses also calls for applying some simple rules: Do not panic. Look for the silver lining. Investment losses, while painful, can be turned into tax deductions in certain circumstances. Tax loss harvesting typically gets a lot of attention in December, but there are strong arguments for why realizing losses when they occur makes more sense.4 Finally, don’t make bets on current stock prices being too high or too low. Neither you nor I nor “experts” know when the stock market has reached its bottom.
1 Statman, Meir. Finance for Normal People (Oxford: Oxford University Press, 2017), 74-76.
2 Baele, Lieven, Geert Bekaert, Koen Inghelbrecht, and Min Wei. “Flights to Safety.” NBER Working Paper No. w19095 (May 2013).
3 Cohn, Alain, Jan Engelmann, Ernst Fehr, and Michel André Maréchal. “Evidence for Countercyclical Risk Aversion: An Experiment with Financial Professionals.” American Economic Review 105, no. 2 (2015), 860-85.
4 Meir Statman, “Why Investors Shouldn’t Wait Until December to Take Tax Losses,” The Wall Street Journal, Nov. 4, 2018. https://www.wsj.com/articles/why-investors-shouldnt-wait-until-december-to-take-tax-losses-1541387520
The opinions expressed are those of the investment portfolio team and are no guarantee of the future performance of any Avantis Investors portfolio.
This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.
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