Eavesdropping on your mind-voice during a market decline
Whenever equity markets decline, there is usually some bad news attached to it.
Intuitively, the first instinct is to extrapolate the bad news and expect the markets to fall further.
However, listening to our boring (yet effective) advice that “no one can’t predict the markets in the short run”, you decide to stick with your long-term investment plan.
But as luck would have it, the market falls again just as your intuition had rightly suggested.
This point in a falling market where your intuition proves to be right in the short-term is where most mistakes are made.
While we told you “no one can predict the markets in the short run”, you actually predicted that markets would fall and the markets fell exactly as per your prediction.
Slowly, doubt creeps in. If only, you had listened to your ‘intuition’ instead of us and moved out. You were right and we were wrong. Period.
Obviously you are annoyed with us.
We still stick our neck out and give you the same boring time tested advice –
‘Stick to your plan. This too shall pass’
The market falls further. This time you totally lose it.
“For God’s sake please take my money out. I am done with this can’t-predict-nonsense”. You finally cave in and take your money out.
And you utter the 5 most dangerous words…
“I will exit now and enter later at lower levels when things improve”
Till now everything seems perfectly logical.
Why in the world should someone put up with the emotional pain of watching their hard-earned money decline day by day?
All you need to do is, just move out and stop the fall in your portfolio.
Then you can enter back later once things become better.
If you agree with this line of thought, welcome to the rest of us.
There is only one small problem. Getting back into equities at the right time is unbelievably hard.
Next obvious question…
Why is getting back into equities after exiting so difficult?
Instead of some theoretical mumbo jumbo, let us time travel back to the 2011 market crash led by Euro crisis concerns.
Indian equity markets (represented by Sensex) fell by 28% starting Nov-2010 till Dec-2011. Then they recovered and rallied by 96% till Jan-2015.
Now take a few seconds and visualize this fall in your mind. How does it look?
Something like this…
So the simple thing to do would be to exit once the fall starts and enter back when the rise starts.
If this is all there is to it, why do we tell you that the ‘exit and enter back’ strategy is so difficult to execute?
For that, let us check the real version.
Reality seems a lot different. If you notice, the fall is not a one-way smooth straight line as we imagined.
The path is extremely messy and unpredictable. There are so many false-upsides during the fall.
Imagine, if you had exited right before the fall and waited to enter back.
The market is up by 7%. Is it the start of the recovery? Should you enter back?
Oops. It’s started to fall again.
The market is up by 12% – Is it the start of the recovery? Should you enter back?
Oops. It’s started to fall again.
The same story continues 7 times over the next 1 year.
Now when the 8th time the same pattern of a quick upside happens, what would be your reaction?
“No worries. I have already seen this before. It will fall further” – the market has successfully lulled the pattern-seeking-brain of yours into complacency and overconfidence.
And here is the killer.
Even the recovery is not smooth. It has several false declines, playing with your mind and always keeping you confused in the short run.
To add to the pain, is the extreme volatility in weekly returns.
Check the weekly returns for the entire period. Can you differentiate the period of fall from recovery?
This is not a story specific to the 2011 fall. All falls have a similar trajectory with several false upsides during the fall and several false downsides during the recovery.
Let us check what happened during Jan 2015 – Feb 2016.
The market fell 23% during Jan 2015 – Feb 2016 led by fears of a slowdown in China. This was followed by a recovery in 2016.
There were more than 6 false upsides during the 23% fall and 3 false downsides during the recovery.
You can see a similar version of ‘extreme volatility’ in weekly returns…
You get the picture.
The reality is a lot messier and unpredictable than you thought.
Add to it, the fact that usually governments and central banks, have many tricks up their sleeves and keep announcing several measures to address the situation. You never know which one the market takes up seriously and which one it tends to ignore.
Also, markets usually recover much before the actual change in fundamentals, as expectations and sentiments change much ahead of time.
Now you know the answer, to why market timing is such a difficult task (if not impossible) to consistently pull off successfully over a long time frame.
The near term – to be brutally honest – is extremely difficult to predict.
This is why we take the humbler approach of not trying to time the markets and ask you to take the time-tested approach of ‘sticking to your asset allocation plan and riding it out’.
For the brave ones, you can even convert the fall into an opportunity via the ‘what-if-things-go-wrong’ plan (refer our earlier blog here)
In case you are wondering how this advice pans out in the long run, look below…
Despite all the short-term volatility, long-term faith in equities, patience to ride the declines out and the discipline to stick to the plan has always led to decent long-term outcomes.
Summing it up
- Timing the fall is pretty difficult
- If in case you manage to do that, it’s not over yet – getting back in is even more difficult
- Why? – The fall and recovery do not follow a smooth straight-line path as we visualise in our mind
- There are several false upsides during the fall and several false downsides during the recovery – making it confusing and emotionally challenging
- The reality is that near term stock market movements are extremely messy, unpredictable and random
- Our suggestion
- Stay Humble
- Keep faith in equities for the long-run – proxy for human ingenuity, grit and ability to innovate
- Stick to your asset allocation plan
- If possible convert the fall into an opportunity via the ‘what-if-things-go-wrong’ plan
- This too shall pass
Is this plan exciting? The answer is an overwhelming “No”.
But as the bestselling personal finance author, Ramit Sethi puts it,
“Most of us would rather fail at something exciting than succeed at something boring”
The choice is yours.
Happy Investing 🙂