There have been many comparisons of President-elect Obama to Franklin Roosevelt, from a Time magazine cover to expectations of a “New New Deal”. Perhaps the most fitting parallel is Roosevelt’s first inaugural speech, given in 1933 in the depths of the Depression, in which Roosevelt declared “. . . let me assert my firm belief that the only thing we have to fear is fear itself – nameless, unreasoning, unjustified terror which paralyzes needed efforts to convert retreat into advance.”
With foreclosures and unemployment rising, there are some legitimate things to fear, and an in-depth psychological study is beyond the scope of this article, but it is helpful to examine some of the ways fear can influence investment decisions.
Fear is a primary emotion triggered by tangible, realistic dangers such as exposure to traumatic situations (a 40% decline in an investment portfolio), observing others exhibiting fear (watching acquaintances lose homes or jobs) or receiving frightening information (the recent conclusion that we have been in a recession since December 2007). While fear can be an important means of self-preservation, unrealistic fears can reduce the ability to make logical and reasoned decisions. In a word, panic.
One of the first manifestations of fear, and the basis for other reactions, is the illogical projection of losses or bad news. A 40% market decline becomes “Will I ever be able to retire?” or “Will I lose everything?” If an investment is too concentrated in specific investments, or if there is too much debt, losing it all is a possibility. But even in markets where there has been precious little place to avoid loss, a properly diversified investment portfolio stands little chance of going to zero. And while a quick recovery is extremely unlikely, the economy will eventually recover and growth will resume.
Most often fear will prompt a “fight or flight” response. It is true that great fortunes are often germinated in times of crisis, but the fight response can lead to uncoordinated flailing in attempts to quickly recoup losses. Making large investment changes, buying an investment simply because it is “cheap” without considering its true value, or buying an investment just for its income yield without gauging the reliability of that income are more likely to increase risk and lead to further losses. More losses lead to even more aggressive and desperate investments. To take advantage of reduced prices for financial assets, it is much better to make measured moves such as the tried-and-true technique of dollar-cost averaging, in which a series of similar purchases are made over time.
A paralyzing inability to even think about the investment portfolio is one form of the flight response. (Ironically, a conscious decision to hold a portfolio through a down market is a valid strategy, and certainly less stressful.) More common is liquidating investments and pursuing “safety”, usually at the point that most of the damage has already been inflicted. Long-term plans and the opportunity to participate in a recovery are sacrificed for short-term relief. As a result, Treasury securities yield next to nothing, and for all their shortcomings, sales of fixed annuities for the third quarter of 2008 were 54% higher than the prior year.
The pitfall of a flight to safety is how and when to return to the stock market. (Again, if staying in cash provides enough resources to meet financial needs and accommodate inflation, the goal has been met and there may be no reason to pursue further growth.) According to Fidelity Investments, missing just the best five days of returns of the Standard & Poor’s 500 Index from January 1980 to December 2006 would have resulted in 26% less return; missing the best 10 days would have meant 54% less return, and missing the best 30 days would have meant a whopping 73% less return than being invested the entire period. The only way to avoid those critical days, of course, is to stay invested.
All of these behaviors are supported and encouraged by crowd psychology, or the “herding instinct”. Steady news reports of layoffs and foreclosures set the stage, and local anecdotes personalize the misery. As fear spreads and feeds the dramatic volatility in the markets, the probability of any individual acting on that fear increases with the proportion of those who have already done so. As more people come to believe in some pending apocalypse, it becomes easier to ignore history and underlying evidence. For the last three months, the vast majority of trading has come in the last half hour of each trading day as both individual and institutional investors react to that day’s trend. And the CBOE Volatility Index, the most popular proxy for market fear, recently reached a peak at a level four times its historical average.
In the face of increasingly bad news and no clear light at the end of the tunnel, these reactions to fear are both natural and understandable. But in the words of Rudyard Kipling, “If you can keep your head when all about you are losing theirs . . . If you can meet with triumph and disaster and treat those two imposters just the same . . . If you can trust yourself when all men doubt you, but make allowance for their doubting too . . . Yours is the Earth and everything that’s in it, and – which is more – you’ll be a Man my son!” You will also be a happier and more successful investor.