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Thursday, 21 January 2016

Be Prepared, Be Resilient

Are You Ready?

So, markets are down, the oil price is seemingly in terminal decline, the (alleged) Ponzi scheme that is the Chinese economy is collapsing and interest rates are on the way up. A crisis? Well, for anyone who’s been around the markets for more than two minutes it’s déjà vu, all over again.

Of course, the wise investor is prepared for this; not merely in the sense of having a trading strategy in place, but in terms of psychological resilience. There’s no point being the best darned stockpicker in the known universe if you flee for the hills at the first sign of trouble – or, even worse, at the last.

Imperfect Strategies

During the not infrequent periods of relative calm in the markets you'll find investors happily explaining their pet investing strategies: which are mostly based on whatever happens to be their particular personal preferences at the time. And, on the principle that a rising tide floats all buoyant objects, including those filled with hot air, many of these work a lot of the time. Unfortunately, they usually fail just when their guidance is needed most.

This isn’t – necessarily – a weakness in the strategies, it’s just that in emotionally driven markets there is no strategy that will deliver perfect results all of the time. Indeed, there’s an argument that any strategy that works in the long term must occasionally go wrong to shake out the feeble and fickle, otherwise it becomes a crowded trade and fails by definition.

So preparing for downturns in the good times is essential. How someone does that is a personal thing: you can hedge, or you can implement stop losses, or you can simply invest in stocks that will never fail completely and ride out the storm. Or something else – anything, in fact, as long as you have a definite plan, which you then track and learn from. The people most likely to escape from burning buildings or crashing planes are those who know exactly where the exits are.

Drawdown Trauma

Psychologically losing a lot of money, very quickly, has peculiar effects on the human brain – in particular we’re likely to demonstrate loss aversion and sit on failed investments in the hope of recouping them rather than addressing the actual situation. The longer term consequences of savage market downturns on investor psychology can lead to people fleeing the markets permanently:
Individuals who have experienced low stock-market returns throughout their lives so far report lower willingness to take financial risk, are less likely to participate in the stock market, invest a lower fraction of their liquid assets in stocks if they participate, and are more pessimistic about future stock returns
Of course, if all you ever have is bad experiences then maybe the problem is you ...

Anyone who invests in stocks will at some point suffer a very nasty decline in the value of their portfolio, no matter how well diversified they are. Inexperienced investors, who tend to be under-diversified will see those losses magnified, and may well suffer permanent losses to their capital. It’s all very well being invested in oil stocks and seeing them halve, or more, as a result of the oil price collapsing but we know, all things being roughly equal, that Exxon or BP aren’t going to go bust – the long term returns, if held from significantly higher levels, aren’t going to shoot the lights out but neither are they going to leave you penniless in your dribbling old age. But sticking all your money in highly indebted shale oil producers while the Saudis are determined on driving them out of the market will likely see you back shining shoes for a living.

Adapt and Thrive

And none of this matters a jot if you can’t implement a plan. Which – circuitously – brings us to the concept of psychological resilience – the ability of a person to adapt to adversity and to deal with stress. Historically the research on resilience arose out of the observation that the children of people with severe psychological problems generally didn’t become mass murdering psychopaths but, rather, fairly normally well-adjusted members of adult society:
Two-thirds of the children who had experienced four or more of such risk factors by age two developed learning or behavior problems by age 10 or had delinquency records and/or mental health problems by age 18. However, one out of three of these children grew into competent, confident and caring adults. They did not develop any behavior or learning problems during childhood or adolescence.
Generally four factors seem to contribute to resilience: (1) The ability to make and execute realistic plans, (2) A positive, but not unrealistic, view of the self, (3) Communications and problem solving skills and, (4) A reasonable degree of self-control. The really important thing is that we don't become too focused on the immediate, scary situation, and take a longer term view of events. That view might indeed suggest that we should sell everything and head for the nearest Cold War bunker, but that response should be based on something more than a reaction to unfolding events.

Plan

Planning, of course, is the core of a successful investor’s strategy. We absolutely know that markets don’t stay the same but all we suffer from the curse of myopia (see: It's Not Different This Time) – the ability to disregard painful past experiences just as soon as they’re no longer current. As a psychological coping mechanism that’s understandable, but as an investing mechanism it’s fatal.

Downturns happen, usually we don’t see them coming so knowing what we’re going to do when they happen is crucial – even if that plan is to adapt as events unfold. But a rough rule of thumb is that if you can’t cope with a 20% loss of capital overnight then you don’t want to be in equity markets.

Solving the Self

Taking a positive self-view is a simple counterbalance to the tendency to blame ourselves for our mistakes. An overly self-confident investor will make terrible decisions, but equally beating ourselves up for simply losing money makes no sense: it’s entirely possible to make correct investing decisions and lose money; and vice versa.

As for problem solving – well, that’s hopefully self-evident. Every corporation is a riddle wrapped in a set of opaque accounts wrapped in a mass of irrelevant detail. Figuring out what’s really important and disregarding the vast bulk of extraneous information is critical to forming a sensible opinion about the real intrinsic value of a company.

Keep Control

Above all, as we’ve seen before in The Secret to a Healthy, Wealthy Life, self-control is the critical thing for an investor. The best investor in the world will destroy their returns by panicking with the crowd. That doesn’t mean the crowd isn’t right sometimes – but fortune favours the prepared and the resilient.

Of course, preaching to the converted is easy enough, but convincing someone who’s only ever experienced the heady ease of a bull market that they’re not Warren Buffett Mark 2 is nigh on impossible. In the end, though, markets move money from the dumb to the smart and those who survive the experience should be better prepared for the next crash. The long-term survivors are either the resilient or the terminally stupid.

Be smart, be ready. And always check where the nearest exits are, you never know when you might need them.

Psychological Resilience added to the Big List of Behavioral Biases

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