The cycle of market emotions

Life is governed by cycles, the four seasons* for example. There are also business, financial, and economic cycles. For investors, though, the most important may be the Cycle of Market Emotions. It is the cycle with the potential to wreak the greatest financial damage.

More and more research provides evidence on how irrational is the average investor, how much damage emotions do to long term portfolio performance.

Consider this:

While the average return of the five most popular US growth funds over the 1995-2005 period was +7.8% per annum, the average annual return earned by investors in these funds was -0.5%.** How could this possibly be? How could the average investor lose half a percent, when her funds gained nearly 8%? Simple. She bailed out when the going got tough, concretizing her losses, and leaped back in when her original investment again looked cheery, buying high, . . . . in time to suffer yet greater losses on the next market tumble.

Now, consider this:

Since the Second World War, there have been 43 corrections of 10% or more***, a quarter of them greater than 20%. Bears and fear-mongers may portray the current situation as worse than all preceding ones, but the same fears and uncertainty were just as prevalent the last 43 times markets declined.

Buying and selling in tune to the cycle of market emotions, the average investor assures a reversal of the mantra, Buy low; sell high. She guarantees the opposite. She buys at the point of thrill; she sells at the point of capitulation. She's correct when she whines, "I would have been better off in GICs." She's right, but who's fault is that? The markets themselves? Or the emotional investor? Could she have been better served by fashioning a portfolio to match her risk profile?

It is natural to feel great when investments are performing well; it is natural to feel uncertain when they decline in value. It may even be natural to hit outright panic when investments tumble precipitously.

But a gut response to such natural feelings may not be rational, may not be in the investor's best long term interest.

Which brings us to John, whose duty it is to encourage rational behaviour. Should you be feeling naturally nervous, feel free to give him a call for a dose of rationality.

*There are those who would argue two seasons for the islands: wet, windy, cold. . . . and wet, windy, not so cold. But climate change may fix that apple cart.

**Cited in Second Quarter 2007 Standard Life Quarterly Investment Newsletter, attributed to John Bogle's The Little Book of Common Sense Investing.

***A correction is a significant retreat from a market high, generally agreed to be 10% or more. For example, the Toronto Stock Exchange topped out at 14,647 in July 2008. A correction of 10% was when it was down 1465 points. At this writing (2008/02/28) it is at 13,797. So that's 850 points off its all time high. 850/14647 = 6%.

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