How to keep cool when the market is not

You may not want to hear this, but volatility is a sign of a healthy stock market. Three experts tells you how use it to your advantage and not get carried away.
By Larissa Fernand |  12-11-18 | 

This year, stocks were on a tear, ripping to record highs. In July, when the Sensex touched 37,000, predictions abounded that the Sensex would touch 38,000 by Diwali.

But how quickly sentiment changes in the stock market.

The falling currency. Brent crude on the boil. Foreign capital outflows. Lackluster exports. Rising interest rate scenario across the globe, and India. NPAs in banks. The IL&FS debacle. Tight liquidity in the NBFCs and HFC space. Turbulence in global markets. This heady cocktail ensured that October truly lived up to its ugly reputation (Great Depression - October 1929, Black Monday - October 1987, Global Financial Crisis - October 2008).

This year was not as dramatic but had its share of anguish. On CNBC, Dickie Wong, executive director at Kingston Securities, spoke about "market routs everywhere" and that "the bear runs especially fast in October". The Guardian reported the worst day for tech stocks on Wall Street in 7 years and explained that “markets were in retreat from Sydney to Shanghai as concerns about the global economy and rising borrowing costs were compounded by local factors.”

Though sentiment has improved, investors know that the bears are out there somewhere and could unapologetically made an appearance again.

Periods of market turbulence are dangerous for investors as they tend to elicit an emotional response and heighten the behavioural biases to which we are all prone. Left unchecked, these biases can lead to us to make extremely detrimental decisions.

Dan Kemp, Chief Investment Officer, Morningstar Investment Management EMEA, suggests four ways to keep our emotional biases in check so that we do not act in a way that will harm our long-term investment returns.

  • First, remember that investment is a long-term pursuit and put all recent price movements in this context. An 8% fall may feel overwhelming but not when viewed in the context of a 10 or even 20-year investment horizon.
  • Second, try to avoid the sensational headlines that can lure you into action. It's normally better to read books than listen to forecasts.
  • Third, if you are going to look for opportunities, ensure that you have a robust framework for setting the real value of assets. This will provide an anchor for your expectations and help you avoid overreacting to short-term price movements.
  • Fourth, if you are in doubt, do nothing. Investors tend to make too many decisions rather than too few.

Cyrique Bourbon, multi-asset portfolio manager for Morningstar Investment Management EMEA, encourages investors to anchor around three disciplines: a) Maintain perspective, b) Let facts outweigh emotions, c) Look at downturns opportunistically.

Focus on valuation and invest for the long term. It is worth remembering that the nature of the falls is a sign of a healthy market. Against this background, valuation acts a bit like gravity, where the effect is not always immediately noticeable, but it will make its influence known in the end.

The future carries a lot of uncertainty. So predicting the near term and trying to pick market bottoms or tops is a futile exercise. Instead, seek to position portfolios for multiple outcomes, not one. Also position the portfolios probabilistically, which to our way of thinking means carrying a bias toward those assets that are the least expensive.

As Warren Buffett aptly put it, "two super-contagious diseases, fear and greed, will forever occur in the investment community. The timing of these epidemics will be unpredictable." We are now starting to see this unpredictability play out, creating our greatest moments to add value.

Steve Wendel, head of behavioural science at Morningstar, points to three biases that investors must be aware of.

  • Vividness bias. I can't help but fixate on dire market scenarios.
  • Recency bias. I can't help but forecast how the sudden drop in the market could extend into a terrible rout over the coming days, weeks, or months. The recent events are likely to continue in the future.
  • Herding effect. I think of all the people around the world who might be rushing to safety, and anxiety starts to bubble under the skin.

Recency bias and herding behavior are egged on further by the headlines and social-media doom­saying that accompany market volatility, making it far more “real” and immediate than a carefully considered long-term plan that was conceptualized with a sober and logical mind.

Recency bias is interesting. If you see the car in front of you crash, you should swerve. But if you see the stock in front of you crash, you should jump right in and buy the stock. It’s the exact opposite. This bias is compounded by our brain’s natural inclination toward herding behaviour—looking at what other people are doing to get cues for what our response should be. If people are running out of the theater you should, too, regard­less of whether you smell smoke. But with investing, if you see the herd going one way, that means there are opportunities in the opposite direction.

To be more effective investors, understand the value of your biases and find ways to either use them to your advantage or at least avoid succumbing to them.

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