The Stock Markets Are High – But Investors Fear the Lows

Let's face it, Shakespeare's dire warning about the "Ides of March" had nothing on investors' year-round tendency to consume – and be consumed by – forewarnings that financial doom & gloom lies just around the corner.

Whether it's the popular press, pundits, politicians, friends, family or the family pet (you get the idea), we seem forever willing to let speculation about worst-case possibilities stoke the coals of our most fiery financial fears.

With markets hitting new highs seemingly every other day lately, and the carnage from the 2007–2008 financial crisis fading, many investors have begun to fret that things seem too quiet. News events deepen our discontent. With natural and manmade disasters forever in the headlines, we worry: 

• How much longer can the stock market keep rising? 
• Is it time to get out while the getting is good? 
• Should we pull some cash to the sidelines just in case?

This is not to say the markets aren't in for bad times ahead. From time to time, downturns happen. But if you've prepared your investment portfolio for the long haul, you're better off being wary of your reaction to the "doom & gloom" news than you are worrying about what lies just around the market's bend, be it good news or bad. 

The reason for this has to do with one of your own behavioral biases known as loss aversion or prospect bias. Academic luminaries such as Nobel laureate Daniel Kahneman and the late Amos Tversky have helped us better understand loss aversion – i.e. our tendency to fear the loss of what we've already got more than we crave potential gains (and to trade accordingly). 

For example, consider this exercise from Kahneman's classic "Thinking, Fast and Slow," in which you are invited to gamble on a coin toss. Tails, you lose $100; heads, you win $150. Even though odds are 50/50 that you'll win more than you'll lose, Kahneman points out that most people would pass on the wager. "For most people, the fear of losing $100 is more intense than the hope of gaining $150."

That's loss aversion in action. What this means from a practical standpoint is that the endless onslaught of negative news – and our own fears that a rising market can't rise forever – can keep us from putting the right actions in place (or sustaining the ones we've got). This harms our ability to best capture the market's expected long-term returns.

Speaking of that last big financial crisis, First Trust Chief Economist Brian Wesbury recently presented us with an interesting exercise related to loss aversion and doom & gloom forecasts.

Wesbury proposed: What if you had been psychic back in October 2007? You knew the market had just hit a high-water mark and it was going to be mostly downhill for a while. You also knew about some of the socioeconomic disasters that were about to unfold in 2008–2009. What asset class would you have picked then, and then agreed to stick with for the next decade, no matter what? Your choices were stocks, cash, bonds, gold or real estate.

We agree with his assessment. Not only did we actually see investors abandon stocks in droves at the time, but we have behavioral finance to inform us that loss aversion struck … again.

So how do you defend your portfolio against the damaging effects loss aversion can have on your long-term resolve? Since nobody has a crystal ball to foretell the future, it's okay to be aware of the range of possibilities, but we recommend making your investment decisions according to evidence-based probabilities. Here are a few such probabilities to consider:

1. You will probably live longer than you anticipate (especially if it's you and a spouse). Your investment time horizon is most likely multiple decades, even after you retire.
2. Your lifestyle today will probably cost more in the future, which is a real risk to be factored into your planning.
3. You'll struggle to maintain your purchasing power over those multiple decades if you only invest in bonds and cash.
4. Near-term stock market volatility is unavoidable but, over time, the markets have ultimately delivered long-term, inflation-beating returns. Check out this Dimensional Fund Advisors' analysis, if you don't believe me.
5. Over time, investors will go through many market corrections; a few of them will likely be painful and severe. The worst thing you can do is succumb to loss aversion and try to actively anticipate their imminent arrival … or panic-sell once they're underway. Instead, sit tight throughout. How? By preparing a diversified asset allocation customized to provide sustainable cash flow for your needs … and sticking to plan.

Nothing too profound here. But remember this post next time you feel your stomach tightening in the face of new doom & gloom prospects. Hopefully it'll help you gain the confidence you need to ignore your loss aversion. Stay the course through thick and thin.