Why Do We Not Sell In Falling Markets?

Last week’s Brief discussed how markets have telegraphed or predicted, since April, the recent slide in equities. It raised a question from a few of you as to why we don’t sell when we know stocks are going down? It is an excellent question deserving of a thoughtful answer, as it goes to the heart of our investment management philosophy.

As human beings, we naturally avoid danger or loss when we sense it. In fact we are hard-wired to fight or flee when confronted by certain stimuli. It is said that in the short-term, markets are driven mostly by fear or by greed. Logic takes over only when the emotions have waned. Benjamin Graham, known as the father of value investing, said that in the short-run markets behave like voting machines, and in the long-run they become more like weighing machines.

The essence to the answer of our question is found in the investment decision-making process. Emotions too often lead us make mistakes and, clearly should not be trusted in decisions that impact the quality our lives. Planning and logic should be the foundation of any investment process. We understand this concept in the theoretical sense, but when tested in the heat of uncertainty, we lose our heads. A line from the classic B sci-fi movie Tremors with Kevin Bacon, sums it up beautifully, “running is not a plan, running is what you do when a plan fails.”

A second point is just as basic and immutable as the first. The future is uncertain and unknowable. Anyone who tells you he can get you out of the market before harm occurs or back into the market before opportunities are lost is drinking too much of his own Kool-Aid. You should realize that he is appealing not to your logic, but to your emotions, more specifically, to your negative emotions.

In the book “Switch”  Chip and Dan Heath quote Martin Seligman, a psychologist at Univ. of Pennsylvania who sums up negative emotions this way: “If you have a stone in your shoe, it hurts and you’ll fix the problem.” The advisor in our example uses negative emotions to motivate your acceptance of his ‘process.’ He tells you he can keep stones out of your shoes. But your desire to avoid market volatility is not a stone-in-the-shoe situation.

According to the Heath brothers, negative emotions tend to have a narrowing effect on our thoughts. “If your body is tensing up as you walk though a dark ally, your mind isn’t likely to wander over to tomorrow’s to-do lists. Fear and anger and disgust give us sharp focus-which is the same as putting on blinders.” In other words, our fears of temporary losses, blind us to the far more important considerations.

But if emotions are inescapable in investment decisions, then ‘positive emotions’ will provide far better results. The emotions of joy, contentment and pride all tend to produce an ‘I’m pleased’ expression according to  Barbara Frederickson, author of the game-changing classic “What Good Are Positive Emotions?” Whereas negative emotions narrow our thinking, positive emotions are designed to ‘broaden and build’ our repertoire of thoughts. “Joy for example, makes us want to play. Play doesn’t have a script, it broadens the kinds of things we consider doing.”

So, rather than focus our energy and fears on what we cannot control, we could far more productively focus our energy and joy on what we strive to accomplish through building and focusing our resources and skills in the direction of your dreams. This is why we devote so much of our attention to the continual development and refinement of your plan. When we understand where you want to go, we can help straighten the course to get you there sooner and more abundantly than you imagined possible, despite the uncertainty of markets.

While we are on the subject of psychology, there is another very important reason we do not sell into falling markets. We find that once we are out of the risk pool a compelling feeling of contentment takes hold. It feels good to be ‘out of harms way’ and we don’t relish the idea of going back into the battle. We begin to relax and to ignore.

The market begins quietly and steadily creeping back. Then, out of the blue, big moves start to occur, headlining the evening news. We begin an emotionally-centered game of second-guessing ourselves – is this a real rally or is it just a tease? These questions give way to – has the rally has gone too far too fast – have we missed it?  I know far too many people who pulled out in the 2008-2009 bear market only to miss large portions of the 90% rally that has come since.

When you sell appreciated stocks in fear of a market collapse in taxable accounts you guarantee yourself a certain loss – taxes on the gains and expenses for the trades. Let’s say you invested $100,000 in 2011 and watched it rise 18%. On November 8th (a peak) you feared the stock market was headed for as much as a 10% decline and you sold your$118,000 stock portfolio. Congratulations. You watched the market decline 8%, 9%, and 10% by 11/25 comfortable (maybe even a little smug) in your decision to get out.

While away from your office on business the next three days the market rose 13.8% to $64.04. You bought back your shares on 11/30 at the opening price at $64.65 only to watch your purchase fall 1% that day. After 35% in taxes at the end of the day 11/30 you had $109,477. If you had simply left your stocks in the market, you would have had $115,191. What if you were lucky twice and bought that Monday after the dip occurred on 11/28/2011 at $61.25? You would have $114,469 at the end of the day 11/30, but still shy of what you would have had if you just sat tight.

In short, you can spend your precious energy and time chasing what cannot be controlled or known, aided by an entire financial services industry, or you can focus your energy, resources, and skills in the direction of your dreams by planning and executing well. The planning part is fun, especially when you free up your imagination from the debilitating uncertainty created by worry over the relentless ups and downs of the market.

The execution part is also vital to your success. Here we can help you keep substantially more wealth by carefully controlling as much of the investment management process as possible, by minimizing your expenses, taxes, and market under-performance.

At the very essence of it, we invest in stocks (a hugely diversified global pool of stocks) because they represent the very best means of saving for long-term purposes. Our stocks represent the sum total of global businesses devoted to growing their profits; and in total they are incredibly and predictably good at it. While their profits and growth vary with the ups and downs of the global economy, their ability to continue doing so is never truly questioned; so why would one rationally abandon them even for a short time? Is it not considerably more probable that they will eventually be rewarded for their profit-making prowess than they will collapse utterly worthless, as behavior too often suggests?

Have a great weekend dreaming of what can be. Don’t let the fog of uncertainty cloud a moment of your joy.