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Three Tips to Better Deal with Stock Market Volatility

In 1997, in a survey of 1,000 Americans, the U.S. News & World Report asked the following question:

According to you, upon their death, who is most likely to obtain a place in heaven?

Of course, it was expected that Gandhi, Mother Teresa or the Pope would get the most votes, but think again: the most popular answer was... "Me"! Yes, people surveyed thought they had a much better chance of going to heaven than Mother Teresa!

This is a great example of the illusion of "superiority bias", a tendency for people to overestimate their qualities, skills and abilities, underestimate their weaknesses and, therefore, feel superior to the average person. In this regard, a study of American students suggests that 93% of them consider themselves above the median with regard to their driving skills!

Obviously, the illusion of "superiority bias" is very present on the stock market. According to psychologist and economist Daniel Kahneman, when we make a decision, we rely mainly on our judgment, our experience and our beliefs; what we call "internal evaluation". Unfortunately, in a bearish and more volatile market environment, we are quick to make mistakes as we divest of shares. This is why Dr. Kahneman suggests adopting an external vision by objectively analyzing facts, statistics and trends. The purpose of this article is to give you three tips to improve your decision making process during episodes of marked decline.

No 1: Beware of the Media

As you can imagine, we are captivated by sensationalism and dramatic events like wars, terrorist attacks, bad weather and natural disasters. Unsurprisingly, many studies show that for every piece of good news, 17 piece of bad news are broadcast by the media. So when stock prices dive, the media predict the worst by evoking a market crash or a possible economic recession. It is therefore imperative to ignore these sensationalistic headlines and remember this: although there is a 46% risk that the S&P 500 will end down on any particular day, there is only a 10% chance that it has a negative return over a period of five years.

No 2: Check Your Portfolio as Seldom as Possible

Online investment firm SigFig points out that investors who check their portfolio's performance on a daily basis have a monthly return of 0.2% below average. For those who do it twice a day, the monthly return is 0.4% below average. In fact, these investors tend to trade more often and are therefore more inclined to reduce their equity exposure at the wrong time, for example, following a sharp decline in stock prices.

To remedy this unfortunate habit, it is essential to understand the non-linear dynamics of stock market returns, that is, to accept the fact that periods of decline are normal and frequent. It is therefore preferable to pay less attention to price fluctuations in order to benefit from a reasonable long-term return.

Decreases in the S&P 500 Average Frequency
–5% 3 times per year
–10% Once per year
–15% Once every 2 years
–20% Once every 3½ years
Source : Ben Carlson. How Market Crashes Happen, A Wealth of Common Sense, 2017.

 3: Respect the Strength of Stock Market Rebounds

Since 1932, the S&P 500 has generated an annualized average return of approximately 9.5%, including dividends. Applying this historic average performance and knowing that the S&P 500 fell by more than 50% between October 2007 and March 2009, it would have taken seven years to trade back at its peak reached in autumn 2007. The S&P 500 reached this level in three years and two weeks! In addition to the fact that it is impossible to accurately predict a trough, rebounds tend to be explosive. It is therefore essential to hold on to one's investments.

In this regard, an analysis of some 3,900,000 client accounts at Fidelity shows that those who stayed the course between the fourth quarter of 2008 and the end of 2015 generated a total return of 147%, compared to 74% for those who sold their equity portfolios at some point between the fourth quarter of 2008 and the first quarter of 2009. Furthermore, over 25% of sellers never reinvested in the market, despite the spectacular rise in prices.

Overall, as a decline in stock prices can be very destabilizing, it is essential to detach oneself emotionally by adopting a more critical point of view and by referring to quantitative observations and data. It reduces stress during more difficult times, an absolute prerequisite for success in the market!

Sources:

  • Ben Carlson. How Market Crashes Happen, A Wealth of Common Sense, January 8, 2017.
  • Bofa Merrill Lynch. US Equity & Quant Strategy, S&P. Probability of negative returns over different time horizons, 2018.
  • Curtis Brainard. What Kind of News do People Really Want, Columbia Journalism Review, August 31, 2007.
  • Fidelity. 6 habits of successful investors, CNBC, January 23, 2018.
  • Ola Svenson. Are we all less risky and more skillful than our fellow drivers? Acta Psychologica, vol. 47, 1981, 143-148.
  • P. Alex Linley et Stephen Joseph. Positive Psychology in Practice, John Wiley & Sons, 2004.
  • Ray Williams. Why We Love Bad News More Than Good News, Psychology Today, November 1, 2014.
  • Spencer Jakab. Heads I win, tails I win, Portfolio/Penguin, 2016.

The author

Michel Villa

Michel Villa

Speaker, stock market blogger and trading coach