Crucial Considerations for Investing During Difficult Market Environments

riPhoto by Mikhail Nilov:

One of the most common tropes you’ll hear when it comes to investing is to buy low and sell high.

This is excellent advice if you’re able to follow it.

Unfortunately, and for reasons that are not entirely our fault, we humans are wont to do precisely the opposite. This can be devastating for our investment returns, our financial health, and, ultimately, our quality of life.

Most people invest in assets, such as stocks, because they tend to provide better returns on your money than if you left it in, say, a bank account.

By investing in stocks, you are putting money into real businesses that provide goods and services, and which get rewarded for how valuable these are to society. These businesses are chock full of employees who will put in sweat and toil on your behalf as an owner, with the aim of increasing the business’s value, and, in the process, growing the money you chose to invest in them.

Doing this on a macro scale by buying into a broad stock index, which is one of the most common and empirically successful investment strategies, is essentially a bet on our capacity as a people to grow and innovate — something we have proven extremely adept at, particularly over the past few centuries.

However, it’s not all smooth sailing on our path to growth, and this manifests itself in the capital markets by way of the crashes we see every now and again.

These can happen for many reasons — they can occur because assets are priced much higher than their true value or realistic earnings potential, like housing was before the Great Financial Crisis, or stocks were during the dot-com bubble. They can be caused by geopolitical issues, with recent examples being the coronavirus lockdowns and the conflict between Russia and Ukraine. Or they can happen due to other, more idiosyncratic reasons, such as the Quant Meltdown of 2007, or the 1987 stock market crash (which many attributes to the proliferation of portfolio insurance strategies, a market decline being the very thing these were supposed to protect against!)

These crashes can be devastating for investors. The S&P 500, one of the world’s most popular equity indices which includes five hundred of the United States’ biggest companies, crashed 48% in a little over 6 months in 2008. Add to this the decimation of the housing market, and you can imagine how hard it was for people to see their net worth go up in smoke, affecting them and their own personal futures, but also that of their families. The raging bull market that was to follow over the next decade-and-a-bit was probably the last thing people expected whilst in the mire that was one of the worst economic crises to be visited upon us in living memory.

We human beings are hard-wired to feel more pain from losses than we would satisfaction from receiving an equivalent gain. This was first outlined in the mainstream by Nobel Prize winner Danny Kahneman and his partner Amos Tversky and forms a bias in our psyche known as loss aversion. It has been estimated that we experience twice as much pain from a loss than the happiness we would from a gain of the same size. When people see the market falling precipitously, it can cause too much pain to bear, especially if they think they are damaging their future prospects by staying invested. In this scenario, many people just cut their losses and sell out their assets in a bid to avoid further pain.

This is often the exact worst thing to do. Just after a crash is when assets are frequently most likely to be at their cheapest, therefore actually being the best time to be invested in them, and the worst time to sell out.

You may remember the stock market tanking because of the incipient coronavirus crisis in February 2020. The Dow Jones Industrial Average then proceeded to have its seven best-ever single-day points gains in March and April. To give an extreme example, Bank of America research found that if you missed the 10 best days of each decade going back to 1930, many of which came just aftermarket selloffs, you would have ended up with a return of 91% for that period — versus 14,962% if you had just left your money invested.

So what is the best way to approach investing during difficult economic times such as a market selloff?

It is important first to note that investing is not a one-size-fits-all type of domain, and your approach will differ based on your goals, your life circumstances, and, crucially, what you will be comfortable sticking with when times get tough.

A key principle which applies to almost all investors is the importance of having a process in place that you can stick with even in difficult market environments. For many people, this can come in the form of a strategy like a dollar/pound/euro/insert currency here-cost averaging — putting a set amount of your income into your investments at regular intervals, such as doing so each and every month after receiving your salary. Doing this, you will be poised not only to avoid selling out at market bottoms, which can be devastating to returns and is what a lot of people end up doing, but you will also end up taking advantage of the low prices on offer when stocks are at their most unattractive to most investors. As Warren Buffett says, be greedy when others are fearful.

We human beings have not evolved for investing in the capital markets. They are an extremely recent phenomenon. A lot of our emotions and biases are programmed for increasing our chances of success in the wild, biases which our ancestors developed over the millennia. We exhibit herd-like behaviour. We look back on things with rose-tinted glasses. We tend to be overconfident in our abilities. We eschew historical lessons and give too much weight to what our recent experiences have looked like. Even if we somehow managed to happen upon the perfect investing strategy, these endemic aspects of our existence as Homo sapiens could completely scupper our chances of financial success.

Having a process you can stick with, and stay disciplined to, can safeguard you against becoming your own worst enemy by allowing these biases and emotions to affect your returns at the worst moments, as they do for far too many people. Having a less than optimal process that you can actually stick to is, paradoxically, likely to be a much better strategy for the long term than having a completely optimal process that you won’t be able to maintain when you see your portfolio lose a significant amount of its value due to a selloff. As Morgan Housel goes to great pains to explain in his book The Psychology of Money, it is important to have an investment philosophy you are comfortable with, even if it may not be the completely rational, textbook way to approach one’s finances. This way you are more likely to stay the course, and therefore see better outcomes than if you were to try and time the market, react emotionally to news events that may have little impact on an investment’s long-term trajectory, or exhibit other pernicious behaviours that are so common among investors, and which the best financial advisors spend much of their working lives counselling against.

Keeping a defined process is not to suggest incorporating a lack of flexibility to your approach, particularly if the investment fundamentals or your own personal circumstances change — such decisions should not be taken whimsically, however. The process selected will naturally differ widely from person to person, but, especially if you have a long-term investment horizon, simply being invested has historically been shown to be a winning strategy.

Take Warren Buffett for example — as well as his ability to take advantage of the leaner economic times we face as a society, when pessimism is high and stock prices are low, Buffett’s secret weapon is his long-term horizon, and ability to stay invested through thick and thin. Many of us would do well to try and emulate him.