The Herd: Part 1

By Reed C. Fraasa, CFP®, AIF®, RLP®

Over the past 80 days, the US stock market has declined about 11%, and over the last 365 days, it is down about 1%. Foreign stock markets have declined about 9% over the last 80 days and are down about 10% for the last 365 days as well. The US bond market, typically a good hedge to the risk of stocks, hasn’t delivered much protection during the same time periods, being up about 1% in the last 80 days and down about 1% for the last 365 days.

Since March of 2009, there have been at least 10 time periods where the stock market declined by 9% or more, only to recover in the following three to six months.

However, in spite of this, investors are risk-adverse and continue to look for signals to avoid experiencing a loss in the market. It is human nature to make impulsive decisions and incur costs today to avoid a possible loss in the future. Even retail stores wait until you are checking out with your purchase to ask whether you want to purchase an extended warranty on a device or appliance. They know we are more likely to make an impulsive decision at the point of sale to avoid a potential loss in the future.

When it comes to avoiding loss, there is a biological reason for our behavior. The human brain is composed of three parts, the forebrain, the midbrain, and the hindbrain. The hindbrain is also called the reptilian brain and functions similarly in primitive animals. The hindbrain manages our involuntary systems like breathing to keep us alive and basic instincts to avoid pain or loss. When you touch a hot stove, the hindbrain takes over and removes your hand. When your reptilian brain is engaged, the more developed part of your brain is not working as much. The hindbrain is constantly monitoring information and responding to the stimuli to keep us safe. Think of the gazelles of the African grasslands who all flee when one of them sees or perceives a lion in the grass.This is a herd mentality or response.

The forebrain is responsible for problem solving, memory, language, judgment, emotions, impulse control, and reasoning. The forebrain helps to interpret a perceived threat, which enables us to understand whether a perceived threat is real. Gazelles have underdeveloped forebrains compared to humans. If the gazelle stopped to consider the probability of a lion in the grass, they wouldn’t live long to pass that knowledge down. Even with our highly-developed forebrains, we are still very likely to exhibit irrational, herd-like behavior when it comes to avoiding loss.

Lately, clients and prospective clients tell us that they believe things are different now. They say that this is like no other time. When asked what is different about this time, they describe the increase in the daily volatility of the stock market, and they believe it is a bad sign. When asked what is so different about this period of volatility and market declines, they share things like the President’s frequent tweets, the tariffs, the market is overdue for a crash, computer algorithms driving trading, higher interest rates, Europe is going to collapse, etc. We share those fearful feelings sometimes. It does feel like the markets are more volatile now than in the past, and it is natural to attribute current events as a cause for the increase. Our brains are wired to look for signals and often leads us to form irrational perceptions of risk, which often precedes bad choices.

Nobel Prize winning research by Daniel Kahneman and Richard Thaler identified several biases that exist in our brains’ biology. One bias is Recency Bias, defined as the phenomenon of a person most easily remembering something that has happened recently, compared to remembering something that may have occurred in the past. Additionally, we significantly overweigh the value of recent experiences in our decision-making process.

Inevitably, when I recall past years (Dot-com Bubble, Enron, Arthur Andersen, 2001 Recession, Great Recession, TARP, HARP, Greece Insolvency, US Debt Downgrade, Brexit, etc.,) people acknowledge that every time period in the past has had unique issues and events that, at the time, also appeared to be like no other time. In hindsight, the past doesn’t feel as bad as it did at the time, and we view past events for what they were – normal periods of disruption and uncertainty that eventually work themselves out.

How traumatic events are resolved is the product of Human Capital, the ability of humans to solve problems, innovate, and work together. It may not seem that way sometimes, and it doesn’t exist in every individual or group, which warrants pessimism, but collectively and over time, human’s do desire to improve our world and we have the capacity to do so.

Typically, it is not what happens to us, but how we chose to respond to what happens that determines our perception. Franz Kafka said, “All human errors are impatience, a premature breaking off of methodical procedure, an apparent fencing-in of what is apparently at issue.”

Is our perception of this market being like no other time valid? As Financial Advisors, we follow evidence-based policies and theories to construct and manage our portfolios. The fact is, our perception is wrong, we are living in times of average to lower volatility, not higher volatility. How can this be when financial news media have daily breaking news reports in red banners proclaiming record high moves?

The answer is simple. Big numbers of daily stock market price changes spark our emotions and make us tune in for more news. However, the larger daily numbers are a result of the higher total value of the index, not higher volatility. A 1% change when the DOW was at 5000 was 50 points, but a 1% change when the DOW is at 25,000 is 250 points. The daily percentage change is a measure of volatility not the number of points. The daily percentage change is at average levels for recent history, and lower than many past decades.

The following chart illustrates the number of days with positive or negative change of 1% or more.

Source: Ray E. Levitre, CFP, Kiplinger.com

Source: Ray E. Levitre, CFP, Kiplinger.com

There are far fewer days with positive or negative change greater than 2%, but the results are very similar.

Source: Ray E. Levitre, CFP, Kiplinger.com

Source: Ray E. Levitre, CFP, Kiplinger.com

The volatility we experience from time to time in the stock market is the risk we are rewarded for taking to receive the equity premium.  The equity premium is the premium we can expect to receive above the return of owning bonds.  Over time, stocks have always outperformed bonds. If stock market returns were achieved with the same risk of bonds or cash, no one would ever buy a bond or put their money in CDs.

Contrary to how it may feel sometimes, since 1926 the US stock market has been up 75% of the time and down 25% of the time.  That is why the lines on the charts always trend up over time. The chart below illustrates the years when the market was up (Blue) and the years when the market was down (Red.)

Source: Dimensional Fund Advisors

Source: Dimensional Fund Advisors

It may appear that our present experience is significantly different from the past, but our perception is not reality. Volatility does spike occasionally and that is normal.  Extreme spikes in volatility are signs that investors are behaving like gazelles, reacting to news of uncertainty and running to avoid loss. Volatility is not a sign that capital markets are not working or that we are living in different times or circumstances.  In my next article, I’ll discuss what drives the investor herd and why “there is nothing new under the sun.”