You catch the news on the way into the office. Yesterday the market reached a 10% low relative to its last peak. Immediately in your mind you begin to filter your clients and prospects. Some will care and others won’t. You’re grateful most of your clients either don’t pay attention to that stuff or don’t seem to react.
Yet in your mind you can picture three or four faces. These are clients that seem to consume the news and, when the market reaches certain thresholds, they become unnerved.
They are unnerved for a simple reason. In their mind a pattern has formed. Their hidden belief is that because the market has gone down 10%, then it will go down another X% (fill in the blank with 5%, 10%, 15% or what have you).
In other words, they don’t mind so much that the market has gone down, but they mind a lot about where they think it’s going to go.
We can’t really blame them. Humans are programmed to form patterns – this is why we see constellations in the stars. As Wall Street Journal personal finance columnist Jason Zweig says in his fantastic book Your Money and Your Brain, “After two repetitions of a stimulus – like, say, a stock price that goes up one penny twice in a row – the human brain automatically, unconsciously, and uncontrollably expects a third repetition”.
This behaviour is everywhere, but it especially hurts us with money. Consider how many fortunes have been blown in the casinos of the world because the gambler thought they were on a ‘hot streak’. Rolling consecutive sevens in craps or hitting 21 on consecutive hands in blackjack makes us think, for some reason, that the next seven or 21 is more likely than it really is.
Carl Richard illustrates the phenomenon this way:
How do we counteract this behavioural bias? By being relentless with the truth. And the truth is this: a recent down turn in the market never has, and never will, be any predictor at all of future negative returns. The graph below shows the how the market performed 12 months, 24 months and 36 months after market falls of varying magnitudes from a previous market high point.
Across the board the median case is that markets were positive after any size drop. Looking at the upper and lower quartiles shows a distribution of results is possible (of course) but it’s mostly positive. We use the S&P 500 to take this illustration all the way back to World War II.
Salient for current markets, the median returns after the markets have fallen 10% is a positive 8.19% for the next 12 months, which is right around what the market returns on average anyway.
As advisers, it may be useful to show this chart to clients so they can read the facts, but perhaps it’s even more useful to memorise the facts for ourselves. How powerful is it if, over the phone, you can say, “I know you’re concerned, Joe, but since the end of World War II, the market has lost 10% from a previous high a total of 14 times. In those cases, the median return 12 months later was 8.19%. Based on that, I don’t think we should read too much into recent performance.”
Of course, there is another approach. An adviser we work with recently told us they say to clients who ask, “I know the market just lost 10%. Isn’t it great?”
“What?” says the client, slightly exasperated.
“Listen, if the market didn’t ever go down then we would never earn the premium for owning shares, and without the premium for owning shares we’d never reach our financial goals. We need volatility! Don’t worry, we haven’t taken on any more volatility than you can handle”.
“Oh, ok” says the client, and changes the subject.