Volatility: why we’re our own worst enemy and an impulse trade I regret
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The boxer Mike Tyson once said, “Everyone has a plan until they get punched in the mouth”. Declining markets can be a sucker punch to the best laid investment plans, with calm, rational decisions giving way to fear and panic.
These are natural responses. After all, no one likes being punched. But it’s crucial for investors to keep their cool in a downturn.
So, what are these hard-to-resist impulses? And why could they be so damaging?
The urge to do something
Just because the market is falling, it’s not necessarily a reason to buy more. And it’s almost certainly not a reason to panic sell.
Often, the best course of action is to do nothing.
This is a lot harder than it sounds. In our hunter gatherer days, when face-to-face with a hungry predator, it wasn’t really an option to say, “I’ll deal with you later when I’m in a better frame of mind.” The flight-or-fight response kicks in and you run.
This is why investors tend to trade more in very volatile markets. But it can be a double-edged sword. Market downturns can throw up opportunities, but also increase the risk of making poor trades at a time of heightened emotions.
I speak from experience. In my previous fund, I sold shares of luxury-goods maker, LVMH, at the onset of the pandemic. This seemed a good move at the time. Its stores were closed, profits were likely to take a hit and times were uncertain. The chart below shows the volatility in LVMH’s share price at that time.
LVMH performance in March 2020
Profits did indeed fall, but quickly bounced back and the share price duly rose well above pre-pandemic levels. Indeed, if you widen the time frame and look at the performance from the onset of the pandemic to today, the volatility of March 2020 pales into insignificance.
LVMH performance since onset of pandemic
Had I waited for the dust to settle, I may not have sold LVMH. It was an impulse trade I regret – but a lasting reminder that doing nothing often beats doing something, even though the latter usually feels more comfortable at the time.
A focus on share prices, not businesses
Big share price movements don’t necessarily tell you anything about underlying business fundamentals, and it can be dangerous to view them as such.
Being too focused on share prices will tend to narrow your time horizon and make impulsive trades more likely. It’s why I spend little time checking how daily share prices are performing. I only check how the stock market is doing after I’ve read that day’s company announcements. This keeps my attention focused on long-term business prospects.
If you are checking share prices, you might consider doing this on evenings or weekends, when the stock market is closed. There are two reasons for this. First, watching share prices bob up and down isn’t conducive to rational long-term decision making, in my view. Secondly, if you do decide to place a trade, it might force you to sleep on the decision, which is probably not a bad thing.
The ability for investors to focus on what really matters is important at any time, but especially in a downturn.
When volatility increases, noise levels rise by an order of magnitude. Every economic announcement seems to be met by wild market swings. News headlines become gloomier and more sensationalist. And a host of ‘experts’ appear from nowhere, offering up stock market predictions.
I try to ignore it all.
It’s human nature to focus on what’s happening right now, but the world can change quickly. Consider what was happening 10 years ago:
- The Eurozone was in crisis
- China and Emerging Markets were in vogue
- Inflation was relatively low and falling
- Globalisation was in full swing
- The term FAANG hadn’t yet been coined
I always ask – will this still matter in five or ten years? If no, I can probably ignore it.
‘Worst case scenario’ syndrome
There’s a strong temptation to envisage worst case scenarios in falling markets.
I remember in the 2008/09 financial crisis, many experts were predicting Armageddon. Similarly, at the start of the pandemic, before any vaccines were developed, some commentators thought large swathes of the population would never leave their homes again, let alone visit pubs, restaurants and cinemas.
Eventually, you are forced to take a view: either the world really is ending – in which case the value of your portfolio probably isn’t the most pressing issue – or it isn’t – and extreme pessimism is probably unjustified.
People tend to forget about humans’ ingenuity during downturns. We may be good at shooting ourselves in the foot at times, but we’re also very adaptable and innovative. Our relentless technological and economic progress over the last couple of centuries is testament to that.
The temptation to get more defensive
A bear market will tend to increase your desire to turn to cash, or companies that look more immune to economic headwinds, like pharmaceuticals and consumer goods.
By the time this urge peaks, it’s likely the horse has already bolted. Just look at the performance of Unilever, AstraZeneca and British American Tobacco, three classically ‘defensive’ stocks, versus say UK housebuilders (Persimmon, Barratt Developments and Taylor Wimpey) so far this year.
There seems to be a lot of bad news already in the price of the builders. Of course, it can always get worse. But more often than not, anything that feels comfortable and obvious (like selling builders and flocking to cash/defensives) usually turns out to be the wrong thing to do.
'Defensive’ stocks vs. UK housebuilders - performance year-to-date
Mistakes are inevitable, but could be a long-term blessing
Whatever happens, you’re bound to make some mistakes in a market downturn. There will companies you should have bought but didn’t. Those you shouldn’t have owned but did. And, if you’re anything like me, trades you most certainly shouldn’t have made.
Don’t beat yourself up – even Warren Buffett makes mistakes. But do learn from your errors.
Periods of high volatility tend to provide the greatest lessons. In my experience, the long-term value from these lessons far outweighs the short-term pain incurred along the way, even if it doesn’t feel like it at the time.
See five-year performance of the shares mentioned above
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