The dramatic stock market sell-off of the past two weeks, capped Thursday by a 512-point, 4.3% drop in the Dow, puts us in mind of a scene in Braveheart, when William Wallace (played by Mel Gibson) exhorts his troops to stay steady and hold off reacting even as onrushing English troops stampede at the Scottish rebels. It’s a nerve-racking scene, and for all we know a product of the screenwriter’s imagination, but there are real lessons in it for modern investors.Falling share prices are having the predictable effect of prompting many investors to pull money out of the stock market. This is a mistake, of major import, for all but a small percentage of investors (basically, those who need their cash now or within a couple of years). For everyone else, succumbing to the pressures of falling prices — that is, failing to hold steady in the face of onrushing hoards of bears — will more than likely cost you a lot of money in the long run.
We touched on this subject in our previous column, which cautioned against market timing. So today we thought we’d explain two related reasons why it’s so tough to resist feelings of panic. The first is recency bias, the tendency to assign too much significance to events in the near past. We often give something more weight than we otherwise would simply because it just happened. This bias is useful in many situations: Labrador Retrievers are known to be very friendly, but a Lab that just bit your buddy is definitely one to run from.
Still, recency bias often leads to conclusions — and actions — contrary to our best interests. In the months following the Sept. 11 terrorist attacks, there was a spike in U.S. traffic deaths. Why? Because more Americans took to the road for long trips, owing to a faulty assessment of the chances that someone would drive another plane into a building. This was, of course, completely understandable, not least because of another core principal of behavioral economics: “availability,” which explains how people’s views and judgments are shaped by information that comes most easily to mind. In the months following 9/11 we were inundated with news, conversations and punditry that made it hard not to imagine another hijacking as likely.
Likewise, today we’re inundated with news, conversations and punditry that makes it hard not to bail from stocks, which to many observers look unlikely to reach previous levels in the foreseeable future. Maybe that’s true, and maybe it isn’t. We don’t know any better than other so-called experts. But Gary has a relevant anecdote from early in his journalism career. It was October 1987, and stock markets around the world had just crashed. In reporting his story, Gary called a grizzled Wall Street money manager, and the two had the following conversation (with some details changed):
Money manager: “Guess how many clients I have.”
Gary: ”I don’t know, 50?”
Money manager: “Wrong, 180. Guess how many have called me over the past two days.”
Gary: “I don’t know, 100?”
Money manager: “Wrong, 158. Guess how many of them told me to sell some or all of their stocks.”
Gary: “I don’t know, half?”
Money manager: “Wrong, 156. Guess how old the other two are.”
Gary: “Huh? How am I supposed to know?”
Money manager: “You’re not, but don’t forget this. Both those clients are older than 80. Both called to tell me to buy. You know why?”
Gary: “No, why?”
Money manager: “Because they’ve seen this before.”
Those longtime investors knew what they were witnessing in the wake of Black Monday: stock bargains galore. So that’s one way to overcome recency and availability biases: Get old. Because the longer you’re on the planet, the easier it is to see the forest of long-term trends (stocks are the best way for most people to build wealth over time) for the short-term trees (share prices will frequently stumble).
Indeed, investors with 10- to 30-year time horizons (anyone younger than 50, really) would do well to think socks, not stocks, at times like these. That is, if you were shopping for anything else — say, socks — you’d be thrilled if prices were dropping. Why should small pieces of good companies be any different? And if you can’t muster the will to actually be a buyer today, at least try to avoid being a seller with any long-term funds.
To borrow from the White Rabbit: Don’t just do something, stand there!