By Christian Gattiker, Head of Research at Swiss Wealth Manager, Julius Baer.
Greed and fear rule markets, they say. While both are met with unease, greed gets much more attention than fear. Yet fear is frugal, fair, and forceful. Since fear is your first line of defence as an investor, you should be able to deal with fear and take the heat – while getting paid for doing so. There are three strategies for tackling fear: rationalise it, ignore it, or embrace it.
In a state of fear, the body activates many stress hormones. Even in smaller doses – when fear somehow nags you – it feels all the more uncomfortable and wears you out over time.Christian Gattiker, CFA, CAIA, Head of Research
1. Rationalise fear by looking at the risks versus the rewards
As John Wayne once said, “Courage is being scared to death… and saddling up anyway.” It may make it easier to be courageous when you get a better grip on the danger by putting it into perspective. In doing so, we use rationality to contain the raging angst. In financial markets, rationalisation is a lot about measuring what the crowd is doing and determining what are the benefits.
The action of the crowd (such as seeking protection by buying insurance) does affect the price of risk well before the crisis fully hits. In such a case, the price of an asset drops long before the danger materialises.
This is so fascinating that people scratch their heads when an outcome eventually leads to completely opposite market reactions; for instance, when stocks start to rise despite the related companies having posted record losses. However, in this case, as everybody had already feared that these losses would come and positioned themselves accordingly, the mood suddenly shifts far ahead of the fundamentals.
In boom times, markets tend to creep up more moderately, or at least hardly show extreme jumps on average, keeping price fluctuations at bay.Christian Gattiker, CFA, CAIA, Head of Research
The main gauges for measuring the fear factor on stock markets are volatility measures, which are known as ‘fever curves’ in financial markets. They may be imperfect, since they only measure price fluctuations, i.e. how fast prices move. Yet as panic usually leads to quite extreme moves, the massive spikes usually only occur when prices go down. In boom times, markets tend to creep up more moderately, or at least hardly show extreme jumps on average, keeping price fluctuations at bay.
When looking at the fear index in the chart below, we can spot all the major shocks caused by fear over the past 100 years or so. When the fear index spikes up, you may be afraid but rationally say, “Everybody else is afraid too.” The same can be applied to the contrary case, according to Warren Buffett’s motto: “Be fearful when others are greedy, and greedy when others are fearful.”
What’s in it for me?
The other way to rationalise fear in markets is to try to find out how much you get paid to worry. Classic tools for determining this are the equity risk premium in equity markets and credit spreads in bond markets.
In the chart below, we depict the amount of return you would have earned by holding risky assets (equities) versus presumed-risk-free assets (government bonds) over the past 70 years. The higher up the curve you are, the more it pays off to be courageous and overcome your own fears.
When looking at this period as a gauge, we see that investors paid to be worried (as opposed to getting paid to be worried during normal times), since the equity risk premium was at or below zero.
Of course, some investors hinted at this conundrum at the time, but I remember the market consensus being so convinced that ‘this time is different’ (i.e. that earnings growth was going to be so strong that one could forget about risk premia). Well, as it turned out, it just was not, since the valuation bubble burst and the stock market tanked.
2. Ignore fear by trusting in the long run
“Buy shares, take some sleeping pills, and stop reading the papers. Many years later, you will see you are rich.” This is the mantra of investor legend André Kostolany and the core of the ‘ignore’ strategy, that is, trusting in the long run. There are a few outliers, of course, but by and large, investors made 6%-7% in real terms every year by holding US stocks. So why worry, then, if it will all turn out fine in the end?
The final strategy is about accepting the fact that losses are a fact of life and learning how to grow based on the experience.Christian Gattiker, CFA, CAIA, Head of Research
Financial markets have the fantastic feature of providing liquidity and valuation any time they are open. However, this poses a major problem for us human beings, as we can follow the changes in the net value of our wealth, in real time and to the very last cent, which turns into a very stressful experience when prices collapse.
One of our seasoned investors shared his secret with me on how to deal with these stressful experiences when markets collapse: “Switch off the computer and go for a walk!” This is a classic way to ignore fear.
3. Embrace fear by growing spiritually
The final strategy is about accepting the fact that losses are a fact of life and learning how to grow based on the experience. The Western way of handling this is best exemplified by an individual account: in the book ‘What I Learned Losing a Million Dollars’, investor Jim Paul tells the tale of a costly experience he had in financial markets and what he learned from it.
I will not spoil the reading by retelling the learnings, but as occurs every so often with US investor legends, he claims that he became a better investor by taking the loss and drawing conclusions from it.
This reminds me a bit of the fairy tale ‘Hans im Glück’ (‘Hans in Luck’ by the German Grimm brothers), where the protagonist learns a valuable lesson from losing a fortune, which helps him to gain deeper insights on life and its meaning. Indeed, it provides some consolation to those struck by adverse fate in financial markets too.
’The raging torrent of the Dow’
The ‘Confessions of a Taoist on Wall Street’ was my first encounter with Wall Street in the 1980s. The writer (an American himself, to be fair) uses the homonyms of ‘Tao’ (pronounced ‘dow’) and ‘Dow’ to draw parallels between Eastern wisdom and the fate of financial markets overall.
The protagonist has spent years in a Taoist monastery in East Asia. At the very end, after sinking a large fortune on Wall Street, the hero (or anti-hero, perhaps) grasps the essence of investing: “Everybody, even the raging torrent of the Dow, even the blood river, back at last to this, to the delta, the great confluence of the Great Divide, back to loss, the mother ocean, Tao.”
To many Westerners, such statements may seem to be said tongue in cheek or may make them feel as though they are being exposed to a hoax after all. They may find relief in the expression “No rain, no rainbow”.