Beware the lingering pain from a market plunge

Even with a quick market recovery, investors may experience an outsized impact on their confidence and outlook

Beware the lingering pain from a market plunge

While the probability of unexpected, unexplained drops in stocks has gotten higher, that doesn’t mean every decline is a cause for real concern. There’s always the possibility that prices will bounce back, erasing portfolio losses.

A case in point: the Dow Jones Industrial Average fell 617 points on May 13, equivalent to 2.4%, and went up by an almost identical amount over the next three days. From a portfolio perspective, it’s almost as if the investor hadn’t lost anything at all. But from a psychological perspective, every downturn leaves a mark, even if it’s followed immediately by a recovery.

That’s the takeaway from a recent column on The Wall Street Journal. The piece focused heavily on research from Yale University economist Robert Shiller, whose work on the impact of human behaviour on asset prices made him a co-winner of the Nobel Prize in economics in 2013.

“His Stock Market Confidence Indices … show that investors are more likely to believe a market crash—on the scale of 1929 or 1987—is imminent in the coming sixth months if a recent sharp drop in stock prices was prominently covered in the media,” the Journal said. The degree of concern increases with the sharpness of the recent fall as well as the prominence of the news coverage.

According to Shiller, the tendency is as present among professional investors as it is among amateurs. “The professionals may be better at reading balance sheets and income statements and the like, but not at evaluating whether this is 1929 all over again,” he said.

That may be due to a psychological negativity bias among humans: generally, negative events get etched more deeply into the mind than positive situations. According to Shiller, it makes sense from an evolutionary perspective as the negative events our prehistoric ancestors experienced — encountering a predator, for instance — tended to decrease their odds of survival.

The scar of a sharp market decline will not necessarily push an investor into panic-driven selling. But it does increase the likelihood that they’ll fear another one in the near future. In one survey Shiller conducted immediately after the Dow fell 23% on October 19, 1987, investors cited the crash as an important factor in evaluating the stock market’s prospects — even more important than major economic indicators, geopolitical events, or remarks by policy makers or financial commentators.

More recent data from the Stock Market Confidence Index showed a similar tendency. In March 2009, more than four out of five institutional and individual investors said there was a strong chance of a US stock-market crash within the next six months, which they concluded based on a near-40% descent in the 12 months prior. But contrary to their expectations, US stocks returned 32%.

Shiller said that in the wake of a big move in stock prices, especially for a downward one, investors tend to scramble for explanations. And the narratives don’t have to be logically consistent to persist: pundits weighing in on the May 13 drop in the Dow blamed the bad news that trade talks with China were taking too long. But over the following three days, it recovered most of its losses on the news that trade negotiations were still inching along.

The findings suggest that investors must actively try to keep themselves on an even mental keel, especially as large price moves become more common. One way to do that is to turn to history: according to the Journal, today’s levels on the Dow should, by historical standards, come with a possibility of stocks falling by at least 520 points once every six weeks or so.


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