Bear Markets Are a Test of Investor Emotions

In a bear market it can be impossible to escape the pervasive negativity. Not only will our portfolios be falling in value, but there is likely to be an incessant flow of news highlighting the harsh realities of the prevailing backdrop. Dealing with this is not just an uncomfortable experience, it changes how and why we make investment decisions.

Our ability to make consistent and considered choices can quickly be overwhelmed by the negative emotions we experience; be it fear, panic or anxiety. It does not matter how many charts of past market declines we have seen; it won’t appropriately prepare us for the challenges of a severe bear market. It is critical that we don’t ignore the emotional demands of investing through such exacting market conditions. 

There are three pivotal means by which the emotions evoked during a bear market can lead us astray:

Emotions can diverge from rational assessment

In 2001, George Lowenstein and colleagues proposed the ‘risk as feelings’ hypothesis; it’s contention was that “emotional reactions to risky situations often diverge from cognitive assessments of those risks”.[i] Not only do emotions impact decisions, they can dominate them; leading us to make choices contrary to what we would rationally believe to be the best course of action.

There are three critical elements of the hypothesis that are relevant for investors and the emotional strains of bear markets:

1) The strength of our feelings is closely linked with vividness – the more powerful and salient the images and stories are, the greater our emotional response will be.

2) Our fear will increase markedly as we approach “the moment of truth”. There will be no comparison between how we feel about knowing there will be a bear market in the next ten years and being in one right now.  We are likely to hugely understate how much emotion will impact us prior to actually experiencing such a negative scenario. Bear markets are easy to navigate on paper.

3) The feeling of fear and a heightened sense of risk will be amplified by the behaviour of other people. Anxiety and panic in others will create a damaging, self-reinforcing feedback loop.

Bear markets are a breeding ground for emotions-based investing. We won’t anticipate how we will feel during them, we will be besieged by intensely negative stories (and realities) and be surrounded by investors reacting in a similar fashion.

It is no surprise that they can transform our decision making.

Emotions can provoke rapid, short-term decisions

Psychologist Paul Slovic and colleagues suggested that individuals use a mental shortcut called the affect heuristic, which can lead to rapid, emotion-led decisions. [ii] Here, how a situation makes us feel generates an automatic, rapid response that serves to “lubricate reason”.

The severe negative emotions that we may experience during a bear market, such as fear or dread, leave us vulnerable to overstating the risks of a given situation (because we gauge it based on the severity of feeling). It is also likely to drastically contract our time horizons – the heuristic pushes us towards dealing with the emotion that we are feeling in that moment.

As with most heuristic or instinctive decisions, it is easy to see its underlying usefulness. Acting rapidly to respond to strong emotional cues (particularly related to danger) is clearly an effective adaption in many instances, yet one that inevitably undermines our ability to withstand periods of market tumult or invest for the long-term.

Emotions can cause us to ignore probabilities

Although investors are not renowned for their consistent use of probabilities, strong emotions can make this problem significantly worse.  In 2002, Cass Sunstein wrote a paper on probability neglect, in which he argued that when powerful feelings are stirred our tendency is to disregard probabilities.[iii]  In particular, salient examples of disastrous, worst-case scenarios tend to overshadow the consideration of how likely they are to occur.

Sunstein offers the example of a study where participants were asked about their willingness to pay to eliminate cancer risk.  Across the subjects both the probability of cancer (one in 1,000,000 or one in 100,000) and its description (clinical or emotional) was varied.  When cancer was described in in a vivid and “gruesome” manner, the impact of a tenfold change in its likelihood on the willingness to pay to remove the risk was markedly less than when the disease was described in non-emotive terms. Simply altering the wording to provoke emotion – in a hypothetical setting – rendered individuals far less sensitive to changes in probability.

In a bear market our fears will be amplified by the inevitably lurid stories of how much worse things will get. Our ability to reasonably assess the likelihood of future developments will be severely compromised. Strength of feeling will outweigh strength of evidence.    

How can we dampen the influence of emotions?

There is no easy or failsafe solution to diminish the impact of emotions during difficult market conditions, but there are some steps that all investors should take.

Although we cannot replicate the lived experience of a severe market decline, we can better prepare ourselves for their unavoidable occurrences. It is very common for investors to be informed of a reasonable expectation for losses over a cycle; for example: ‘with this global equity portfolio you should expect periods of drawdown of at least 40% over the holding period’.  Yet this type of framing does not go far enough.

The presentation of an anodyne historic number is no guide whatsoever to what this sort of loss actually means and how it might feel. While we will never anticipate the precise cause of a bear market, we do know that it will often arrive amidst ceaselessly negative news, bleak forecasts about the future, some cataclysmic predictions and perhaps a recession with all that entails. Investors need to prepare as best they can for the emotional realities of losses and be forewarned of what a period of severe decline might mean about the broad backdrop.  

As we are currently experiencing a challenging market environment, now is not the ideal time to plan for how we might cope with one in the future. So, what can we do now to ward off the dangers of emotion-laden decision making?

There are two key behavioural actions. First, is to remove ourselves from emotional stimulus – turn off financial market news and check our portfolios less frequently. Long-term investors should stop doing anything that provokes a short-term emotional response. Second, we should never make in-the-moment investment decisions, as these are likely to be driven by how we feel at that specific point in time. We should always step away and hold off from making a decision, and reflect on it outside of the hot state we might find ourselves in.

These actions are no panacea; we cannot disconnect ourselves from the impact of emotions on our investment decisions. We know, however, that the negative feelings of stress, anxiety and fear that we experience during a bear market are likely to encourage some of our worst behaviours and we must do our best to quell them.   

[i] Loewenstein, G. F., Weber, E. U., Hsee, C. K., & Welch, N. (2001). Risk as feelings. Psychological bulletin127(2), 267.

[ii] Slovic, P., Finucane, M. L., Peters, E., & MacGregor, D. G. (2007). The affect heuristic. European journal of operational research177(3), 1333-1352.

[iii] Sunstein, C. R. (2002). Probability neglect: Emotions, worst cases, and law. Yale Lj112, 61.

I have a book coming out! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can find out more here.

What Can Sherlock Holmes Teach Investors?

In the first full length Sherlock Holmes novel ‘A Study in Scarlet’ the brilliant detective’s sidekick, Watson, is staggered to discover that Holmes is apparently not aware that the earth revolves around the sun.[i] Watson cannot comprehend how an astonishingly intelligent individual can be ignorant of such basic facts. Holmes, however, explains that he actively disregards and forgets information that is not relevant to his detective work:

“A fool takes in all the lumber of every sort that he comes across, so that the knowledge which might be useful to him gets crowded out”.

Holmes’ approach provides a useful framework for investors. It is essential that we find a means of cancelling out incessant market noise if we are to behave in a manner that will allow us to meet our long-term goals.

For Holmes, skill is about our ability to focus singularly on the elements that are relevant to our task:

“Now the skilful workman is very careful indeed as to what he takes into his brain attic. He will have nothing but the tools which may help him in doing his work”.

Here Holmes is distinguishing between signal and noise. Noise, as defined by Daniel Kahneman, is where our judgements are “strongly influenced by irrelevant factors”.[ii] There is probably no field where noise or erroneous considerations impact our choices more than investment. The overwhelming majority of what we hear and see about financial markets is entirely inconsequential to achieving our objectives. It is just exceedingly difficult to accept this.

There are two forms of noise that matter to investors, which we can think of as conscious and unconscious noise:

Conscious noise is where we react or respond to information that we think is meaningful but is entirely redundant. Worse than that, the fact that we interpret it as some form of signal transforms it from being innocuous to damaging because it leads to poor behaviours. Take, for example, a long-term investor consistently checking the latest stock market movements or worrying about how some macro-economic event will impact their portfolio. There is no signal in this, nothing that can be used to better fulfil their aspirations, quite the contrary.

Unconscious noise arises in situations where our decisions are influenced by extraneous factors, but we have no awareness or acceptance that they have affected our judgement. The best examples of this are related to emotions; how we feel – pressurised, stressed, excited or fearful – can lead to wildly inconsistent choices through time.

The concern Holmes expresses on noise is around it’s propensity to obscure or overwhelm the insightful knowledge he holds or the mental models he wishes to use. Likewise, an investor might be applying a simple and effective set of models to meet their long-term needs – diversification, rebalancing, regular saving, and compound interest – yet this sensible framework can be torn asunder by the magnitude and force of market noise:

“Depend upon it there comes a time when for every addition of knowledge you forget something that you knew before.”

It is in treacherous market conditions – like those we are facing at present – where the potential for noise to wreck our investment intentions is most pronounced. Emotive and salient negativity will be inescapable, and it will seem negligent to ignore it. This not only risks us forgetting our best laid plans but questioning whether they are even still relevant.

As investors we not only need to ensure that we are able to focus on what matters and why, but we must be constantly on guard against the often-irresistible spectre of noise.

“It is of the highest importance, therefore, not to have useless facts elbowing out the useful ones”.

[i] Doyle, A. C. (1904). A Study in Scarlet. Harper & Brothers.


I have a book coming out! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can find out more here.

Short-Term Performance is Everything

Two years ago value investing was dead, now it is the obvious approach to adopt in the current environment. What has changed? Short-term performance. There are more captivating rationales but underlying it all is shifting performance patterns. These random and unpredictable movements in financial markets drive our behaviour and are the lifeblood of the asset management industry; but they are also a poison for investors, destroying long-term returns.

Narratives + extrapolation

The damage wrought by our fascination with short-term performance is a toxic combination of two behavioural impulses– narrative fallacy and extrapolation. Narrative fallacy is our propensity to create stories and seemingly coherent explanations for random events; a means of forging order from noise. Extrapolation is our tendency to believe that recent trends will persist.

Short-term performance in financial markets is chaotic and meaningless (insofar as we can profitably trade based on it); but we don’t see this; instead, we construct stories of cause and effect.  Not only this, but the tales we weave are so persuasive we convince ourselves that they will continue.  

This is why when performance is strong absolutely anything goes. Stratospheric valuations, unsustainably high returns, made up currencies and JPEGs of monkeys cannot be questioned – haven’t you seen the performance, surely that’s telling you something?

Of course, it is telling us very little of use. It is just that we struggle to accept or acknowledge it. There must always be a justification.  

Performance is not process

In the years before the stark rotation in markets, I noticed a fund manager frequently posting on social media about the stellar returns that they had generated. Their approach was in the sweet spot of the time – companies with strong growth and quality characteristics, often with a technology element – but this was never cited as a cause of the success. Instead, the focus was on how their process and sheer hard work had directly resulted in consistent outperformance over short time periods. They were simply doing it better than other people.

This was palpable nonsense. Financial markets do not provide short-term rewards for endeavour. Nor can any investment approach consistently outperform the market except by chance (unless someone can predict the near future, which if they could, they wouldn’t be running money for us).

Many investors, however, seemed to accept this. Why did they laud such a bizarre notion? Because performance was strong. If performance is good a fund manager can say almost anything and it will be accepted as credible (that must be right, haven’t you seen their performance?) If performance is bad then everything said will be disregarded (don’t listen to them, haven’t you seen their performance?)

The problem with extolling short-term performance as evidence of skill (rather than fortunate exposure to a prevailing trend) is what happens when conditions change. If we say that our process leads to consistently good short-term outcomes, what do we say when short-term outcomes are consistently bad?

When performance is strong it is because of ‘process’, when it’s weak it is because of ‘markets’.

Sustaining the industry

Although the fascination with short-term market noise is a major impediment for investors, it serves to sustain the scale of the asset management industry. There is an incessant stream of stories to tell, fund managers to eulogise or dismiss, and themes to exploit. If financial markets were boring and predictable the industry would be a very different place.

Not only do the vacillations of markets give us something to talk about, but they also give us something to sell. The sheer number of funds and indices available to investors is a direct result of the randomness of short-term performance. There will always be a new story or trend to exploit tomorrow.

The impact of the reams of ever-changing narratives is compounded by our inclination to mistake positive short-run performance for skill. If investors struggle to disentangle luck and skill it means unskilled fund managers are rarely ‘competed out’ of the industry. It also incentivises new entrants – I have no skill in picking stocks, but if I selected a random portfolio there would be a decent chance of me outperforming over one year or three years, maybe even longer. It is a pretty lucrative business, so I might as well give it a go.

If we make judgements based on short-term performance everyone will look skilful some of the time.

ESG scrutiny

We have recently been witnessing an emerging backlash against ESG investing and, as the obverse of the resurgence of the value factor, this has undoubtedly been fuelled by weak short-term performance. Returns from ESG leaders, in-vogue companies and aligned industries have lagged and therefore the narrative has changed – outcomes are bad, maybe everything about it is bad.

The underlying problem is that any benefits of ESG investing were consistently obscured by unsubstantiated and unrealistic claims about its return potential. ESG investing was never (and should never have been) about the performance of any given fund or area of the market over arbitrary time horizons. As soon as we base the credibility of something on its potential to deliver short-run performance we are simply waiting for the reversal.

The desire to link every aspect of investing to the vagaries of short-term performance does nothing but scupper long-term thinking.

Misaligned incentives

The obsession with short-term performance is a vicious circle. Everyone must care about it because everyone cares about it. We can be the odd one out, but also out of a job. 

This creates a pernicious misalignment problem where professional investors aren’t incentivised to make prudent long-term decisions; they are incentivised to survive a succession of short-time periods. Irrespective of whether this leads to good long-term results.

The best way to preserve a career is to think short-term.

The more we are gripped by short-term performance, the worse our long-term returns will be.

Any investor with the ability to adopt a long-term approach has a profound and sustainable advantage, there are just very few of us able to exploit it.  

I have a book coming out! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can find out more here.