While the full impact of the COVID-19 pandemic is unclear (and likely will be for some time), public crises inevitably have a dramatic impact on financial markets. A look at past crises makes that clear, with widespread economic disruption and uncertainty leading to nervous investors and plunging markets. So, while the current market disruption may be historic, the underlying dynamics of market volatility are extremely familiar.
For better or for worse, market volatility is a fact of life. Understanding that volatility — what drives it, how financial professionals typically react to it, and what should and shouldn’t happen as a result of a crisis — is essential for anyone looking to navigate the current crisis and position themselves for long-term success.
We can learn from the past, provided we take the time to look.
HISTORY AND PSYCHOLOGY
Big events that drive market disruption stretch all the way back to the Great Depression in the 1930s, and include national disasters, political upheavals, recessions and major economic downturns, geopolitical unrest, energy market disruptions, and even health scares. What every crisis has in common is a tendency toward investor overreaction and emotional decision making. It’s human nature to think the good times will keep going, and it’s human nature to do a U-turn when circumstances change.
We tend to think of market indices as made up of dollars and cents, but we are reminded in times of trouble and turbulence that they are fundamentally human commodities. In other words, markets trade in confidence — or the lack of it. Understanding the common psychological pitfalls that have led investors astray in the past is just as important as knowing what assets to buy and sell and what investment strategies to pursue.
OBSTACLES AND OPPORTUNITIES
Warren Buffet once noted that most investment decisions are made based on two things: fear and greed. He also pointed out (correctly) trying to “be fearful when others are greedy and to be greedy only when others are fearful” is a formula for smart investing.
In simpler terms, don’t follow the herd. That can be tough to do in a crisis. The fear of losing, or even being perceived as losing, can be a powerful motivator. The urge to want to be a part of shared successes can overcome a lot of good decision-making. It’s also exactly the wrong impulse to follow in a crisis. There’s a reason why reluctant sellers, and early buyers, during the recession of the late 2000s saw rates of return more than double those who hesitated to buy back into the market.
The key to overcoming those self-destructive impulses is discipline. Savvy investors and experienced financial professionals understand that discipline requires a plan, and the ability to execute that plan. Even an imperfect plan is likely to be better than no plan at all. However, past crises — and those who have come through them the best — have shown time and again that sticking to a plan doesn’t mean being rigid. It means having an approach and a mindset that will ensure you are prepared and committed to make decisions the right way, and for the right reasons.
Read the rest of the article from the July issue of Real Assets Adviser here.