A little lengthy – but I thought we could use several thoughts as we welcome 2016 with a lot of topsy turvey events and markets, as well as peer into our 2015 mostly negative year investment statements.  I hope some of these market sentiments help bring some rationality, and empower you with confidence as you continue on with your individual plan.

10 Bear Market Truths

A few truths about bear markets in stocks:

1. They happen. Sometimes stocks go down. That’s why they’re called risk assets. Half of all years since 1950 have seen a double-digit correction in stocks. Get used to it.
2. They’re a natural outcome of a complex system run by emotions and divergent opinions. Humans tend to take things too far, so losses are inevitable.
3. Everyone says they’re healthy until they actually happen. Then they’re scary and investors who were looking for a better entry point begin to panic.
4. The majority of the people who have been scaring investors by predicting a bear market every single month for the past seven years will be the last ones to put their money to work when one actually hits.
5. It’s an arbitrary number. I have no idea why everyone decided that a 20% loss constitutes a bear market. The media will pay a lot of attention to this definition while it doesn’t matter at all to investors. The 1990s saw zero 20% corrections but two 19% drawdowns. Stocks also lost 19% in 2011. Does that extra 1% really matter?
6. Buy and hold feels great during a long bull market. It only works as a strategy if you continue to buy and hold when stocks fall. Both are much easier to do when stocks rise.
7. Your favorite pundit isn’t going to be able to help you make it through the next one. Perspective and context can help, but there’s nothing that can prepare an investor for the gut-punch you feel when seeing a chunk of your portfolio fall in value.
8. History is a broad outline of what can happen in the markets, not what will happen. Every cycle is different.
9. They’re very difficult to predict. All of the valuations, fundamentals, technical and sentiment data in the world won’t help you predict when or why investors decide it’s time to panic.
10. These are the times that successful investors separate themselves from the pack. Most investors mistakenly assume that you make all of your money during bull markets. The reason so many investors fail is because they make poor decisions when markets fall.

This excerpt reminds me of the all too common pull to want to do something when markets go down, or move unexpectedly – when staying the course is probably best (even though it may not feel like it)

Unconventional

…..Have you heard of the high school football coach who never punts: Kevin Kelley, the head football coach at Pulaski Academy.

Kelley says he read a report from a Harvard professor who analyzed 2,000 football games over a three year period. His conclusion was that field position wasn’t as important as most coaches believe. The huge takeaway for Kelley here was that you should never punt the ball. This is the kind of thing that I have only seen people do when they’re playing Madden so I had to see the numbers on this to be convinced.

Kelley lays out an example, with evidence. Let’s say his team is backed up on their own 5 yard line and it’s 4th down. If they go for it and don’t make it the other team gets the ball and they’re going to score a touchdown 92% of the time. If they instead punt the ball the other team gets the ball at around the 40 yard line. From there the number only drops to 77% of the time that they score. So it’s not a huge difference in terms of scoring odds.

But if you factor in the 4th down conversion rate it makes even more sense to go for it every time. Pulaski says his team converts 50% of their 4th downs to keep drives alive. Now going for it every time doesn’t sound so insane. They don’t even have a punter on the team.

They also onside kick every time. Kelley says you can tell who wins the game 75%-80% of the time just by looking at the turnover battle. He’s just trying to force turnovers through onside kicks. On an average kick-off the other team would get the ball at the 33 yard line. With the average onside kick (when they don’t recover it) the other team would get the ball, on average, at the 47 yard line. So they’re only giving up 14 yards when they don’t recover the onside kick. Their onside kick recovery rates average around 20%, so they get the ball back one out of five times. This can really change the complexion of the game.

There is also a stat that the team with the most big plays — 20 yards or more — wins 80% of the time. So he’s structured his offense to make more big plays by utilizing laterals and throwing the ball deep

Here are a few ways in which investors can be forced into making an irrational decision with their portfolio at the worst times:

Not having enough high quality sources of short-term liquidity for spending needs. This one should be easily apparent, but when the fear of missing out sets in, investors tend to forget about the importance of their liquidity needs. You never want to put yourself in the position of being forced to sell an asset after it’s already taken a huge tumble because you didn’t set aside enough cash-like instruments to get you through some market turbulence.

Not having a portfolio in place that matches your risk profile and various time horizons. Again, this one is fairly simple, yet investors are constantly changing their portfolio holdings based on the market’s movements, not their own unique situation or goals. Striking a perfect balance between your need, desire and ability to take risk is not an easy task, but this is usually where most investors go wrong when making short-term decisions with long-term capital. If you don’t know yourself as an investor, there’s no way you can tell how you’ll react under stressful situations with your portfolio at stake.

Chasing yield. Want a higher yield? You’ll likely have to endure periodic losses and more price fluctuations. Want to avoid severe price fluctuations? You’ll likely have to endure a lower yield. Chasing yield after prices have risen is generally a terrible strategy, yet one that investors make on a consistent basis at the wrong point in the cycle.

Career risk. Why do so many professional investors, who mostly know better, partake in irrational moves such as window dressing, performance chasing, closet indexing and shorter-ism? In short, career risk. Every day there are terrible decisions being made in the markets by people who are trying to please others to keep their own job. This is a huge source of market inefficiency and forced irrationality, even though it’s mostly self-inflicted.

Leverage. Leverage tends to amplify moves in both directions, but it really makes things more painful on the downside when you’re forced sell to meet margin calls.

Having no plan in place. Investors with no plan at all practice a form of continual irrationality because it’s only a matter of time before a huge mistake takes place. Following a plan is never easy, but one of the biggest mistakes I see with investors is that they don’t have a process or set of guidelines to guide their actions when the markets go against them. It’s much more difficult than people realize to ignore the herd mentality because (a) sometimes the herd is right and (b) even when they’re wrong it’s much more comfortable to go with the safety in numbers syndrome.

The best investors understand how to minimize their own irrationality and take advantage of the irrationality of others.

Quote:

Alabama football coach Bear Bryant:

“Have a plan. Follow the plan, and you’ll be surprised how successful you can be. Most people don’t have a plan. That’s why it’s easy to beat most folks.”

Question:

Why do you think so many underperform the markets consistently?

Answer:

Markets are hard. And we’re often our own worst enemies. Good investing is counterintuitive. Plus, most people are overconfident in their abilities. No one wants to admit that they’re not one of the best investors out there. The Dunning-Kruger Effect has shown that people generally have a difficult time recognizing areas of their life where they are incompetent or overconfident.

Plus, costs and taxes can be a huge hurdle for most investors to overcome. As I said in a recent post, index funds are nothing special. They’re low cost, disciplined, low turnover, systematic, transparent, occasionally rebalanced and low maintenance. Most investors can’t say the same thing about their own investment strategy, especially the disciplined part of the equation. I like to say one of the first questions every investor needs to ask themselves is not, “Can I beat the market?”, it’s “Do I need to beat the market?”

Creating a personal benchmark to evaluate your own portfolio isn’t easy, but investors have to measure their progress and performance. Progress towards your goals is the first one that comes to mind, but you have to understand that they will probably change over time. Some milestones, such as market value or actual vs. expected returns can help when it comes to judging the success of your portfolio. And it’s not only the actual goals that matter, but also how much stress is involved in achieving them. If you can’t sleep at night because you’re constantly worried about your investments, I don’t consider that a successful investment plan.

The first step involved in becoming a good investor is to become a good saver. It doesn’t matter if you can pick stocks like Warren Buffett if you’re not able to consistently save money over time to build up your nest egg. This is especially true when you’re young and time is your biggest asset.