Logical Thinking During Downturns

Paul Winkler: Welcome to “The Investor Coaching Show,” a podcast to help you get an insider’s view of the financial world and escape common investment traps. We look at the financial news of the day and help you make sense of it so you can relax about money.

I thought I would share something that has been going on in my brain this week with market volatility. As I always say, everybody loves upside volatility; it’s downside volatility that can be unnerving. It just leads to a lot of different things.

Markets Can Be Unnerving

I had a local company reach out recently that had a lot of its employees worried about the market. People were asking, “What’s going on? What’s happening? I heard the economy’s going to get worse and I need to pull everything out or stop contributing to the plan.” One of the higher-ups in the company came to me and said, “Hey, Paul, can you help? What can you say?”

So then I thought I could do a segment on it, because I think it’s a concern that a lot of people have. Markets, when they do their little gyrations, can be unnerving.

It’s just what happens. People hear news about how the economy’s going to get worse and how things are getting bad. The reality of it is the whole idea that the economy is going to be bad going forward is noticed by markets long before it actually ends up happening.

So for several months markets went down in anticipation that things were going to be bad. Then, of course, we had the month of July. It jumped way up almost 10%, and that’s because everyone started to think maybe it wasn’t going to be as bad as we thought it was going to be.

Then new news came out saying, “Well, maybe the Fed’s going to raise interest rates more than we thought they were going to raise them.” Then maybe there are bigger problems than what meets the eye, so markets went back down again to where they were.

In general terms, let’s look at the logic of this, because if we really examine the logic of our thoughts, maybe we can actually decide whether they’re rational and whether they’re irrational.

There’s a whole idea that we tend to take action based on our beliefs, so I’m big on let’s shape our beliefs because that’s going to shape your actions.

People tend to take action based on their beliefs, so let’s shape our beliefs well when it comes to investing.

If we first look at the trend of getting out of markets before it is thought that the economy will be bad. Just ask yourself this question: “If the economy is going to be bad, are risks now higher or lower than they were before it was thought that the economy would be bad?”

How Does Risk Work?

Now, you would say, rationally, that risks are higher. So anytime that I feel like there’s a lower risk of getting my money back, I’m going to charge more interest. If I have a risk that I’m going to have bodily harm from a job that I’m doing, I am going to demand a higher pay scale because I’m taking more risks.

If a job is harder, I’m going to demand more pay. If it is harder to prepare for a job, like if I’ve got to go through 10 years of schooling versus two years of schooling, I will charge more.

We do this in every aspect of our lives. We charge more whenever there is a hardship being borne upon us, right?

So it’s not unusual, it’s not unlikely to think that we would be paid more for taking more risk when it comes to investing. If I look at, for example, credit card companies, who do they charge the highest interest rates to?

They charge the highest interest rates to the people that they’re wondering, “Is this person going to repay the loan or are they not going to repay the loan? That’s really what they’re concerned about.

When we decide that we’re going to get out of stocks because we think the economy’s going to be bad going forward, what are we really saying? We’re really saying, “Oh, I think that these companies won’t have to pay me any to use my money.”

What are you doing when you’re buying stocks? You’re letting companies use your money.

Now, the more that it costs to use your money, that then correlates with higher returns, right?

Returns are a payment for the use of your money.

To say that the economy is going to be bad going forward is to say that there are greater risks to come. So to come out and say, “Oh, you know what? Stock markets are going to be bad going forward. The returns are going to be negative, so not only do you not have to pay me much to use my money during this bad economy, I’ll pay you.” You should pause and think, “Wait a minute. That doesn’t make any sense.”

Are Our Fears Sensible?

When we have fears, are they really sensible, anyway? I mean, if you think about it, a lot of things that we fear and worry about aren’t sensible.

I often tell people about studies which look at the things that we fear. Only 30% of the time do the things we fear actually come to fruition, which means that 70% of the time the things we fear do not happen.

Also, we can handle our fears better than we think we will be able to handle them. Some things are going to happen to you in life that you just can’t do anything about, right?

Markets will go through gyrations, and they will do so often. That’s why I always tell people, expectations are so key.

Expect it.

Don’t think that the market mightfall. Just expect it.

It’s going to happen. Also, expect that you won’t be able to predict when it’s going to go up or down. You might be able to get lucky a few times and successfully predict the market’s movement, but then it is false confidence.

We think we figured it out and after the fact think to ourselves, “I knew that was going to happen.” Well, then why didn’t you go market your house if you really knew it was going to do what it did?

“Well, I’ve just pulled my money out of my 401(k), and I ended up being right.” Let’s say you were right on a market downturn and you got out. Well, did you get back in at the right time? Because you have to be right twice with market timing. You can’t be just right when you get out, you have to be right when you get back in.

There was this one guy that was an anecdotal story that was, he missed the market downturn, he missed three major market downturns. I mean, this person was good. They got out. I think it was like the 1987 one and in 2002 was another one, 2008 was another one. Then they actually examined the returns of his investment portfolios and found that they were lower than the market.

Market Expertise

Well, what was going on there? Well, he was right when he got out, but he wasn’t right when he got back in. You have to be right both times.

When I get out of the market, I’m selling to somebody else that thinks that markets are going to go up, and the problem is one of the two of you is going to be wrong. Now, if I get lucky, I’m right, I’m going to pat myself on the back all day long and go, “Man, I’m good. I’m really good.”

But if I’m wrong, nobody will ever hear about it. That’s the way this stuff works, right, because nobody ever wants to talk about their failures.

So often I hear people say, “Well, this market expert…” The reality of it is the market experts don’t get it right. We look at the market experts and we see that there’s a different one every time you look.

The so-called market expert of the day is different every time you turn around, so we all need to realize that market experts don’t really exist.

Go back and look at 20 years, 30 years of the big investment magazines out there. One of the things you’re going to notice is that the cover, the poster children for great stock picking and great investing prowess constantly changes.

Now, you won’t see anybody that says, “Well, I don’t know what’s going to happen next.” You won’t see that because it’s not exciting. There’s nothing exciting about the person that says, “I don’t know what’s going to happen next.”

But it is exciting if somebody tells you, “Hey, here’s going on the economy. Here’s what China’s doing, here’s what Brazil’s up to, here’s what the U.S. is doing, here’s what the president’s doing, here’s the likely effect on the market.”

That’s exciting. Why? Because we want a prediction about the future because I fear the future. I’m so worried about what’s going to happen next that I want somebody to tell me where things are going so I can make the right moves.

We Too Easily Forget

There is always one guy, constantly saying, “Hey everybody, the market is going to crash, the market is going to crash.” Then all of a sudden, the market goes down, and he is front and center. The financial planning world puts him front and center, which shows you the financial planning world is as messed up as anything.

They put him front and center first and say, “The market’s going to be crashing. It’s going to be the worst thing ever.” And I think, Yeah, yeah, yeah. Okay. Where was he last year?

He was predicting the market was going to go down, and what did it do? It went up. Where was the year before? He was predicting the market was going to go down and it went up. Where was he the year before that? He was predicting, the market was going to go down and it went up.

He was wrong, wrong, wrong, wrong, wrong, wrong, and then all of a sudden, the market does go down, and you put him back on the stage again, which he loves because he loves the idea that you always forget when he’s predicted wrongly.

You never remember. You remember if he gets it right, and then put him front and center. Why? Because the magazines want to seem like they’re relevant.

The problem is that people come to the assumption that the person predicting has some special ability that in reality they really don’t have.

Then with market segments around the world, you always have something different going on that you can report on. You have technology stocks, and you have energy stocks. There is always something that can be put front and center or a fund manager that can be put front and center.

Where Should the Money Come From?

The vast majority of the money that you have in retirement should be money you didn’t put there. It should be a small amount of money that you put in, and the rest should be from growth.

If you look at history in the way markets have delivered returns, most of the money over the past 40 years by far—it’s not even a small amount—was just growth, so long as you captured market returns. Yet what we see by the allocation data, investors underperformed inflation with their returns.

What this means simply is that investors earned after inflation was less than what they put in.

Then people go, “Well, this stock market is not what it was cracked up to be.” No, it wasn’t because you spent your entire life trying to outthink markets and outguess them. So much of it is ego. So much of it is desiring to look good.

People want so badly to impress humanity through their knowledge, through their skills, through their prowess.

It is the desire of all humans to do that. We want to be important. We want to be significant. Now, some people want significance, or they crave it more than others.

But if you admit it, everybody wants to feel important and they want to feel that they’re needed and necessary.

We’re treated differently and seen differently when we have something that’s special about us, and for some people, it’s about market prediction. Then what happens is somebody that doesn’t know anything about the market acts like they do.

Then people will hear them talking very confidently about their beliefs on what’s going to happen next, or what others should do with their money, or how people should invest and be managing their money right now. And ultimately people are attracted to that confidence.

We have a tendency to follow people who seem to know what’s going on—even if they really don’t know any better than us at all.

It’s just like confidence in general. Think about the popular people in high school. Was it that they were any better than anybody else? Not really, no, but they were more confident.

They were more sure of themselves, and therefore people followed them simply because they seemed to know what’s going on. This is what we do with investing, too.

Don’t Engage in the Market Guessing Game

Well, you can’t go back and fix the past, but you can surely fix the future and not engage in this game of figuring out where markets are going to go and when they’re going to go there. Don’t engage in it.

When markets are down, if you have to stick your fingers in your ear and go, “La, la, la, la, la, la, la,” or hide your statements, do it. Whatever you have to do, whatever coping mechanism works for you, that’s what I would do.

Now, when I say, “Stick your fingers in your ear and don’t look at anything,” you still need to be aware. I always benchmark stuff, so I’ll look at what large stocks did.

Okay, what did my fund do? If large U.S. stocks go down 20%, then I had better look at my statement and see that the part of my portfolio that’s exposed to large U.S. stocks also went down 20%. It better not be up 10%.

Because if it went up 10%, that tells me that the fund manager gambled and missed a downturn. And you’d better know that if they can gamble and miss a downturn, they can surely gamble and miss the upturn as well.

Ignore the distractions and illusions, but stay aware of what’s going on in your own investments.

As I said with that guy earlier, he figured out every downturn, yet he still couldn’t figure out when the upturns were going to happen. Then the investor that does that time and time again, listening to the experts that seem to know what’s going on just ends up with a big old bullet hole in their foot.

They shoot themselves in the foot simply because they think they have abilities that they don’t have. They think that other people have abilities that they don’t have, and they think because they see what the economy’s doing and where the economy’s going, that they know where the market will go.

The Market Doesn’t Move With the Economy

The problem is the market doesn’t move with the economy. We’ve seen it over and over again, and the belief that if a person invests during a period of time that seems a bit treacherous, and there’s fear and danger everywhere, that nobody should have to pay to use my money during those periods of time.

Now, it may be that you don’t get a return. It may happen. You could have a bad economy and the market does go down and it actually is a negative return during that period of time, but to assume it on the front end is to assume that every informed investor out there is more than willing to let people use their money, and there’s no cost involved.

That’s like saying, “We’ll pay you to use our money.” That obviously doesn’t make logical sense, yet that is what we’re doing when we pull out of markets when things seem to be the most dangerous.

The reality of it is we can’t predict the future and investing based on that idea is nothing but folly.

Investing based on the idea that you can predict the future has hurt investors year in and year out for decades, for as long as the stock market has been around.

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