How our caveman brain sabotages our investment decisions
“Stocks rally 555% from March 2009 low”
“Stocks correct 10% from December’s record close”
Both headlines accurately describe what happened this past January, but we’re confident that most investors focused on the latter story (and in so doing, harmed their portfolios.) How do we know this?
We live at the apex of human civilization. We carry trillions of bits of high-quality data in our pockets at all times. Despite these advantages, our decision-making process evolved little since our days as tribal “hunter-gathers.”
10,000 years ago, a caveman walking through the woods would simply bolt at the snap of a twig. That noise could be a signal of food, or a mate, or a tiger. By running away, the caveman gave up his chance to obtain food or a mate, but also avoided an unpleasant encounter with a predator. The caveman who lingered to find out what was really behind the sound ran a good chance of getting eaten and not surviving to reproduce.
Even though we no longer face threats from aggressive animals, we still evaluate every alert as a “life or death” threat. Avoiding pain remains our #1 decision-making criterion.
The Saber tooth S&P 500
After twenty months of mostly positive returns, the S&P 500 sold off 10% during January and the NASDAQ 100 declined 15%. Both indices rallied into the January 31st close, which we attribute to position squaring (traders closing out short sales at month end.) Stocks may well remain under pressure for the next couple of months.
Market corrections, defined as a pullback of 10% or more, happen, on average, once every 18 months while bear markets, a pullback of 20% or more happen on average once every 4 years. Where a less experienced investor might see a market in free-fall, we see a market bubble letting out some air and settling back to fair value.
In December we told our clients that, in 2022, a booming US economy would power corporate revenues and earnings to push stocks higher, but three increases in interest rates would push stocks lower, for net gains by year end of just 6-9%. That forecast will NOT get us invited on CNBC.
Meanwhile this forecast, ”Grantham Sees Stocks ‘Super Bubble,’ Says Selloff Has Begun, Predicts a Drop of 50% in the S&P 500” received much attention. Why? That headline to most people looks exactly like what a saber toothed tiger looked like to a caveman. Run!
Many investors exit stock positions during downturns and take up new positions when the markets bounce back. In other words these investors “Sell low and buy high,” which is the exact opposite of what we are supposed to be doing.
How We Manage Our Caveman Instincts
We keep an eye on the Morningstar Market Fair Value chart, which estimates the “fair” value of the market, relative to what its actual value is at any given time.
A few weeks ago, the Morningstar chart showed that stocks were moderately overpriced; now stocks are moderately underpriced – scarcely reason for panic in either direction.
We also like the CNN Fear & Green Index. The farther that index presses into Fear, the more likely we will invest. Right now the index shows 38, with 0 as Extreme Fear, 50 as Neutral and 100 as Extreme Greed. During the Covid-19 Pandemic Bear Market of 2020, this index hit 2 at as stocks slid 35% from February to March. From March 2020 to January 2022, the S&P 500 gained 96% - how’s that for a signal!
Finally, we segment our clients’ investments into buckets of short, medium and long term needs.
Cash needed in the next 12 months for a house closing, a tax bill, or a tuition payment should only be held in a checking account. The funds MUST be there, so clients can’t take any volatility risk.
For financial needs in the next one to five years, we invest in bonds. Bonds are less volatile than stocks, and the yields, while low, may still out-return inflation.
For financial needs of the next five years or more like retirement, we invest 100% in stocks, both U.S. and international. Volatility risk is irrelevant compared to longevity risk – the chance of outliving your money!
We adjust the percentages over time to emphasize reliability over growth. A 30 year old with a secure job can easily invest 100% in stocks, while a retired couple in their 60’s or 70’s can readily draw their monthly income from a portfolio invested 65% in stocks and 35% in bonds.
David Edwards is president and wealth advisor with Heron Wealth, a $500 million registered investment advisor based in New York City working with 225 client families across the U.S. and around the world. Dustin Lowman contributed additional research for this column.