Equity investors over the last two decades experienced two of the worst bear markets in market history. Since March 2009, they have also experienced one of the strongest market rallies in history. Ben Graham, Warren Buffett's teacher, and mentor came up with an allegory that describes this market behavior: Mr. Market.
In the allegory, Mr. Market offers you a price each day for your business, but the problem is he has incurable emotional problems. As Buffett describes in his 1987 shareholders letter:
At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him.
I listened to a podcast recently where the guest described this same Jekyll and Hyde behavior in another context. The guest used the term “burnt child syndrome” to describe the results of alternating between punishing and rewarding a child for the very same behavior. Being inconsistent in this way produces a series of negative results for kids—hesitation to make decisions, poor decisions when they do make them, and generally not enjoying life very much.
Investors are subject to getting burned in this same way. The markets can alternate between rewarding and punishing us for the same behavior. Take a look at the chart below. By taking the same action (owning stocks) there are periods where we are handsomely rewarded for this behavior (late 90’s, 2009-2016) and periods where we are severely punished for this same action (2000, 2008).
But it’s actually this fickle nature of the stock market, the oscillation between gains and losses, which leads to higher returns for stocks than bonds.
Stocks differ from bonds in a couple of ways. First, stocks are lower in the capital structure of a company than bonds—meaning, in the case of bankruptcy, bondholders will get paid off before any money goes the owners of equity; And second, owning stocks allow you to participate in the growth of a company. Therefore, they are more sensitive to changes in a company’s revenue, profit, growth prospects and health of the economy in general.
Because stocks are higher risk, and because of Mr. Market’s fickle nature, the prices for stocks fluctuate a lot more than bond prices. This is a reason stocks have commanded an “equity risk premium” over time. Since 1926 U.S. stocks have returns 10.1 percent annually compared to 5.3 percent annually for bonds. And increasing your return by 4.8 percent annually is the difference between turning $100k into $288,000 or $685,000 over a twenty-year period!
So how do we avoid becoming a “burnt investor” and take advantage of the compounding power of the “equity risk premium”?
One key is to change your mindset; view crisis as opportunity. Actually, do what Warren Buffet famously said, “Be fearful when others are greedy and greedy when others are fearful.” Research shows simply changing your mindset can have powerful effects.
Ben Carlson, on his blog, wrote about the effects re-branding emotions and framing them differently. For example, most people get butterflies before giving an important speech. In an experiment, some participants were told to try to calm down before an important task and others were told to get excited. They found:
People who viewed their anxious arousal as excitement not only reported feeling more excited, they also performed better on all tasks than the other participants: their singing was about 30 percent more accurate, their scores on several dimensions of public speaking were approximately 20 percent higher, and their performance on a timed math test was about 15 percent better, according to the paper, which ran in the Journal of Experimental Psychology last June.
So the next time the market sells off like it did to start the year, remember that Mr. Market is a fickle friend. Reframing these anxious periods as opportunities is important. Instead of letting the fear overcome us, a better response is to remind ourselves that it’s actually this capricious nature of the stock market that had led to higher returns over time.
We can’t change the erratic nature of the market. But realize it’s precisely this uneven nature that leads to larger returns. Viewing the moments as opportunities will allow deliberate investors to maintain the discipline needed to be successful.
To learn more about how Cordant uses their wealth management process to help current and former Intel employees deal with Mr. Market and be deliberate investors, attend our upcoming presentation "Navigating The Intel Retirement Plan." Click below for more.