When It Comes To Investing We’re Built To Overreact
I was recently coaching my son’s travel baseball team for a typical game during our busy summer season and one of the kids on our team was batting while I was manning first base. The first pitch arrived, a close pitch but probably just a bit too far outside, and it was called a strike even though it appeared to both of us to be a ball. He looked at me as if to say, “No way!” The batter was clearly frustrated. On the next pitch, the same situation played out again. When the third pitch was also called a strike, the batter, out of frustration, threw his helmet down and was sternly warned by the umpire. From my obviously biased position, a few of the pitches probably should have been called balls. The boy remained frustrated. This is a relatively common occurrence with many players on the team, even if it is a regular season baseball game at the 10-year-old level for the B travel team. In the scheme of life, this game and this at-bat hardly mattered. Yet he still overreacted. We, as humans, often become overly passionate and emotional about events. We overreact. Investing is no different.
Human actions and reactions have been refined through thousands of years of human evolution. For most (if not all) of human history, humans likely needed this skill in order to survive. If a caveman was walking in the woods and heard a nearby noise, he realistically had two choices. Run away or continue/explore the sound. Most of the time that noise was probably caused by a bird or squirrel or something innocent that couldn’t hurt the caveman. But occasionally that noise originated from something dangerous, such as a competing tribesman or dangerous animal. The caveman was faced with a choice. But for that caveman, the risk/reward was heavily skewed towards running away. There were no hospitals and the risk of personal injury was a risk that came with potentially severe consequences not only for the caveman but also for his family and tribe. Through centuries of human evolution, humans were taught to run first and ask questions later. Those that stayed to explore the noise were likely slowly eroded out of the gene pool. We were bred to run away. It was always safer to assume the worst because that caveman’s survival probably depended on it.
Today, however, we don’t often face this kind of problem. We have food, shelter, improved lifestyles, automobiles, healthcare, dental care, and many luxuries in comparison to the times of cavemen. But we still are genetically trained to react. Indeed for many people, it still doesn’t take much for the hundreds of thousands of years of fear training to kick in. Run first and ask questions later. Survive. In investing it is no different and we see this run-first behavior in equity markets frequently.
As I wrote about in a recent commentary, the S&P 500 has declined by more than 9% on eight separate occasions since 2009 and the average decline of those episodes was 14%. Each pullback occurred over the course of a single month, on average, and the market’s full recovery was completed over the subsequent two months. So over a three-month period, the market fully cycled through a sharp decline and rebound. Each of these demonstrates a gross market overreaction that took place over just a few months. Each of these declines was an example of investors overreacting and misreading the market. Attempting to time any of those declines would likely have resulted in severe underperformance because the rebounds happened so rapidly. Indeed, each of those eight incidents was a false alarm. Run. Hide. It is pervasive. We’re now in July 2019 and only half a year removed from the December decline of nearly 20% and we’re already making new highs.
Sharp market overreactions happen much more frequently than these eight market declines suggest. In fact, they happen on an almost daily basis. According to DataTrek Research, going back to 1958, the average number of 1% or greater daily changes in the S&P 500 is 13 times per quarter. That suggests nearly 50 instances in each year when the market climbs or falls by at least 1% in a given day. That’s incredibly volatile and also hard to believe. Does the entire U.S. economic value truly change by over 1% nearly 50 times in a single day throughout the year? That would be an incredible amount of fundamental volatility for an economy as large and as diverse as the U.S. economy. Yet it happens time and time again, year after year. That suggests that either the economy truly does change by that much on a daily basis or it is expectations that are changing – and that reflects an overreaction by many investors. Far more likely is that the run and hide first mentality inherent within human nature and reinforced over millennia is an almost impossibly powerful force to overcome.
As investors, we want to be mindful of where things are going over the long run. Over time the population grows and people buy more stuff. The economy grinds higher. But in the short term, there is a lot of noise. Tariffs, North Korea, Iran, taxes, political changes all serve to cloud the broader trajectory that the world is on. And the media hypes all of this news to feed the 24/7 news cycle. In reality, we are slowly and steadily improving with an occasional hiccup. Timing the market is incredibly difficult and that short-term volatility is exacerbated by human nature. As the market now grinds towards yet another new high, this is something to keep in mind during the next market sell-off—or a fastball that’s called a strike, despite being just a bit too far outside.
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