- There will be stretches of time when the market goes down and this will trigger strong emotions like fear, regret and even panic.
- These emotional responses, which help us take action in response to immediate dangers, are not well-suited for a rational, long-term activity like investing.
- Recognize this up-front and prepare yourself, which hopefully will help you get some distance from your emotions and exercise greater control over them when you inevitably are tested.
- There is a pay-off in doing so, as stock market returns over time frames suitable for investment have been rewarding, as long as you ride through the dips, most of which are mercifully brief.
So far, our discussion has been almost exclusively aimed at helping you develop a rational perspective on investing. I have outlined how to define your investment time frame and illustrated the power of compounding of returns. We have discussed aspects of risk. And we dove deeply into how to manage one aspect of risk, volatility, by examining it in relation to the time frame you have to work with. This reasoned discussion supports a framework for a plan—a logical course of action—that analysis suggests will give you the best shot at reaching your long-term goals.
So, it is now time to quote Mike Tyson: “Everyone has a plan ’till they get punched in the mouth.” As I noted at the outset, to be a successful investor, temperament is at least as important as smarts. Like any other skill, cultivating the right temperament takes preparation. This section is all about helping you get prepared emotionally. Because the market will punch you in the mouth, really freakin’ hard from time to time. This will trigger emotional responses that will be the greatest obstacle you face in sticking to your plan, even though it’s the right one.
Here’s Your Brain, Here’s Your Brain While Investing
It may seem odd for a site about investing, but I’m going to start with a quick overview of how our brains are geared. For me, recognizing the biological basis of emotions and how these shape my thinking helps me better put these emotions in perspective. It allows for a little more distance from my emotions as they arise, hopefully allowing me to exercise a bit more control. And I hope this helps you in a similar way.
So, here I go with a brief discussion of how human brains evolved and how they operate.(1) This is a layperson’s treatment, and limited to a few topics that are relevant to human behavior as it applies to an activity like investing. Apologies to any doctors, physiologists, brain researchers and other experts reading this.
Evolutionary Development of Our Brain
A simplified theory of the evolutionary path of animal brains, leading to our current human brains, goes something like this. As a result of mutational trial and error over eons, auto-control systems for things like breathing, heartbeat and body temperature were the earliest brain structures. Next came structures that aided in developing behaviors that secured agreeable experiences and avoided disagreeable ones. These are systems that motivate, through sensations, actions like feeding, mating or the “fight or flight” response—things that today we might describe as instinctual. These suggest a semblance of elementary emotion and memory. Finally, structures evolved that support imagination, abstract thought, language, planning, and what we generally think of as reason and consciousness.
The theory holds that most of these evolutionary changes were additive. The older structures remain, at least in some form, because they continue to be helpful in surviving in our external environment. This is why we share many of the same or similar brain structures as other animals, especially other mammals, up until this day. What distinguishes the human brain is the relative size and complexity of the various structures and the interconnections among them.
Notice that systems involving sensations and emotions developed earlier than faculties for reason. Geared toward taking action quickly with respect to immediate external stimuli, these were no doubt very useful in survival. For example, for our hominid ancestor, in making that split-second decision to run away from that saber-toothed tiger or grab a club and fight!
While external stresses have changed dramatically, these ancient brain systems continue to serve us as modern humans. Who hasn’t felt a surge of fear, triggering that shot of adrenaline—the deep breaths and pounding heart? But, today, we often experience these emotional responses not in reaction to imminent dangers but rather to more abstract, future concerns. This includes our investment accounts!
Investing is clearly an invention of human reason, as is the idea of retirement and retirement planning, and yet our thoughts about these things are often governed largely by emotions. The point is that these ancient emotional systems of reaction are not ideally suited to handling matters like investment decision-making. Be mindful of this.
Our Brain Today
The human brain of today has a pair of structures called amygdalae, which play a central role in processing emotions, especially fear and aggression. They pick up signals from our senses about potential threats and send alerts to other parts of the brain to orchestrate the body’s response. The amygdalae are complex and complexly interconnected with other parts of the brain, including the cortex. The cortex is one of the most recently evolved brain structures in animals. It is the folded surface of the brain, which is comparatively large in humans versus other animals and contains 75% of the human brain’s 100 billion neurons. Brain capabilities that are uniquely human—reasoning, planning, language—occur in the cortex.
Interestingly, each amygdala sends signals over multiple paths—some directly to the body for immediate action and some routed through the cortex for further processing. Here experience and reason can inform and temper the raw emotions, before we take a final course of action. Thank goodness! Over time, we can even condition ourselves so that the automatic fear trigger diminishes. We can exert a measure of conscious control over our emotions.
Given that fear and panic generally do not support constructive behaviors in investing, we should aim to do exactly this. And the point of describing how the brain functions is again that this knowledge may help you develop greater self-awareness and self-control.
Prepare Yourself Emotionally
Back to my boxing analogy. If a boxer enters the ring thinking he or she is not going to get punched, he or she is already in trouble. Same thing in investing.
There will be trying times that test your resolve. Thinking otherwise is unrealistic and leaves you mentally unprepared and emotionally vulnerable, thus prone to self-defeating behaviors and decisions. So, I am here to tell you up-front a hard truth: there will be stretches of time when the market goes down and this will be emotionally painful. Prepare for it.
Let’s take a look at the price history for the S&P 500 over the 20 years ending December 31, 2015.
During this 20-year period, you had to stomach two of the largest declines in the history of the stock market, with drops in the S&P 500 of -49% from March 2000 to October 2002 and -57% from October 2007 to March 2009. Talk about a punch in the mouth! Painful.
Obviously, taking pain for pain’s sake makes no sense; but there is a pay-off here. The total return on the S&P 500 averaged a compound annual 8.2%, comprising 6.2% in compound annual price appreciation and 2.0% yearly return from dividends (including their reinvestment). If your expected return for stocks was 7.2%, this actual return would have been more than satisfactory. And the 8.1% annual return for the S&P 500 was significantly larger than the 5.4% return for 10-Year Treasury bonds over this same period.
This particular 20-year period is about as dramatic an example as you can find in illustrating the type of bloody periods you need to expect. But even over benign spans, there will be periods of decline that will test your mettle.
Here’s a graph from the March 2009 low through December 31, 2015.
This looks like a market we could easily stomach. And indeed this period was remarkable for its low volatility, especially the nearly three years from mid-2012 to mid-2015. But even in this period of relative tranquility, there were unnerving declines, as shown in the following graph:
You had to live through four declines of 10% or more (corrections in the parlance) and eight other declines of 5% or more from recent highs. In hindsight these all were relatively short-lived, a mere two to three months. And that is good perspective to have—most periods of pain are mercifully short in the larger scheme of one’s life. But while you’re actually living declines like these over two to three months, they are often nerve-wracking and unpleasant.
Again, there is good reason to learn to accept or overcome this discomfort. For this period, the total return on the S&P 500 averaged a compound annual 17.4%, including the reinvestment of dividends.
So, here again are the key take-aways for this section. Even though logic suggests your long-term plan will very likely get you to your destination, the ride at times will be more roller-coaster than railroad, especially with stock investing.
During drops, you will experience emotions, like fear, regret, even panic. You need to understand this up-front and prepare yourself. Know that you can count on having interludes of market decline. But also know that they will come to an end, just as a roller coaster ride does, and that over the long-term you can live with them. The pay-off makes it worthwhile to do so.
Knowing all this, hopefully you will be in a better position to get some distance from your emotions and exercise greater control over them. Such a temperament is key to you developing the steadfastness—the constancy—needed to be a successful investor.