• Natural to feel uncomfortable in face of a loss but be aware of irrational behaviours
  • VanEck Australia head warns investors can either remain smart or yield to emotion
  • Focus on fundamentally sound assets to strengthen their portfolios during ASX market correction

They’ll say: “It’s not like we didn’t see an ASX market correction coming.”

But that hasn’t lessened the impact or the shock of the hammer blow.

It’s the day after a long weekend for most of Australia and investors who’ve been paying close attention to the US (big bro) market plunge over the Queen’s Birthday have been anticipating a similar fate.

Wall Street’s grim year reached another tough milestone as the S&P 500’s drop of 3.9% on Monday confirmed an official bear market for the first time since March 2020, falling the necessary 20% from its January 3 record closing high

Sky-high inflation, a hawkish Federal Reserve and concerns over future economic growth has seen the S&P 500 keeping heading south.

And little brothers tend to follow their big brothers’ example – it’s why I keep telling my eldest put down the machete and think carefully about what kind of role-model he’s setting.

The (lil bro) Australian share market dived 5% on Tuesday morning or 349.4 points to 6582.6 in the opening minutes of trade.  All sectors were in the red, with IT and materials stocks leading the laggards.

Framing: Don’t let uncertainty breed irrationality

There’s a good many careful of us investors out there today with that dreaded feeling in the pit of our stomachs as we wonder just how much money we’re losing and how low it can go?

Deakin University behavioural finance expert and Morningstar analyst Erica Hall said it’s absolutely natural to feel uncomfortable in the face of a financial loss.

She said the seminal paper In Prospect Theory: An Analysis of Theory Under Risk (Kahneman and Tversky 1979) provided the original demonstration that humans not only abhor uncertainty, but – when under pressure to make decisions in the face of uncertainty – exhibit what the field has rather gently coined ‘irrational behaviours’.

“We have a lot of uncertainty in our market at the moment – for example we typically feel the pain of a loss twice as much as we feel the pleasure of a gain, and the research was able to demonstrate we will behave differently depending on whether we are facing a potential gain or loss situation,” Hall said.

Now, when in a potential gain situation like a rising market we will typically exhibit risk averse behaviour. Why threaten a good thing?

But frame the process in a scenario of compounding losses – like in falling markets – and the typical exhibit is riskier behaviour shown as irrational attempts to control, stop or stem the bleed and avoid losses and pain.

“How something is framed matters to the decision we make and the risk behaviours we exhibit,” Hall said. “Our responses to gains and losses are asymmetric and this phenomenon is called loss aversion.”

She said loss aversion is a typical and serious cognitive bias which can work against an investor.

“When you are feeling the pain of a loss the natural inclination is to make the pain go away and sell the investment that is on downward trajectory.”

Conquering your cognitive bias – #1 – Revisit original financial goals

Hall said ask yourself the fundamental question “has anything changed?” She said if not, investors need to focus on the long term and turn down the short term noise.

“There is a saying that the market takes the stairs up and the elevator down, this seems to link nicely to the asymmetry exhibited in prospect theory,” she said.

“We like acquiring gains, but we really dislike experiencing a loss and when markets are dropping, particularly if there is a lot of uncertainty relating to the future we just tend to want to get out of the position as quickly as possible.”

But Hall said depending on the investment this may not necessarily be the most sensible thing to do and at this point it’s a paper loss –  selling will only crystallise the loss.

She says once you’re out of the market you then need to make a decision on when to re-enter and it may be hard to determine a reference point when making this decision?

  • Is it the highest price the stock has ever exhibited?
  • Is it the price you bought in at?
  • Is it the price you predict the stock will go to?
  • Is it friends and family, the media that is influencing you?
  • What are you anchoring your decision to?
  • Are you acting rationally or emotionally?

“Ironically investors feel more comfortable buying stocks when they are rising, known as buying high, yet if the company is a quality one and its price has corrected then buying a great quality company at a lower price, known as buying low, is surely the better option,” she said.

#2 – Beware of heuristics

Hall said we are bombarded with a plethora of information every day and we have built ‘heuristics’ or shortcuts based on our experiences to help us make decisions efficiently.

If you touch something hot it will likely burn you; if you drive too close to the car in front of you, you run the risk of hitting it; if you are cold put on a jumper etc – all great heuristics to help us in life.

However, she said in investing, these heuristics or biases can lead us astray.

Two of the key ones are:

  • Following the herd
  • Confirmation bias

“We are social creatures, so we like to be part of the pack, and  it can be uncomfortable to go against the herd and take a position that is different to others,” she said.

She said herd bias also plays to our Fear Of Missing Out (FOMO).

“If you see others being successful in investing in certain stocks it’s not surprising that you will be tempted to jump onto the bandwagon too,” she said. “You still should do your own research and due diligence to ensure it is the right investment for you.”

Hall warns don’t get caught up in the hype and the emotion of the crowd, with herd bias often the root cause of market bubbles forming, because confirmation bias is where you only seek out information that backs up your point of view.

“In the age of social media more and more we are operating in an echo chamber and the algorithms know what we like and feed it to us so we are often just getting our own point of view reinforced over and over again,” she said.

Hall said the way to combat confirmation bias is by considering the opposite position.

“Are we making the correct assumptions?  Do we have our blinkers on?  Seek out a devil’s advocate if you will to help make a more informed decision,” she said.

#3 – Don’t sell off quality stocks 

ETF provider VanEck Australia CEO and managing director Asia Pacific, Arian Neiron, told Stockhead Tuesday was the 13th worst day in the last 20 years for the S&P/ASX 200.

(Neiron is one of those Australian investment leaders I would certainly want to have at a dinner party to talk strategy during these volatile times.)

“Emotions are naturally high, as is uncertainty. However, bear markets teach us more about ourselves as investors than any bull market. Investors can either remain smart or yield to emotion, which can have significant impacts on long-term gains,” Neiron said.

He said emotions can compound in bear markets and to add to this, we have an environment where there is a fear of stagflation, rising interest rates and inflation worldwide.

“To avoid emotion, investors need to understand what the fundamentals of their portfolios are and how asset prices will behave now that we are in an inflationary regime,” he said.

“They also need to be cognisant of the behavioural biases that can lead them astray. Behavioural finance theory has been well documented by the likes of Daniel Kahneman and Richard Thaler.

Also, obviously also a student of prospect theory and aversion to losses, Neiron emphasises that investors perceive asset gains and losses differently.

“Investors place more weight on perceived gains than losses, but losses cause a greater emotional impact – and with that comes a desire to act to alleviate loss,” he said.

“Put simply, investors tend to be more motivated to avoid loses due to emotion than to take action for gains. – and this can deliver poor results.”

Neiron said we need to take note of investing great and Warren Buffett mentor, Benjamin Graham’s famous quote: “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”

“That is, over the short term, markets tally up the popular versus unpopular but over the long run, it’s more about weighing and assessing the substance of a company,” he said.

Neiron said ultimately, the fundamentals of a company matters and given the current market conditions, investors need to focus on fundamentally sound assets to strengthen their portfolios.

“According to billionaire hedge fund investor Howard Marks the biggest investment errors come not from factors that are informational or that are analytical but come from psychological factors,” he said.

“Our body is wired to act impulsively when faced with fears, but our brain needs to remind us, over and again, to stay level-headed, stay patient and stick to your investment plan.

“After all the human mind is the ultimate black box so if you don’t trust yourself, see a financial adviser.”

#4 – If all else fails, breathe and downward dog

My legendary mate and mad yoga instructor Virginia McDermott of Movement Vitality in Brisbane puts it pretty simply. Virginia switched out of her career at the big investment banks in New York for a life of teaching functional movement.

She said it’s all about trying to keep calm.

“Slow down, pause and breathe knowing markets go through cycles – and I’ve worked through two of them,” she said. “A downward market simply means more downward dog.”

Oh, and then there’s the good advice of my lovely old neighbour, a successful investor who well into his 80s has experienced both the good and bad times.

“It will come back – buy quality stocks you’re happy to put in the bottom drawer and not get caught up in short term fluctuations knowing they’ll be good in the long run,” remains his advice.