Managing Discomfort & Cognitive Biases

May 6, 2024 | Blog

By Greg Stewart, CIO

A few weeks ago, as the market experienced a pullback for no apparent reason, I began to hear a little grumbling around the office (OK, I’ll admit, it was Dan Darchuck doing the grumbling).

After a great run that gave us significant growth over a five month period, we suddenly gave a small chunk of it back. Predictably, the media outlets began gleefully producing headlines of fear, gloom, and doom. 

However, pushing “pause” for a moment, and looking at our 1 year and 6 month trailing returns, it was obvious that in spite of some downward pressure in April, we had enjoyed a great run that actually started in late October of 2023. 

Historical market behavior points to the fact that, on average, most years have two 5% pullbacks that occur for absolutely no reason. Of course, some years have more than others, and some fewer.

Interestingly, the pullback that we saw recently happened long before there were drone strikes on Israel by Iran. In fact, one morning, I woke up convinced that this geopolitical change would result in negative market results. I pondered what action we would need to take to manage through this. Would we buy more gold? Oil? Reduce risk further?

Yet, when I checked in … all of the market futures had turned positive. It was entirely counterintuitive.

As human beings, it’s natural to have a strong reaction to significant events, especially if there is real concern that the event could have a negative impact on our life, and on our world as we know it.

Related to this, an interesting bit of research shows that individual investors, even those investing in passive index funds, tend to underperform the market. How could that be the case? Could it have something to do with our tendency, as humans, to run to the hills over a 5% pullback, even in the aftermath of a 25% gain? 

The culprit is our discomfort with “downward” volatility, and as you already know from my initial reaction following the drone strikes, everyone experiences that discomfort. We don’t like to lose.

It’s how we “manage” the discomfort and our own natural cognitive biases that makes all the difference. 

Managing means being able to recognize the reaction, understand why it’s happening, and take a deep breath. Just because something is happening right now doesn’t mean that it will happen forever.

Short-term reactions do not generally equate to long-term results. 

Managing means taking a detached look at the data… in the moment! It means zooming out from one month to six months. From six months to twelve months. From twelve months to five years, etc. 

When we take a long term perspective, and we look for longer term patterns, we find greater opportunities, and much less real volatility.

Nothing in life moves forward in a linear fashion. Volatility happens, and those downward movements are opportunities to learn, to adjust, and refocus on what we’re truly trying to achieve. 

A few additional thoughts…

Bear markets generally have a catalyst. Consider 2022, which was full of interesting catalysts like war, inflation, and dramatic interest rate changes.

Trying to time catalysts like this is incredibly difficult. There is no one person, or group of people, who have the proverbial crystal ball that will inform us of the emergence of such catalysts and what the actual impact on financial markets will be. 

This means that attempting to move everything to the sidelines is a strategy that typically doesn’t pay. Guessing right once in a row constitutes a great track record!

As we’ve said before, being out of the market on just the few best days in a given year can mean missing out on nearly all of the growth in that same period. 

This doesn’t mean that you can’t make adjustments to risk exposure. Having long-term, core positions is important, as is adjusting this when things look a bit overdone. The ability to take profits in positive moments so that you are well positioned to pivot, and capture currently available momentum can be a powerful ally.

Going forward in 2024, we’re continuing to watch for catalysts that could create change.

Even as inflation seems to be abating a bit, the US economy shows signs of resilience as indicated in the 12 reporting regions of the Beige Book. There are even reports from airlines around the world of record-setting levels of leisure travel.

Perhaps most notably, business innovation is on the rise, and at Topturn we have continued to refine our opportunistic strategy which allows clients to invest in businesses that are feeding the next cycle of technological, medical, and other innovation.

This is, of course, a complement to our core investment strategy, giving clients the opportunity to participate in such growth areas while still seeking to maintain the stability of a well diversified financial program. We invite you to ask us for more information during our next conversation.


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