Emotion makes us strangers to common sense

Please repeat after me: “Bear markets are a natural part of the economic cycle, and I should expect a bear market every three-and-a-half years. Moreover, bear markets, recessions, corrections, high volatility and especially the incredible uncertainty are the psychological price that I pay for potentially high returns.”

I encourage you to sip on these words from Ned Davis Research for a minute. Swirl them around. Relish their essence. No, do not spit it out just yet. Take a good long taste because if we truly savor it, internalize it and most importantly believe it, we should not fall prey to the dreaded plague of investor’s misbehavior!

As we know, another bear market and significant stock declines will happen again. When will it happen? It would not surprise me in the least if it transpires before this narrative goes to print. On the other hand, I would not be amazed if we do not witness a prolonged decline in stock prices for one, two or three years! The fact of the matter is that nobody knows the direction of the stock market.

Perhaps some of you might think that I am trying to be a wise guy, but the truth is that I have no stronger conviction than the opening quote. Bear markets and prolonged declines in stock prices never make me change my long-term game plan. Of course, just as I do for clients, I may tweak my asset allocation between stocks and bonds, and if I am fortunate enough to have cash on hand, I will likely add some of my “Benjamins” to my existing investment program. Sure, it is painful to watch my portfolio value and clients' accounts shrink as the declining stock prices run their course, but I recognize this type of action is normal and expected.

The common definition of a bear market is when stock prices decline at least 20 percent from their peaks. According to our friends at First Trust Research, the average bull market lasted nine years with an average cumulative total return of 470 percent, while the average bear market lasted just 1.4 years with an average cumulative loss of -41 percent. At the risk of appearing pompous, I ask you again to sip on these words for a minute.

The characterization of a correction is when stocks fall 10 percent or more from their peak. There have been 24 declines of 10 percent or more during the past 30 years, according to Paul Franke from Seeking Alpha. With the simple back of the napkin math, that works out to almost one correction every year! This is just another example of an incredible fact that we all should...yep...sorry...last time...sip on these words for a minute. Swirl them around. Relish their essence. No, do not spit it out just yet. Take a good long taste because if we truly savor it, internalize it and most importantly believe it, we should not fall prey to the dreaded plague of investor’s misbehavior!

Warren Buffet said the following in his 2017 shareholder report, “Big market drops can and almost certainly will happen. The years ahead will occasionally deliver major market declines—even panics—that will affect virtually all stocks. No one can tell you when these traumas will occur." If we agree with the Forrest Gump of Wall Street and we comprehend the above mentioned facts regarding the likelihood of bear markets and stock market corrections, than why do so many of us panic when the dynamic duo (corrections and bear markets) rear their ugly heads?

The answer is simple: fear and greed! These two amazingly controlling sensations are why I argue that you and I are the greatest risks to our respective long-term wealth creation and only in hindsight do we learn that our regrettable decisions were not controlled by logic, but our emotions of either greed or fear.

It is easy to talk a good game about being greedy when others are fearful and fearful when others are greedy, but it is quite another thing to do it. Successful investing is emotionally difficult because staying disciplined in an emotionally charged, 24-hour news cycle world is a challenge. It requires incredible self-control and discipline. If managing human behavior is the keystone to being a successful investor, than the willingness to seek help should be the best predictor of good behavior. I suggest that financial advisors’ most critical role to their clients is acting as their behavioral coach. Look at the following illustration courtesy of Carl Richards CFP® otherwise known as the napkin-sketch guy.