Daniel Kahneman once said,
“The idea that the future is unpredictable is undermined every day by the ease with which the past is explained.”
As investors, in fact as human beings, we’re constantly fighting the last war. In other words, we overweight recent events when we make judgment on the probability of an uncertain future event. We simply extrapolate the most recent event indefinitely into the future.
Think about the most recent economic decline, investors we’re running for the exits with the view that the ‘things we’re going to get worse’. The financial crisis of 2007/2008 was one of the most painful experiences in almost a century, yet it only lasted 18 months. I know plenty of investors who retreated at possibly the worst time, and were left hanging out to dry after the market bounced off the bottom, waiting for ‘the right time to get back in’.
Contrast this to how the market has been performing since the bottom of the GFC (March 2009), we have witnessed one of the longest recoveries in history, as illustrated in the chart below. This is probably one of my favourite charts – Bull markets since 1950 in measure in both duration and magnitude.
I know plenty of investors who have either bought back in after they had sold out at the worst time, or have been redeploying cash because they believe the market will continue it’s stellar performance.
Source: Yahoo Finance
Investor’s not only extrapolate the most recent events, but also try to plan ahead for the next GFC and how they’re going to deal with it, and it causes investors to shift their tolerance for risk at precisely the wrong time. If you’re worried about a 10% correction in the stock market, stocks are not a place for you. Unfortunately for investors, no two market cycles are ever quite the same, so studying the last crisis is unlikely to prepare you for the next. Studying how you behaved during the last crisis on the other hand, may be quite beneficial.
Financial markets never follow the exact same route more than once, yet human behaviour follows precisely the same route, each and every time. Here’s a great, simple 30 minute animated video by Ray Dalio, on how the economy works. It’s probably one of the best videos on the economy I’ve seen.
The timing, the impact, and the duration of recessions are all different. Here is every US recession going back to the Great Depression along with the corresponding stock market performance.
Source: National Bureau of Economic Research, Ben Carlson
Even if you knew when the next recession was going to hit, the duration, and the impact it would have on the economy, it’s unlikely you would be able to profit from it. The stock market’s performance during each of these recessions would surprise most investors. This is one of the reasons why you can’t ‘wait for things to get better’ before investing – the stock market is a forward looking machine, not backward.
On average the stock market:
- Has been up during a recession
- Has been up 6 months prior to a recession
- Has returned over 20%, 12 months after a recession has ended
- Has returned over 52%, 3 years after a recession has ended
- Has returned over 85%, 5 years after a recession has ended
By the way, we don’t need a crisis or a recession to see the stock market go down. Here’s 13 instances where the stock market has fallen 10% or more without a recession:
Source: Stocks for the Long Run, Ben Carlson
Paul Samuelson once said,
“The stock market has predicted nine out of the last five recessions.”
Next time you find yourself captivated by the alarming predictions made by the guy or gal on the television, in the paper or on Twitter, please remember this: More money is lost in trying to anticipate a collapse in the stock market than the collapse itself.