Head Games

Adam M. Grossman

WARREN BUFFETT once quipped that, “You only find out who is swimming naked when the tide goes out.”

I’ve been thinking about this idea over the past two weeks, as markets around the world have given up all their year-to-date gains and then some. Since peaking on Jan. 26, the U.S. market, as measured by the S&P 500, has lost 8.8% of its value.

When the tide goes out like this, the emotional impact can be powerful—and the headlines just make it worse. For the past week, my phone has been lighting up with alerts like, “DOW DROPS 600 POINTS, ON TRACK FOR WORST WEEK SINCE 2009.”

The advice from industry experts is less sensational, but often so convoluted that it’s hard to know what to make of it. This, for example, was the comment Friday morning from one Wall Street analyst: “I know SPX corrects in about 5.56% increments, so that would be the 200-day moving average or about 2,540 with some room for modest overshoot.”

And it isn’t just Wall Street types who are weighing in now. On the radio on Friday, the local DJ spent time gloating over a recent stock sale. “I feel like a semi-genius,” he kept repeating. “I’m a winner.”

Struggling to make sense of the headlines and the crosscurrents of commentary? Here are four thoughts that may help you maintain perspective:

1. Admire your gains. Yes, the market has seen a sharp drop-off over the past two weeks, and it may continue. But prior to the decline, the market had more than quadrupled since 2009. Recent losses just turn the clock back to prices we saw as recently as Thanksgiving.

This is important to recognize, so you aren’t paralyzed by what’s going on. Thinking of rebalancing your account to reduce your risk exposure? The past two weeks’ losses shouldn’t stop you. In fact, market corrections like this are a good reminder that you should never try to time the market. If you have a plan, stick to it. Don’t drag your feet, hoping for a better price tomorrow.

2. Recognize biology is working against you. Research by behavioral economists Daniel Kahneman and Amos Tversky revealed a crucial fact about human psychology: We dislike losses much more than we enjoy gains. Roughly speaking, they found a two-to-one ratio. In other words, to make up for the emotional impact of losing $1, we would need to gain $2.

Think about it: The headlines last year were so quiet while the market was climbing an impressive 22%. But when the losses started in late January, suddenly the headlines switched over to ALL CAPS. This loss aversion, unfortunately, is just the way we’re wired. Sometimes, things really are as bad as they seem, but often they aren’t, so keep in mind that our internal systems overreact to the negative.

3. Look at the market through your own lens. Try to tune out the headlines and instead focus on your own financial picture. If you have a well-structured financial plan in place, the daily movements of the market should be irrelevant to you. In fact, if you are at a point in your career when you are saving, you should welcome a market pullback, because it allows you to buy at lower prices.

4. Remember the market isn’t just a giant slot machine. In the short-term, results can seem random and unpredictable, as emotions drive prices higher and lower. But when you strip out those emotions, there’s actually a fairly simple formula that underlies stock prices.

In technical jargon, it’s called discounted cash flow. Or in Warren Buffett’s plainspoken words, it’s the value of all the cash that a business might generate during its remaining life. As long as the population grows, and businesses innovate and become more productive, there is a reason you should expect stock prices to increase over time. It may not happen every year—and if we’ve had more than we deserve in recent years, we may have to give some back—but over time it is logical to expect the market to go up.

Adam M. Grossman’s previous blogs include Five Ways to Diversify, About That 22% and Five Steps to a Better 401(k). Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.

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