Are Markets Retesting Your Mettle?

Global markets retested the correction's lows Monday, and with the volatility came more dreary headlines. We had Wall Street strategists cutting their S&P 500 forecasts, pundits warning about slowing capex, chart-watchers finding scary things in charts, and banks and tech stocks replacing oil and China as the nexus of fear. Odd as it might seem, this is all quite encouraging-freakouts and a vain search for fundamental cause are normal in corrections, and capitulation often escalates as a correction's end approaches. The further sentiment falls, the easier it is for any bit of positive news to be a pleasant surprise-the sort of pleasant surprise that buoys stocks. While no one can know when this correction will turn around, we believe now is a time for steely nerves and patience.

We often pick on the media a bit for peddling fear during corrections, but chances are your biggest enemy isn't the headlines. Most likely, it is your brain. The human psyche is hard-wired to respond to volatility with a fight-or-flight mentality. When the going gets tough, survival instincts kick in, telling us to stop the bleeding-or, in other words, to sell. It's a myopic instinct, making people forget their time horizon could stretch 10, 20, 30 years or more, depending on where they are in life. It's all too easy to forsake the future for instant comfort in the now.

This instinct is often magnified by a behavioral phenomenon called myopic loss aversion-our tendency to feel the pain of a loss far more than we enjoy an equivalent gain. When paper losses mount during a correction, most folks feel it far more than they feel equivalent paper gains during a rally. Not knowing when the correction will end sows further discomfort, as it means not knowing when that pain will end. Hitting the "sell" button seems like the solution.

In Monday's New York Times, personal finance writer Carl Richards shared an interesting twist on this behavioral error. It starts with an anecdote about a sick patient who underwent a battery of medical tests and was visibly disappointed when everything checked out and the doctor advised rest and fluids:

This happens all the time, according to my friend. It often seems like the patient would rather have a bad diagnosis than face an uncertainty that could well be labeled "good." It's fascinating: We yearn so badly for clarity that we often prefer a negative outcome we're certain about to one that leaves us in suspense.

So what happens when this mentality bleeds into our investment lives?

One way this fear manifests itself in our investments is when we make hasty or rash decisions based upon cataclysmic market forecasts, like the one this year from RBS suggesting that people sell everything in their portfolios except high quality bonds.

In spite of the abundance of evidence that proves that market forecasts are often wrong and lead individuals to make decisions that hurt them over the long run, we still embrace and act on them. We do something that we know is a bad idea just to eliminate that feeling of uncertainty. Selling when your portfolio is down ... we know that's a bad idea. But we prefer the negative outcome of locking in those losses because it's certain.

Understanding this instinct-and recognizing it in yourself-can help when the seas get choppy. While people often have a burning need for clarity and certainty, those are two things that just don't exist in capital markets. Stocks will always be volatile, and there will always be uncertainty. On-the-one-hand/on-the-other economic analysis will always exist, even when things look great. Markets will never sound an all-clear telling you it's time to buy. The only way to do well, over time, is to embrace the uncertainty and remember that in the long run, markets reward risk-taking.

Thinking through the consequences of selling after a downturn can also help tremendously. Last week, a CNBC op-ed shared a tactic we found intriguing: Considering the potential pleasure and pain of both selling and staying invested, weighing them against each other, and seeing which has more weight. Doing so will force you to think through the long-term ramifications of a hasty decision:

The pain involved in moving to cash is that I may miss the upside, thereby eliminating my opportunity to recoup recent losses in the next market up move. We know this, but the recent pain of loss is a far more powerful emotion than the projected pleasure, however probable, of gains in the future. The pain is often dampened by the hope that you'll be able to get back into the market on the way up, a gamble statistically proven to be in the neighborhood of hopeless.

The pleasure in staying invested is that I'm giving myself a better chance to achieve my financial goals in the long term - the whole reason I invested in the market in the first place. The market historically has paid investors a premium over cash and bonds precisely because it requires you to endure times of volatility. Without volatility, we'd have no reason to expect higher long-term gains. And for most of us, without the higher long-term gains we expect from equities, we simply wouldn't meet our financial goals.

We recommend you take that snippet, print it out, laminate it, and hang it near your phone, computer screen or wherever you are most likely to enter a sell order in the heat of the moment. A simple gut check could save you from selling right before the rebound and getting whipsawed when stocks rise past you.

Again, there is no way anyone can know when this correction will end. Sentiment-driven swings are just impossible to predict and time, at the top or bottom. But we do believe most of the downside is behind us, and in our view, this isn't a time to sell. This is a time to hang on, think long-term, remember your goals and time horizon, and keep your eye on the prize.