Recent uncertain times have shaken the confidence of investors, traders and all market participants. It is quite evident that the bears tightening their grip on markets, investors, especially retail investors, have suffered losses or get shaken out of what eventually become profitable positions. We need to understand that bear markets are painful, but temporary. There are always market dislocations that can provide opportunities to enhance returns. In a bear market, stocks of both good and bad companies tend to go down. However, bad stocks are hit badly, while good stocks recover and get back on the growth track.
So, if the stock of a fundamentally sound company goes down, that presents a buying opportunity. Moreover, the current market correction is due to a pandemic, and it is beyond the control of investors, which is a systematic risk. It is both unpredictable and impossible to completely avoid. While it is not possible to avoid systematic risk altogether, it is always possible to reduce its impact by diversifying investments.
Let’s try to understand the nemesis of the bear market and various strategy or risk protection tools that can help us sail through, when there is a systematic as well as unsystematic risk.
Never rely on hearsay
Markets are driven 100% by fear. On the way down, it’s the fear of losing everything, while on the way up, it’s the fear of missing out, or “FOMO”.
Fear is what drives us to hear a harrowing projection of the future direction of the economy, a specific sector or a particular theme, and then make investment decisions based on that anecdotal evidence.
A mindful investor focuses on the hard evidence. Instead of focusing on what should happen based the anecdotes, focus on what is happening based on the price.
Anecdotal evidence is still a good thing, don’t get me wrong. But anecdotes should drive you to dig deeper into the evidence to validate what you’re seeing and hearing, as opposed to driving your investment process on its own.
Never get emotionally attached
We tend to attribute greater value to things we own. That is, if I have a special coffee mug that has sentimental meaning for me, I will see the mug as quite valuable even though for you it may just be a convenient way to hold your coffee.
This is the endowment effect, and it’s what leads us to hold on to stocks way too long. When the chart starts to turn negative, instead of exiting a losing position and moving on to other things, we tend to hold on for way too long because of an emotional connection to the stock.
The endowment effect causes us to basically ignore clear warning signs and instead feel good continuing to hold the stock due to our emotional attachment to the name.
Over reliance on analogs
This is relatively newer technique, but could misfire badly. The problem occurs when we assume that the current movements will closely mirror those in the past. There is absolutely no guarantee that tomorrow will mirror any previous market movement. The best we can do is bet on probabilities and try to understand the conditions that may cause two different periods to play out in similar ways.
So analogs are good if they spur discussion and help you question how conditions may be the same as or different than before. They are not good when you make bets based purely on the idea that this time will be the same as another time!
Avoid being sucked by bear market
Rallies in bear markets are brutal. They are quick, they are sudden, they bring huge percent moves that make you feel like you’ve already missed out on the entire move.
Bear markets are a process, not a moment. They take time. And most bear markets have involved crazy bounces that suck in lots of investors before the next down leg evolves. Always focus on the long-term trends.
Getting married to a narrative
We love narratives. As humans, we relate to the world around us in narratives. This is why, when you’re buying a car, the salesperson is not selling you on the specifics of the engine or why a specific feature is designed a certain way, but rather they’re selling you on the narrative. They put you in the car so you can see it as your own.
Narrative bias is where we hear or develop a particular narrative, for example, that stocks and crude oil are positively correlated, and we then start to think of the world in the context of that narrative.
In reality, stocks and crude oil are two variables among many out there. The markets are not a simple system with a small number of variables. They are a complex system combining thousands of variables that can cause asset prices to evolve in infinitely complex ways.
So saying Price A should do a specific thing because of Price B is an overly simplistic way of addressing intermarket analysis. So you should treat narratives as you treat analogues. They can be helpful only if they encourage you to dig deeper.
There’s a humility that comes with investing, and bear markets tend to be humbling experiences. A process that seems solid during the bull phase may seem much weaker when the going gets tough.
Bear markets can be frustrating and challenging and stressful, but they can also be fantastic learning experiences.
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