Investor Psychology

How to Handle a Bear Market

If you’ve got to take action, boost your savings rate or scout for mispriced securities. And check that your portfolio is in line with your goals.

There’s a reason bear markets are often referred to as panics. This one may turn out to be short, but no one can say it hasn’t been severe, with investors not only worried about financial security, but about their very lives. The worst thing you can do, though, is panic. It’s impossible to escape human nature in this turbulent, scary time, but you can take steps to make sure that the decisions you make now don’t do long-term damage to your portfolio.

First, realize that the stock market is a dynamic, psychological entity. Sure, prices may be rational over time, but in the short term, they’re driven by fear and greed. If bull markets are steered by optimism and euphoria, bear markets are marked by panic and, finally, capitulation—the selling crescendo that washes out the last remaining optimists and sets the stage for the next bull cycle. Do recent rallies signal the end of the bear? That’s hard to say. But reaching a bear market bottom is a process that could well test the market’s lows and maybe even find new ones before the next cycle begins (see Ahead).

While this process plays out, be aware of your own psychological biases. “In everyday life, we have a set of shortcuts to help us make quick and, often, very good decisions,” says Steve Wendel, head of behavioral science for investment research firm Morningstar. “In times like these, those normal rules don’t apply and can lead us astray.”

Call to action. Consider the tendency to take action in times of turmoil. It feels unnatural to do nothing when the market is so volatile. Couple that with our herd instinct, and it usually means you get out of the market when everyone around you is similarly panicked. “In investing, it’s better to step back and make a calm, careful analysis—and maybe take action, but not in the heat of the moment,” says Wendel.

Similarly, beware of recency bias. If a car is coming at you, the natural assumption is that it’s going to keep coming, and the best thing is to get out of the way. When stocks are falling, no one knows if recent declines will continue or whether the market will head back up. Our decision-making shortcut doesn’t work in the context of investing.

Here’s another behavioral trap to watch out for: We humans hate losses roughly twice as much as we love gains, research shows. So combine that loss aversion with recency bias and you’re perfectly set up for missing out on the next bull market. In April 2013, I wrote an article entitled Learn to Love Stocks Again. That was four years into the bull market that followed the financial crisis, but surveys of investors and the steady flow of assets out of stock funds showed that many people still weren’t buying in.

The best way to make sure that impaired decision-making doesn’t derail your portfolio is to externalize the rules you follow for managing it. That means actually writing out, and sharing with your adviser, how you will handle market downturns in terms of contributing to your portfolio, adjusting your asset allocation, and buying and selling securities. You can call it your Odysseus contract, after the mythological hero who asked to be tied to his ship’s mast to resist the Sirens’ call. The phrase was coined by researchers who designed savings accounts with a commitment feature that restricted access to the funds, thereby boosting saving levels.

If you’ve just got to take action, consider increasing your savings rate or scouting for mispriced securities. Double-check that your portfolio mix is in line with your long-term goals. And try to unplug from the barrage of scary news—before it puts you in a panic.

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