Think of a recent situation in your life that you really wouldn’t want to go through again . . . perhaps an illness, a difficult relationship, a tense situation at work. Imagine that you suddenly find yourself facing something that feels very similar. How do you feel? Probably instantly stressed, like someone has flicked a switch, perhaps even fear. On a physical level, you probably feel a drop in energy levels. Anticipating having to go through all that again makes you feel exhausted before you even begin.

A similar mechanism is affecting stock market investors right now. Just the thought of reliving the anxious years of 2008/2009 fills investors with dread, but at every jolt from the news, that’s the movie that replays in their minds, with a sequel that stretches into the future. These projections into a catastrophic future create a cascade of hormones that drive stress levels up and energy levels down. Investors react with fear or even panic—I have to get out of these markets now!—and investors are overcome by an energy-draining pessimism that leaves them too mentally and physically tired to cope with more market volatility.

On a macro level, the result is a pervasive pessimistic mood and lack of investor confidence that drives market volatility. In fact, measures of investor pessimism are higher now than they were in 2008/2009. Are there rational reasons for this increased pessimism? Not really. Based on the facts, investors should be feeling significantly less fearful now. Corporate earnings and cash positions, economic data, and the overall equity market are significantly healthier and higher today than they were then. So how can one account for this disproportionate response?

There are at least two related behavioural factors coming into play here: one is the fatigue factor caused by recurrent volatility in the markets that we’ve already discussed; and the other is something called the ‘recency bias’ which leads investors to focus on recent events and extrapolate those events into the future. This bias pushes us to build expectations based on anecdotes and emotional beliefs, rather than proven data.

What prescription can we write for investors seeking a better investment experience? Simple awareness of the above two factors will help you monitor your own reactions and take corrective action to fight the onset of stock market fatigue and untoward pessimism. Fight emotions with logic and a clear understanding of how the markets work, so you can let them work for you and not against you. This involves shifting your perception of the markets so that you see them as an ally and not an adversary. In other words, you focus on taking advantage of the ways markets are right and the ways they compensate investors, as opposed to the ways they are wrong.

In a free market economy we can expect a return on our capital placed at risk, and this is confirmed by historical data. Our goal in portfolio design is to capture what the market offers in all of its dimensions. Markets reflect a vast network of information and human expectations. As information meets expectations, prices are driven to a fair value or a form of market equilibrium.

Risk and return are related, but not all risks produce reliable rewards. Companies compete with each other for investor capital, quickly driving prices to a fair value and ensuring that no investor can expect more return without bearing more risk. Given that prices for public securities are fair, persistent differences in portfolio return are explained by differences in average risk. For this reason, it is possible to outperform the markets—but only by accepting more risk.

Armed with the knowledge that as an investor you are rewarded in proportion to the risk you take, you can then frame your investment decisions around risk factors in the public equity and bond markets for which you will be compensated. You can rely on evidence provided by financial science over the last fifty years to point you in the direction of which risk factors produce an expected return.

Our knowledge of the risks that are worth taking and the ones that are not can be summarized in three dimensions*:

  1. Stocks have a higher expected return than bonds,
  2. Small company stocks have a higher expected return than big company stocks, and
  3. Lower priced ‘value’ stocks have a higher expected return that higher priced ‘growth’ stocks.

In each circumstance the higher expected return is accompanied by higher risk – but a risk that you have taken after careful deliberation and for which you can expect to be rewarded!

* The Cross-Section of Expected Stock Returns. Fama and French. Journal of Finance 1992.

This article by Daryn Form was published in the December 2011 edition of Sask Business Magazine.

Daryn Form is a Senior Financial Advisor with Assante Capital Management Ltd. providing wealth management services to principals of family-owned and privately held companies. Assante Capital Management Ltd. is a member of the Canadian Investor Protection Fund and is registered with the Investment Industry Regulatory Organization of Canada.  The information mentioned in this article is for general information only. Please contact him to discuss your particular circumstances prior to acting on the information above.  The opinions expressed are those of the author and not necessarily those of Assante Capital Management Ltd.  Rates are not guaranteed and are subject to change at any time without notice.