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Adapting to buying shares when markets fall

The Australian share market experienced what felt like a virtually uninterrupted winning streak for the roughly six years between the March 2009 bottom of the GFC and the recent highs in April 2015. The falls since then are likely fresh in your mind.

The Total Return Index, including dividends reinvested, between the ‘bottom-tick’, ASX200TR index at 21298.06 on 6 March 2009, and the most recent ‘top tick’, ASX200TR index at 52822.21 on 27 April 2015, the advance amounted to over 148%. $10,000 became more than $24,800 without any of the stress and effort of individual stock selection.

If you sell, when do you buy back in?

Despite your memory of that period likely being constant gains, the recent fall is one of four double-digit reversals in the index over that period, the others being:

  1. 15 April 2010 to 5 July 2010 saw a 15.0% decline.
  2. 11 April 2011 to 26 September 2011 saw a 20.4% decline. A bear market is customarily defined as a reversal of at least 20% from the previous peak. The 2011 reversal is remarkable for the fact that the index was in a technical bear market for exactly two days, 26 September and 4 October 2011. Perhaps the shortest ‘bear market’ in Australian investing history.
  3. 14 May 2013 to 25 June 2013 saw a 10.5% decline.

In Australia lately, the old line ‘sell in May and go away’ seems more applicable to April. The bigger problem if you chose to do so is when to return, for each of the falls described above, despite starting within 33 days of each other ended in different months.

There were a few other instances over the period with reversals that didn’t quite make it to double digits, so it really has not been a steady one-way path to profits. There have been plenty of opportunities to make big mistakes of timing, buying at tops and selling at bottoms.

Why do investors react in these ways?

Behavioural economists Daniel Kahneman and Richard Thaler have written excellent texts on the various ways our mind is predisposed to trick us. Over thousands of generations, humans have evolved to employ heuristics for much of our day-to-day decision-making. A heuristic technique allows for a rapid decision, but often not the optimal decision. Given we customarily make thousands of decisions daily, this process is critical to efficient operations, but it gives rise to occasional sub-optimal decisions.

When we were living as tribesman on the plains of Africa, heuristics were enormously useful: “Quick, a hungry-looking lion, better run” or “I’ve never seen anyone eat these berries before, so I won’t either.” In fact, those who failed to use heuristics ensured the tendency toward such decision-making techniques passed down through the ages because those failing to use them were often eliminated from the gene pool.

In the financial markets, heuristics will often lead to the wrong decision, so you need to train yourself to override these natural tendencies. In his book ‘Thinking, Fast and Slow’, Kahneman describes two systems of thinking. System 1 is the foundation for heuristics and it is very fast, almost automatic. System 2 is applied when we slow down and really reason out a problem. System 2 is what you need to train yourself to employ in your decision-making in financial markets.

Contrarianism is something that is given much lip-service in investment circles, but is much harder to apply in practice. This is for good reason, as the crowd is usually right more often than wrong. Despite this, crowds are occasionally also very wrong. When the stock-market is plunging, the driving force is usually a reason that sounds quite reasonable at the time. Inevitably, in retrospect, it seems overblown or short-term.

Once we can master the emotional side of investing, we place ourselves in a position of considerable advantage. We must train ourselves to consider whether whatever economic problem is causing the market concerns of the day actually has a practical effect on the underlying valuation of the business we are investigating. Suppose you were considering buying Telstra shares, and you decided at prevailing prices they would deliver a sound economic return over coming years. However, you didn’t buy because the debt issues in Greece caused you to feel uncertain. You probably made a mistake of reasoning. If you were considering buying BHP shares and the apparent slowdown in China caused you to feel uncertain about the long-term prospects for commodity prices, then your reasoning was probably on more solid ground. 

Opportunities arise in tough markets

When the wider market drops by 15%, there will often be individual stocks that might fall by perhaps 30% (or not at all, of course). In order to succeed at investing, we need to train ourselves to reflexively consider this as a likely opportunity and go searching for where the best opportunities have arisen.

We seem to be able to reflexively adapt our habits as consumers. When a desirable product that has previously been fairly valued or expensive suddenly becomes inexpensive, consumers pounce. These critical supply and demand structures often become disjointed in investment markets. For the patient and disciplined investor, as Albert Einstein said, “In the middle of difficulty lies opportunity.”

 

Tony Hansen is Chief Investment Officer at Eternal Growth Partners. This article is for general educational purposes and does not address the investment needs of any individual.


 

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