History Teaches, But Do We Learn?

Try to remain rational and calm, despite the storm

I will never forget as we clustered around a single Quotron watching as market prices plunged more than 23 percent on that fateful day back in 1987.

I was a rookie analyst in a trust department and distinctly remember the shock and horror that everyone, from newly minted analysts to gray-haired veterans, felt as we watched the seemingly impossible happen right before our eyes. Honestly, having survived one "500-year flood" event, I never imagined I'd still be in the business when another came along.

While it took four more days this time, history has repeated itself with an even bigger bang--and not just in a single asset class, but in virtually every asset class of every country on the planet. When individuals had to (or believed they had to) question the safety of their cash in traditional banking institutions, it was apparent we were in epochal territory. When rearrangements of the status quo happen in such a spectacular fashion the only truly rational response is "Okay, what did we learn, and what do we do now?"

1) Markets really are pretty efficient. Technically, "efficient" simply means that all information is available and being acted upon. It doesn't imply that it's being processed well or even as the models project they will. As we initially learned from the 1987 crash, just because the model says rational people will buy when prices are cheap, it doesn't mean that real market participants will. Given the large increase in the percentage of the population that owns public securities, as well as the increased volume and velocity of shares trading hands, the "process of processing" happens with dizzying speed. While this efficiency can be unsettling in volatile times, it means markets are liquid and doing what they need to do--providing a way for buyers and sellers to meet their individual objectives.

2) But humans are rarely rational. While markets tend to be efficient most of the time, humans are all too often irrational, especially at key turning points when it really matters. Crisis and stress bring out the worst in most folks, causing our innate "hard wiring" to kick in. The most basic responses (fight-or-flight) can easily cause knee-jerk responses we must consciously harness lest they run away with us. After being inundated day after day with words like crisis, panic, debacle, bailout, plunges, bank runs, and bankruptcy in the direst of forecast voices, how can we help but want to sit in a corner with our hands over our ears and eyes? Such hard wiring, however, can easily lead to decisions based on fear (or greed in rampant bull markets), rather than decisions based on hard inputs.

3) Fear is a particularly insidious emotion. When struck with fear, humans tend to move toward one of two courses: "Deer in the headlights" or hyperactivity. Both can be detrimental. With portfolios down such large percentages, individuals closer to retirement may feel internal pressure to take more "aggressive" stances to quickly make up the losses. Similarly, public and private pensions that have lost gaping amounts (even as their payout promises increase) can feel backed into a corner, searching high and low for more aggressive courses of action to regain devastated ground. On the other hand, younger individuals may seek to "preserve" what's left of their devastated retirement funds by converting any remaining assets to cash. This then locks in the loss, but leaves them exposed to the risk of having insufficient assets for retirement.

4) Risk and return are still related. It never seems to fail. The longer the period of relatively benign markets or reasonable economic performance, the looser the memory link between risk and return becomes. It's as if people forget that all entrepreneurial ventures contain some level of risk for which compensation must be made. After long periods of relative calm, it is not unusual (though it usually ends up being highly unwise) for risk to become exceedingly underpriced. After periods of great turmoil, risk can similarly be overrated in the system if investors are pricing in an outcome that is far worse than what actually transpires.

5) Margin in both big and small things matters. While I define margin a little differently than in the strictest portfolio sense, it is important to have sufficient "space" in each of our financial situations. Unfortunately, we are often not very good at properly assessing it. Margin may be having that three-month salary cushion should you lose a job, or having enough in cash/bonds in your portfolio to cover your grandchild's college tuition. Margin in the business world includes pension or endowment fund managers who have adequately matched their cash flows or assets with specific liabilities--without the need to achieve gargantuan or heroic investment performance.

6) Nobody cares what you paid. Whether it's for your shares, your company, or your house, when you get ready to sell the only relationship that matters is what today's market will bear and how badly you want to unload the merchandise. Don't get wedded to what you paid. (In behavioral finance terms, this is called "anchoring.") It's really irrelevant in the greater scheme of things.

7) Knowledge is abundant, yet true wisdom is often in short supply. Never before have we had access to so much information on such a wide variety of issues. Yet having the information and using it to make wise choices are not always synonymous. All too often, the wisest choices (e.g., saving for retirement, buying when stocks are really beaten up, selling overvalued asset classes, etc.) involve significant mental anguish and may fly in the face of consensus pundit opinion.

Periods of drama and stress, such as what we're currently experiencing, are always unsettling. As humans, we behave much better when things are settled and predictable, even though history shows they seldom stay that way for long. Reminding ourselves to stick to the basics can help us make more rational decisions, no matter what the backdrop.

Carol M. Clark, CFA, is a partner and investment principal of Lowry Hill, a private asset management firm that provides proprietary investment management and financial services to families, individuals, and foundations with wealth greater than $10 million. The firm manages approximately $6 billion in assets for nearly 300 families and more than 60 foundations from offices in Chicago, Minneapolis, Naples, and Scottsdale. She welcomes questions and comments at cclark@lowryhill.com.