The world celebrated the life of a great entertainer this week by remembering his music and singing and dancing to his tunes. Stocks on the other hand, danced to another tune, and investors worried over a different kind of thriller—the possibility of revisiting bear market lows.
The MSCI World index is down about 8% since reaching this year's high in June. The move reignited worries the recession will last longer than previously thought and thus a market recovery will similarly falter. But the truth is, undead bear markets are zombie stuff. Fearing the ghouls of the not-so-distant past—from major bankruptcies, to the dismantling of Wall Street, a worldwide credit freeze, and smooth criminals like Madoff and Stanford—is bad strategy because those problems are already reflected in current prices. Markets discount widely known information and look to the future.
More broadly, market pullbacks are normal and shouldn't spur changes to a long-term investment strategy. The only time one should consider changing course is if they see something big, bad and ugly that's not already priced in.
We all know the market doesn't go up in a straight line, so why does it feel so terrible when it dips? Ask a behavioralist and he'll tell you its human nature—people hate losses about 2.5 times as much as they like gains, which is why we exert more effort to avoid pain than achieve gain. In the world of behavioral finance, this is called "myopic loss aversion"—a cognitive error intimating shortsightedness and an overactive reaction to short-term movements, causing investors to act or feel the need to act in order to avoid any further losses, usually at the detriment of longer-term goals. The "myopic" part refers to our tendency to weigh the short term more than the long term, despite the fact that eventually it's the long term we end up with.
It's important to keep in mind if you have a long time horizon, short-term moves should not matter. Moreover history shows the first twelve months following bear markets yield great returns—around 44% on average. But these returns don't come sans volatility—the road leading to a new bull market is usually bumpy. Those who stay focused enjoy the gains of the longer and stronger bull market that follows, and those who exit stocks and stay on the sidelines miss out on substantial returns.
Despite the recent pullback, global markets are up close to 35% since March 9th lows. Some argue this is just a "sucker's rally"—if you believe that, history is not on your side because for it to be true, it will have been nearly the biggest counter-trend rally of all time. Even if we test another low, which is always a possibility, it's important not to lose sight of the long-term and remain focused. So before market volatility drives you mad and makes you want to beat it, think like successful long-term investors, take the strong advice, and remember to always think twice.