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With the most dramatic part of the storm hopefully over, the question is whether the market has bottomed. When is the recovery? Before we get into how to visualize market recovery, let’s offer some perspective on the recovery of the emotional trauma.
According to the prospect theory in behavioral finance, the pain of losing is twice as powerful as the pleasure of gaining. This phenomenon is also known as loss aversion, a common behavioral bias.
The episode we just had is proof of prospect theory. A tsunami of shock, fear and pain was triggered when S&P 500 lost 30% in 2020 (as of March 22, 2020) due to the coronavirus outbreak. Did it generate a wave of joy of the same magnitude when S&P 500 gained 30% in 2019? Granted, the loss in 2020 happened in a matter of weeks, making it more traumatic. It nonetheless illustrates how much more sensitive we are to losses compared to gains.
Another kind of pain is regret, i.e., looking back and thinking that, “I should have seen it coming.” After all, we were at the end of the bull market, and the coronavirus was spreading rapidly causing the biggest disruption to daily lives since World War II. Some people did see it. Some politicians were reported to have “smart” moves after attending confidential briefings, when the rest of the country was told that it was a bad flu and things were well under control in the U.S.
It is okay to acknowledge that the crisis was unfolding too fast for most of us (professionals included) to react. Instead of dwelling on it, let’s focus on monitoring it going forward.
In a previous article, I talked about how to reduce panic by visualizing the risk and return over longer timeframes. The same tool can be used to visualize recovery. As an example, this is what it looked like for the one-month ending March 31, 2009.