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The two things to do when the stock market goes crazy

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The two things to do when the stock market goes crazy

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For more than a year, it looked like the stock market could only go up, supported by a river of money gushing from the government. Last week, that illusion was shattered.

Growing certainty that the Federal Reserve intends to raise interest rates, most likely as early as March, has scared investors away. On Monday, the Dow Jones Industrial Average moved 1,000 points in a single day – twice. It fell more than 3%, then rallied to close with a gain. Stocks have turned the rest of the week, with the S&P 500 down more than 9% so far in 2022 and the Nasdaq-100 index down more than 14%.

But what happens next is not the right question to ask.

In a speech given in 1963, the great financial analyst Benjamin Graham said: “In my nearly 50 years of experience on Wall Street, I have found that I know less and less about what will the stock market, but I know more and know more about what investors should do.

You should do two things. First, put recent market moves into a long-term perspective. Next, recognize that the type of investor you are matters more than the investments you own.

There is nothing out of the ordinary about the way stocks have risen and fallen in recent weeks. It’s the calm of last year, when stocks soared almost 28% but fluctuated with about two-thirds of their usual intensity, it was abnormal.

Two factors had allowed stocks to rise smoothly until this month: government policy and investment automation.

The Federal Reserve’s low interest rate policy and trillions of dollars in stimulus spending flooded the markets with cheap money. This sent the shares soaring.

And, whenever the declines become significant, financial advisors and pension funds send automated buy orders that automatically buy stocks when they fall below a target level. This prevented the shares from falling too far.

Such gentleness can breed complacency.

“We’re going through these long normal to low volatility regimes,” says Joanne Hill, head of research and strategy at CBOE Vest Financial, an investment advisory firm in McLean, Virginia. “And then you have these surges of market storms that come by.”

In what’s sometimes called “hazard compensation,” you’d probably ride the hairpin bends of a mountain road faster if it had strong guardrails than you would if nothing was sticking up. between you and those deep ravines. The feeling that the environment is safer can encourage you to take more risks.

Last year, buyers of biotechnology, electric vehicles and other “green energy” stocks, cryptocurrencies and other hot assets concluded that their future growth would be so great that it was almost impossible to overpay them.

With so many of these stocks selling for hundreds of times their expected earnings, or having no earnings yet, the prospect of an end to the Federal Reserve’s easy money policy has hit hard this month. -this.

Still, it was far from the first time stocks had been beaten in recent years. The S&P 500 has closed at least 1% for the day 448 times since the start of 2008, according to Dow Jones Market Data. In 2020, stocks suffered daily losses of at least 1% 45 times; on five of those occasions, the shares fell 5% or more.

Chances are you barely remember these declines. Investors are exceptionally adept at retroactively revising their memories. Nobody likes to admit fear or feel stupid or incompetent, so we’re polishing our own past; what was terrifying then isn’t so bad now.

This is why it is so important to understand who you are as an investor.

The falling markets have created a battle between your current self and your future self.

In 2022, your current self may suffer from anxiety and stress as you watch the gains dissipate. Will you lose even more in the days and weeks ahead as stocks keep going up and down?

“Our far future selves look like different people than we do now,” says Hal Hershfield, a behavioral scientist at the University of California, Los Angeles, who studies how the weather affects people’s decisions. “It can become especially difficult to keep these distant selves in mind when there are so many emotions in the present, in the form of temptation or fear.”

Investors should care about wealth levels: how much money they have. Instead, they care about changes in wealth: how much they just gained or lost.

How happy you would be with $1 million today largely depends on whether you had (say) $100,000 or $1.9 million last week. If you just won $900,000, having $1 million is exciting. If you just lost $900,000, having the same million dollars will turn your stomach. It’s natural.

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Evolution built us that way. Changes, rather than states of wealth, were what mattered to our hunter-gatherer ancestors. Even a slight reduction in their food supply would have spurred the clan to action. No wonder the bad events, outcomes and possibilities are more important than the good ones.

Now imagine that your future self has been watching you since 2032, 2042 or 2052. Would you remember the fear you felt in January 2022? (If you don’t believe me, see if you can describe or even remember a single investment decision you made in January 2012. I’ll wait.)

When you buy or sell stocks based on short-term market turbulence, the person you are trading with is your future self. Remember: in every transaction, there must be a winner and a loser. So who gets the best deal?

If you still have decades to invest ahead of you, then your future self will likely be annoyed – or may even be materially altered – by the rash decisions made now.

If you’re retired or about to retire, your future self may be glad you reduced risk if stocks go down later. The same is true if you’re the type of person who cut inventory at the start of 2020 or in 2008-09.

When you pass money from your current self to your future self, “it’s a road that’s hundreds of miles long, full of potholes, icy patches and mountain passes,” he explains. investor and financial historian William Bernstein of Efficient Frontier Advisors in Eastford, Connecticut. “You can easily skid off the road unless you drive very slowly and carefully.

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He adds: “It is better to be too conservative and end up with a few dollars less than to overestimate your risk tolerance and end up panicking and selling low.

Keeping your future in mind also means that you have to accept uncertainty.

By historical standards, inventories are far from cheap to 40 times their long-term average earnings, adjusted for inflation, according to data from Yale University economist Robert Shiller. It is one of the highest for more than 140 years.

But stocks have been significantly overvalued, by the same amount, for most of the past 30 years. If you had left stocks in 1992 and not been in it since, you would have missed a bargain; stocks continued to grow an average of about 11% per year over those three decades.

One of the reasons stocks tend to have high long-term returns is to compensate investors for the ever-present risk of losing at least half of their money in the short term.

The prerequisite for being a long-term investor is whether you can accept this uncertainty.

Write to Jason Zweig at intelligentinvestor@wsj.com

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