You can’t predict, but you can prepare

You can’t predict, but you can prepare

Oil prices dropped almost 30%. Stock markets have plunged. The Corona virus is spreading chaos across both the real and the financial world. We have been riding a very long economic prosperity wave, but within days we’re in cold water again. Whether the depth of impact of the Corona virus is large enough to be the catalyst for a worldwide recession will have to be seen. But what it is already reminding us of again is how markets and people react to a spreading sense of an uncertain future and fear. How, if the impetus is sufficient, markets are eager to buy into the fear. The AEX index recorded a 22% decline over the past 2 weeks. A loss that is larger than after the Lehmann Brothers bankruptcy, and after 9/11.

 

With asset prices inflating to bubble-like proportions under an excess of liquidity, and the economy currently being on the longest growth streak ever recorded, we all know a correction is imminent. And we’re bracing ourselves.

 

The psychology of the cyclical economy

The question is though, how do we handle ourselves when it happens? How composed will we be when we’re going to see liquidity evaporation, collateral shortages, bubbles imploding, panics, fire sales, risk-shifting, contagion? 

 

It is at these moments of serious distress, when the future is uncertain and dark, that our emotions kick in strongest. Just as when they have us buy into market optimism when times are good. And they often trump our critical thinking. As Warren Buffet says: “It’s an easy game, if you can control your emotions.”

Emotions are a key exemplar of what Nobel-prize winning behavioral economist Daniel Kahneman terms our System 1 thinking. A thinking system that is quick to react in knee-jerk fashion. It is also a system that is characterized by a bias to belief and confirm (i.e. follow the herd). That focuses on existing evidence and ignores absent evidence (i.e. draws conclusion from the present, when the future is uncertain – availability bias). And that responds more strongly to losses than to gains (i.e. don’t catch the falling knife).

 

Research shows our rational and critical thinking System 2 is ultimately in charge, with the ability to resist suggestions from System 1, but we have to be self-critical. We have to recognize and understand the way our System 1 operates and be aware of its biases and heuristics to be able to battle it and impose our rational critical thinking on it.

 

And this is difficult. For many people. Researchers studying individual investor behavior found systematic violations of the principle that humans make decisions in a rational, forward-looking way.

 

It’s probably only the top value investors who understand these psychological effects fully and have trained themselves to be thoroughly unemotional in those times where you have to invest anti-cyclical. World renowned distressed investor Howard Marks knows it too: “The biggest investing errors come not from factors that are informational or analytical, but from those that are psychological.”

 

You have to think differently, and think better. Then you can find robustly valued investments at a discount. It is the motto we live by at Globitas. We are preparing to act on the next economic crisis. Are you? Reach out to us if you’re looking for ways to benefit too.