Be Not Afraid: Fear, Politics and Investing

Monday, October 31, 2016

By: Christopher P. Cline

Yet all the data tells us there's little to fear. The economy is growing, and unemployment is shrinking (though perhaps not at a rate we'd like). You're more likely to be killed by falling furniture in your home than by a terrorist (the odds of being killed by a terrorist are 1 in 20 million). There are more people moving from the U.S to Mexico than in the other direction. Globalization, according to every available resource, has improved the lives of the lower classes as well as the middle and upper classes by reducing the cost of living. These are all undisputed facts. So why are they being ignored?

The answer lies in our own brains. According to neuroeconomist Gregory Berns, in a New York Times article that was written in the depths of the 2008 - 09 recession,

[w]e are caught in a spiral in which we are so scared of losing our jobs, or our savings, that fear overtakes our brains. And while fear is a deep-seated and adaptive evolutionary drive for self-preservation, it makes it impossible to concentrate on anything but saving our skin.

This reality is as true now as it was then.  According to Berns, "no good can come from [fear-based] decision-making. Fear prompts retreat. It is the antipode to progress. Just when we need new ideas most, everyone is seized up in fear, trying to prevent losing what we have left."  Reacting from a place of fear causes a retreat toward what feels safe, what used to be.  Fear makes us "anti-everything:" anti-government, anti-immigrant, anti-globalization.  In the face of this emotional reaction, facts lose their power to persuade.

Fear wreaks similar havoc in investments. Experts have long wondered about the "equity premium puzzle:" the fact that, although stocks tend to outperform bonds over any long-term period, a significant number of long-term investors avoid stocks in favor of bonds. A 2005 study conducted by Stanford University, Carnegie Mellon University and the University of Iowa (reported by the Stanford Graduate School of Business) compared the investment patterns of those with lower emotional response levels to those with normal levels. The study involved a game in which each participant was given $20 in a 20-round gambling game. A coin was tossed each round, and each participant had the option to risk $1. If a participant won the toss, she received an additional $1.25; if she lost, she only lost her original $1. Logically, therefore, each participant should have bet on every round. However, of the 41 participants in the study, 15 had suffered damage in the areas of the brain that affected emotions, and these were the people who took the most profitable approach to the game. They invested in 84 percent of the rounds, earning an average of $25.70. In contrast, “normal” participants invested in just 58 percent of the rounds, earning an average of $22.80. The researchers concluded that fear in the "normal" group caused them to make the poorer investment decision.

This study may even understate the problem.  According to Ibbotson Associates, in the 70 years between 1926 and 1996, a dollar invested in the S&P 500 grew to $1,114.  However, if a person invested that same dollar in 1926, but got out of the investment during the 35 best months (out of a total of 840 months), the investment only grew to $10.  Put another way, 99% of the return during that period occurred in only 4% of the months in it.  Miss those months out of fear, and you miss the return.  Fear can make a terrible mess of a portfolio, just as it can of an election.

This is not to say, of course, that there aren't real concerns to be addressed.  Globalization may be good for the overall economy, but it doesn't help the people whose jobs were lost overseas.  Stocks may outperform bonds, but that doesn't help when your retirement nest egg loses half its value. The answers to these concerns, though, isn't in retreat, it's forward. The answer is found by following the evidence.

So although there's little any one of us can do individually to affect the outcome of the Presidential election, we can all remember that the market movement that follows the election, whether up or down, will not in the long run affect our portfolios.  We can also remember during times of market fear to follow the evidence.