“Nothing any good isn’t hard.” – F. Scott Fitzgerald
Memories of painful experiences are often a critical and adaptive part of living, in that painful memories can keep you out of harm’s way by minimizing repeat mistakes. The challenge, however, is that memories are highly subjective, and with the passage of time you often forget how intense something felt at the time.
In the realm of physical pain, my biggest outlet for stress is training and competing in triathlons with my wife and several colleagues from ClearBridge. They are all better than me, which is painful enough, but I often don’t have enough time to fully prepare for the longer events. This inevitably leads me to swear off competing again, until I ultimately find myself standing in a cold body of water at the beginning of another grueling physical experience. In all seriousness, I love competing, and the rewards of doing so from a health and emotional perspective far outweigh short bouts of physical pain that are soon enough forgotten.
On the other hand, the pain that investors frequently encounter as they navigate the vagaries and complexity of financial markets is a different beast altogether. In fact, as the great behavioral psychologists Daniel Kahneman and Amos Tversky detailed with the concept of myopic loss aversion: investors feel the pain of losses at roughly twice the magnitude of comparable gains. To make matters worse, investors typically check their performance and evaluate their portfolios frequently, almost guaranteeing a steady stream of shortterm emotional pain.
Unfortunately, the potential for short-term pain was extremely high during the recently concluded third quarter. The S&P 500 Index was down over 6%, which was the worst return since the third quarter of 2011. In many ways the key behavioral challenge, and ironically the opportunity, of this entire market cycle is that it started with the acute pain of the Great Financial Crisis (GFC). During the GFC, many stocks dropped to levels that rightly reflected the existential risks of another great depression, as investors grappled with frozen credit markets and a debt-driven deflationary spiral. These extreme initial conditions have been followed by smaller but nonetheless painful deflationary storms: the first Greek exit risk (2010), the loss of the U.S.’s AAA credit rating (2011), Eurozone breakup risk (2012) and last year’s Ebola scare. During this quarter’s deflationary storm, market fears centered on risks of an Emerging Market (EM) crisis, driven primarily by slowing growth in China. To be sure, these are all real risks: deflation and debt is a particularly toxic brew for risk assets, and the probability of an EMdriven credit event has clearly risen." Download below to read full report
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