Who’s afraid of the bear market?

"Bottom line: Nothing lasts forever."

The bellweather Philippine Stock Exchange Index is in bear-market territory. A bear market is a lengthy period where investment prices fall and widespread pessimism causes the negative sentiment to be self-sustaining. Last Friday’s close brought the index to 7,004.77 or 22.7 percent below its Jan. 29 peak of 9,058.62. The sell-off has erased more than P2 trillion of investor wealth over the last eight months.

Are you pessimistic? Are you fearful? Will you buy or sell?

Let’s play a simple game. At the start of the game, you are given P200 and told the following: The game will last 20 rounds. At the start of each round, you will be asked if you would like to invest. If you say yes, the cost will be P10. A fair coin will then be flipped. If it comes up heads, you will receive P25. If it comes up tails, you will lose your P10.

Now, there are two things we know about this game. First—and perhaps most obvious—it is in your best interest to invest in all rounds due to the unequal nature of the payoff. That is to say, you stand to make more than you lose in each round; the expected value per round is P12.50, giving a total expected value to the game of P250. In fact, there is only a 13 percent chance you’d end up with total earnings of less than P200, which is what you’d have if you chose not to invest at all and just kept the initial endowment. The second thing we know is that the outcome in a prior round shouldn’t impact your decision to invest in the next round—after all, the coin has no memory.

However, when experimenters studied this game, they found some very unusual behavior. They asked three different groups to play the game. The first group was very unusual; they had a specific form of brain damage—these individuals couldn’t feel fear. The second group of players were people like you and me—seemingly without any evidence of brain damage. The third group consisted of people who had brain damage but in parts of their brains unrelated to the processing of emotion (and hence fear).

Who do you think fared best? Not surprisingly, it was the group with the inability to feel fear. They invested in 84 percent of the rounds, whereas the so-called normals invested in 58 percent of the rounds, and the group with non-fear-related brain damage invested 61 percent of the time.

The group who couldn’t feel fear displayed their real edge after rounds in which they had lost money. Following such rounds, they invested more than 85 percent of the time—pretty optimal behavior. This was a huge contrast with the other groups, who displayed seriously suboptimal behavior. In fact, so bad was the pain and fear of losing even P10 that these groups invested less than 40 percent of the time after a round in which they had suffered a loss.

You might think that, as time went on, people would learn from their mistakes and hence get better at this game. Unfortunately, the evidence suggests a very different picture. When experimenters broke the 20 rounds down into four groups of five games, they found that those who couldn’t feel fear invested a similar percentage of the time across all four groups. However, the normals started off by investing in about 70 percent of the rounds in the first five games, but ended up investing less than 50 percent of the final five games. The longer the game went on, the worse their decision-making became.

You may be wondering why I am telling you this story—well, it naturally parallels the behaviors that investors exhibit during bear markets. The evidence above suggests that fear causes people to ignore bargains when they are available in the market, especially if they have previously suffered a loss. The longer they find themselves in this position, the worse their decision-making appears to become.

Of course, this game is designed so that taking risk yields good results. If the game were reversed and taking risk ended in poor outcomes, the normals would outperform the players who can’t feel fear. However, the version of the game outlined above is a good analogy to bear markets with cheap valuations, where future returns are likely to be good.

The bottom line:

Nothing lasts forever: More often than not, recent extraordinary economic and financial events tend to reverse.

Never forget legendary investor Sir John Templeton’s valuable advice, “To buy when others are despondently selling and to sell when others are avidly buying requires the greatest of fortitude and pays the greatest ultimate reward.”

eric.jurado@gmail.com