Think for a moment before you answer the following question: What are the odds that the stock market will fall at least 12% in a single day at some point during the next six months?
After pondering this question, perhaps you conclude this happens occasionally. Would you say there’s at least a 10% chance?
That’s what a majority of investors said when the Yale University School of Management posed this question during a study in 2016.
Based on that and related data, the Yale researchers concluded that investor pessimism about the stock market was at its highest in three years.
The study was conducted in the middle of February — when the stock market had fallen more than 10% since the beginning of the year.
The researchers noted that people’s predictions about what’s likely to happen next in the market are often mere extensions of what has just happened. In other words, many investors’ forecasts are really “after-casts” — simple projections of the recent past into the future. We call this behavioral finance phenomenon recency bias.
Words charged with negative emotion — media favorites are “crash” and “plunge” — also play into this. You may remember reading or hearing those words during the first six weeks of that year.
Because the market fell 10% during that period, many people likely assumed that week #7 would follow the same pattern. Instead, during the next four weeks, the S&P 500 Stock Index rose 11% — gaining back the previous losses.
Had the study been conducted at that point, perhaps it would have found that investors were more optimistic than they had been.
If you think the stock market might fall 10% within six months, you should know that history says it’s very unlikely. In the 87-year period from 1929 to 2015, there were 174 six-month periods. Drops of 10% or more occurred just 1% of the time, according to the Yale finance professors.
The study also found that professional investors — including active managers of mutual funds — tend to exaggerate the odds almost as badly as individual investors do.
So instead of allowing feelings of optimism or pessimism to influence your investment decisions, the best course is to maintain perspective. Trust the statement printed on the front page of every mutual fund prospectus: Past performance is no guarantee of future results. Any assertion to the contrary is a federal offense. Don’t assume that what happened in the past week, month, quarter or year is predictive of what will happen next.
Instead, here’s how to manage your assets wisely and effectively: Invest in a highly diversified manner, maintain a long-term focus and rebalance your portfolio as warranted.
Are your family members or friends missing the benefits of this three-part strategy? If so, refer them to us. Let them know we’d be glad to help them.