Editors' Note

The editors of Fidelity Interactive Content Services (FICS) selected this content because it offers valuable information for investors.

Markets, emotions, and you

Understanding market cycles and your emotions can help you be a better investor.

  • Facebook.
  • Twitter.
  • LinkedIn.
  • Print

Life has its cycles. And so do the economy and the financial markets. We can't change either. But we can change how we respond to them. When it comes to markets, we are hard-wired to find the wrong thing tempting—feeling overly exuberant (and buying) at market highs and overly pessimistic (and selling) at market lows. That's a recipe for losing money. Instead, successful investors do the opposite. As Warren Buffet says: "Be greedy when others are fearful and fearful when others are greedy."

So, how do we learn to overcome the instincts that can undermine our long-term success?

Three simple techniques can help:

  1. Understand where you are in the economic and market cycle—and learn how to manage the emotions that come with its various turns.
  2. Know where you are you are in your life cycle—and how much risk you can afford to take with your money.
  3. Build a long-term asset allocation plan that aligns with your situation, goals and risk tolerance, and stick with it despite market turns.
 

The economic and market cycles and our emotions

The economy and markets move in cycles. Not every economic cycle is the same length, ranging from 28 months to more than 10 years. Some even retrace a phase before moving forward. And stock market cycles have typically anticipated economic cycles by 6–12 months on average.

But the cycles themselves are remarkably similar. So are the emotions we feel at different phases of the cycle, as well as what we want to do—versus what we should do to help maximize our long-term investment success.

That's why having a long-term asset allocation plan, and rebalancing back to your target mix of stocks, bonds, and cash when the market shifts your portfolio significantly, is so critical to success. Having a plan and sticking with it over the ups and downs of a market cycle can force you to do the opposite of what you feel—so you aim to buy low and sell high. That's how you can build wealth over time.

The top

The market cycle will eventually reach a top. Think of 2006 and 2007, when a fast-growing economy fueled by low interest rates had led to a rash of low-cost, low quality mortgages and a spate of financial engineering that ultimately led to the financial crisis and Great Recession.

At this stage in the cycle, growth is still strong but moderating, unemployment is low, and interest rates are often falling. Meanwhile, corporate earnings are under pressure, and the risk of recession and a bear market are rising. But intoxicated by seemingly unending stock market gains, many investors feel invincible. Those who succumb to this elixir take on more risk in stocks. They buy high—often just when the market is about to turn down.

What to consider: Instead of buying more stock at inflated prices, most investors should think about selling some of their winners and capturing some gains. That's particularly true if the bull market has pushed their allocation to stocks above their long-term plan and comfort level. Investors might also consider buying some high-quality bonds to help prepare for the eventual turn of the cycle to a bear market.

Turning down

After the peak comes the beginning of the bear market, when the economy is near or in recession, unemployment is rising, and corporate profits are falling, typically taking most stock prices downward too. The Fed may begin to cut rates.

At first, investors tend to experience a mix of wishing and hoping that the bull market could continue. As the market heads south, anger and regret can set in, along with the temptation to sell, even at falling prices.

What to consider: Think long term. Now the name of the game is protection and patience. That does not mean going completely to cash, which can seriously undermine your ability to grow your money long term. As always, it's a good time to check your asset mix to make sure it still conforms to your goals and time horizon. If it does, it may be a good idea to stick with your plan, and continue investing.

Hitting bottom

The bottom of the cycle is the dark before the dawn. The economy is in recession, inflation is falling, unemployment is rising, and corporate profits are falling. Stocks can continue dropping during this phase. But the light at the end of the tunnel is typically that the Federal Reserve cuts rates to help revive growth.

For investors, the time near a market bottom can be an emotional low. Even if you have stuck with your investment plan, you may feel defeated, even paralyzed. But while this is the point of maximum pain, it is also the point of maximum potential to build wealth long term.

What to consider: Now, perseverance is key. In most cases, the way to go is to continuing to invest and rebalance—and not succumb to the temptation to go to cash, which effectively means locking in your losses. At this point in the cycle, stocks are on a super sale. People who have the perspective and fortitude to buy at this point of maximum fear have done very well when prices begin rising again. Indeed, historically, powerful rebounds have followed some of the deepest market drops.

Rebounding

After the bottom comes the beginning of the bull market. The economy is showing signs of a rebound, employment is ticking up, interest rates are low, and corporate profits are beginning to pop. So are stocks: The average increase in the S&P the year after the bottom of a market cycle is 47%.

But by this point, many investors are feeling regret and have checked out. They don’t even want to look at their statements. As the market rises, many remain skeptical and can sit on the sidelines long enough to miss the early, often powerful, rebound.

What to consider: Think like a contrarian. The stock market is rebounding, often sharply. If you have stayed invested, you can see that your balance is coming back. If your allocation to stocks has fallen below your long-term goals, now is the time to steel your all-too-human nerves and bring your portfolio back to your long-term target.

Rising again

Now the bull market is in full force. The economy is in a strong expansion, unemployment is falling, corporate profits are growing, and stock prices are still going up. Toward the end of the cycle, corporate profits are less predictable, volatility heightens, and new stock market highs are fewer.

At this stage, investors can grow more confident, even greedy. Now convinced that the bull market is real, many forget their target mix of stocks, bonds, and cash, the one that aligned with their long-term goals and time horizon, and let their portfolio drift too heavily into stocks.

What to consider: While asset allocation cannot guarantee a profit or protect against loss, keeping your target asset allocation in mind can help provide the discipline to hold greed at bay, and prepare your portfolio for the next turn in the market cycle when the bear returns. This time, rebalancing your portfolio could include selling some stocks and buying some bonds.

The cycle of your financial life

Knowing where you are in the economic and market cycle, and what investors can do to help maximize returns may be able to help you improve your portfolio. But more importantly, you also need to know where you are in your financial life cycle—and how much risk you are able and willing to take. That means ensuring that your mix of stocks, bonds, and cash is right for your goals, stomach for risk, financial situation, and when you will need your money.

Saving years

If you are in your 20s or 30s with many decades until you will need your retirement savings, it makes sense to retain a heavy allocation to stocks. Yes, your balance will go down during the bear phase of the cycle but if you stick to your plan and keep investing, you will be buying stocks when they are on sale, and your portfolio should rise during the bull phase.

Spending years

On the other hand, let's say you are in retirement or nearing it. You have ridden the current bull market like a champ and have saved enough to live well in retirement. But your asset mix is heavily weighted to stocks. Since you are or will soon be living off your savings, you may be more sensitive to losses in the value of your portfolio. In that case, it may be a good time to meet with an advisor and reconsider your asset mix, dialing back stocks and building a more resilient portfolio for the next downturn of the cycle.

Managing your emotions with a plan

Ask any successful investor what they do to stay on track, and you'll get different answers, but the most common (other than "Turn off the TV!") is to make a plan—and stick to it. What they mean by a plan is not a generalized hope or dream, but a well-considered asset allocation strategy that begins with understanding their goals, time horizon, and ability to take on risk at different stages in the market and economic cycle—and their lives.

To stick to their plan, they often work with a financial advisor who helps them focus on their goals and rebalance their asset mix as needed, adding to losing investment classes, and lightening up on the winners. Over time, that discipline helps successful investors—despite emotions—buy low, sell high, and build wealth.

Along the way, understand where you are in the economic and business cycle. Perhaps most importantly, stay in touch with your emotions and what's driving them—but don't let them get the better of you as an investor!

  • Facebook.
  • Twitter.
  • LinkedIn.
  • Print
close
Please enter a valid e-mail address
Please enter a valid e-mail address
Important legal information about the e-mail you will be sending. By using this service, you agree to input your real e-mail address and only send it to people you know. It is a violation of law in some jurisdictions to falsely identify yourself in an e-mail. All information you provide will be used by Fidelity solely for the purpose of sending the e-mail on your behalf.The subject line of the e-mail you send will be "Fidelity.com: "

Your e-mail has been sent.
close

Your e-mail has been sent.