3 reasons crashing markets mess with your mind

Us humans are terrible both at predicting and remembering our emotional responses to extreme situations. The only time an investor is genuinely well placed to understand how they’ll react to losing a large chunk of their wealth is when it is actually happening. During such events, an honest assessment of emotion and behaviour (especially behaviour that is both regrettable and avoidable) can be invaluable in planning for the next time a similar situation occurs.

What does all this have to do with a column about stock screens, though? Well, the screen I’m running in the column this week – the Cornerstone Value screen devised by Quant maestro Jim O’Shaughnessy – was designed to take investor psychology into account. It does this by sacrificing higher returns in exchange for low volatility compared with the market. 

True, the comfort offered by level pegging with a market that's dropping like a stone may feel like limited solace. Nevertheless, for those seeking to take the long-term perspective espoused by Mr O’Shaughnessy, this is certainly preferable to currently holding a portfolio of cratering travel company shares, for example.

But before looking at the results from this year’s Cornerstone Value screen, a detour back to behavioural finance. I’ve selected three nuggets from the copious research psychologists have undertaken into human behaviour that help illustrate why crashing markets mess with our minds.

(1) Hot head

In behavioural economics bestseller Predictably Irrational, author Dan Ariely cites an experiment in which he and a colleague got male university students to fill in a questionnaire about their amorous, bedroom preferences and behaviours. The questions were first answered in a 'cold' state and then some weeks later in an impassioned 'hot' state. 

To save readers’ blushes, I will not go into detail about how the 'hot' state was induced or why the academics thought it best to wrap in cling-film the laptop on which the questionnaire was answered the second time. However, the results from the experiment were very illuminating in regard to how human behaviour changes at moments of visceral excitement – such as when stocks plummet. 

Indeed, what the participants thought were their preferences when in a 'cold' state, was very different from what their preferences actually turned out to be when they were in a 'hot' state (the state in which such choices are actually made). When 'hot', participants felt far more relaxed about the precautions they would take during a romantic foray (far more likely to make costly mistakes) and were far more adventurous in the activities they expressed a desire to experience (far more willing to take risks).

(2) Total despair

During extreme events, it becomes very hard to see beyond the here-and-now. Nobel prize winning behavioural economist Daniel Kahneman coined the term What You See Is All There Is (WYSIATI) to encapsulate the many behavioural traits that stop people thinking beyond a dominant narrative. Many of these traits were identified by himself and long-time collaborator Amos Tversky. 

A key cause of WYSIATI stems from the human brain’s tendency to put significance on information based on how recent and attention-grabbing it is – known in academic jargon as 'recency bias' and the 'availability heuristic'. Research shows, if unchecked, the recency and availability of information massively trumps its actual statistical significance in influencing our judgments and decisions. 

A commonly cited example of this phenomenon in action occurs following natural disasters. Demand for insurance against the recent event spikes immediately after it has happened before slowly retreating. The grim irony here is that insurance cover is normally back to the pre-disaster level the next time it is actually needed. 

For investors experiencing sharply falling markets accompanied by strong negative narratives – such as potentially far-reaching economic consequences from the spread of coronavirus – this means it becomes very hard to tune into alternative scenarios.

(3) Big loser

A third important factor dictating how we respond to financial loss centres on another Kahneman and Tversky discovery: the emotional pain wrought by a loss is roughly twice as great as the pleasure caused by an equivalent gain. This provides reason to believe the default setting for the average (perhaps almost every) investor is: 'sell low, buy high'. Loss aversion creates an inextricable pull towards panic selling as well as reticence to buy into a potential recovery as fear of further loss trumps the desire for possible gain. 

So what?

Given we are fated to feel such pain from financial losses, any losses currently being incurred may as well be regarded as payment in exchange for a valuable lesson into our own psychology. Such a lesson may help foster a better understanding of long-term investment priorities as well as inform planning for the next extreme market event. And even investors that have had the prescience to move to cash or hedge ahead of recent falls can gain insights at times like these given the psychological difficulty of reversing bearish bets.

But, sadly, something that behavioural finance certainly can’t tell us is how the current market turmoil will play out. If there was any serious amount of certainty about this, then the emotional response to falling markets would not be so febrile. Worst still, knowing about common behavioural foibles is unlikely to prove much of a defence against them if a clear plan for dealing with such circumstance has not already been put in place. Importantly, though, there is always a next time.

Cornerstone value

But back to the business of stock screens. Mr O’Shaughnessy’s Cornerstone Value screen is pretty straightforward. Its objective is to outperform the index while trying to mimic its volatility. The version of the screen followed by this column is based on the method set out in Mr O’Shaughnessy’s seminal book What Works On Wall Street when it was first published in 1997. It involves selecting a portfolio of the highest-yielding “market leaders” – the criteria for identifying a market leader are set out below and is the product of significant backtesting by Mr O’Shaughnessy. 

How to spot a market leader:

• Market capitalisation of at least £500m.
• Greater-than-average number of shares outstanding.
• Higher-than-average cash flow per share.
• Turnover of more than 1.5 times average.

Since the first publication of What Works On Wall Street, Mr O’Shaughnessy has updated his valuation method to use a composite of various valuation ratios rather than just dividend yield. Another thing to note about my Anglicised version of his screen is that I’ve had to adapt the market leader criteria to reflect the diminutive nature of the UK market compared with the US market that the screen was devised for. Another concession in this regard is that the screen is based on a selection of the 25 highest-yielding market leaders rather than the top 50 (the FTSE All-Share can’t even muster 50 'market leaders' in total). The less diverse portfolio means the screen can be expected to do a worse job at keeping step with the index than if it was based on 50 stocks.

Even though my screen is not entirely faithful to the original, it has done a reasonable job at achieving the long-term objective. That said, performance over the last two years has disappointed. The cumulative total return since February 2011, when I began to monitor it, now stands at 87 per cent compared with 67 per cent from the FTSE 350 (see graph). If I take the necessary step of adding in a notional 1 per cent annual charge to represent dealing costs, the total return drops to 72 per cent. The performance of last year’s screen and this year's picks are set out in the tables below. 

2019 Cornerstone value performance

Source: Thomson Datastream

2020 Cornerstone value shares

Source: S&P Capital IQ