With U.S. stocks surging this past week and breaking into the black for 2016, remember: What you expect the stock market to do next is shaped largely by what it just did.
Earlier this year, when stocks lost 5% in January and were down 10.5% at their worst, individual investors were the most pessimistic they had been since 1987 according to AAII’s bullishness index.
And if history is any guide, the mood of investors is already lifting in lockstep with stock prices. The more stocks go up and the faster they rise, the more likely you become to expect more of the same. And when they go down, your expectations fall with them. Investors are often told not to get caught up in other people’s emotions — but it’s at least as important not to get swept away by your own.
You can ask yourself one of the key questions: What are the odds of a one-day crash of at least 12% in the U.S. stock market over the next six months?
You probably answered at least 10% — even though that is roughly 10 times the likely chance of a disastrous daily crash in the coming six months, based on the historical record. (The 87 years from 1929 through 2015 consisted of 174 six-month periods. But, with only two single-day crashes of at least 12% over that span, such declines occurred in just over 1% of the half-year periods.)
What’s more you probably would have put higher odds on an imminent crash back in January than you would now. Or, would have six months or a year ago. That is partly because a sharp recent drop makes future declines seem more probable, and partly because the news media uses words like “crash” much more often after the market falls sharply.
Words charged with negative emotion not only darken your view of the future, but they may make you feel that riskier investments have place in your portfolio. No wonder the great analyst Benjamin Graham wrote in his book “The Intelligent Investor,” after which this column is named: “The investor’s chief problem — and even his worst enemy — is likely to be himself.”
BOTTOM LINE: use a system to keep your emotions in check: like the “Heat Map” which follows.