The Psychology of Bear Markets

The desire to feel safe when danger is lurking is a primal instinct. We feel it in the streets, we feel it in nature, and we sure as hell feel it in the stock market.

Everyone has a breaking point, and it’s only in times of distress that we learn where that point is. The psychology of a bear market goes something like this.

Everybody’s tolerance for pain is different, but for the purposes of this mental exercise let’s assume your breaking point is a 40% decline. Let’s also assume that you don’t sell at the exact bottom, and the market goes lower after you move to cash.

If you sell 40% below the highs, when stocks are 45% off the highs, that would be 8% lower than where you sold. When stocks are 50% off the highs, that’s 17% lower, and at 55% of the highs, they will be 25% below the levels that you ran from.

As bad as you felt before you sold, that’s how good you’ll feel now. You had the foresight to get out before it got worse. You protected yourself and your family from danger.

This makes sense from an evolutionary perspective, but in the market, bad things happen when system 1 overrides system 2.

So you’re in cash, now what?

Do you wait for stocks to go lower before you buy? How much lower? And forget about passively waiting, do you actively root for stocks to go lower? Selling might give you short-term relief, but what type of person wants to root for stocks to go lower? Believe me, that’s not a place you want to be.

If stocks bounce, do you get frustrated? If they keep going higher do you get mad? If they get back to the place where you sold do you get back in? If markets blow past the point you sold do you get angry? Do you think markets are rigged? Do you ever get back in?

If you sold yesterday with the market down 10%, what do you today if it closes up 4%?

This is why you should never think in terms of “in or out.” If you have to downshift on how much volatility you can stomach from the stock market, fine, do it. But like Obi-Wan said, only a Sith deals in absolutes.

I want to share with you how I’ve approaching the recent selloff. I’m continuing to make contributions every two weeks to my 401(k), which is 100% invested in stocks. I haven’t looked at my balance, why would I? I know it’s disgusting, I don’t need to see it. I also cannot, I repeat cannot, touch this money for 25 years. I am under no illusions that this is the bottom, but long-term returns get more attractive as short-term pain gets more acute.

In my taxable account I’ve recently made two additional deposits on top of my automated monthly scheduled contribution. This portfolio is also all stocks, and again, I haven’t looked at the balance. I do have plans in place to make additional deposits if stocks continue to go lower.

This week will shape an entire generation’s view on risk. Young people will remember the coronavirus and they’ll remember what it did to the stock market.

The silver lining of this painful experience is that investors will have a better respect for risk. All the highs they’ve experienced over the last few years are offset by the lows of the last few weeks. It doesn’t feel good now, but we’ll get past this, we always do.