The Nature of Fear

Humans are terribly fearful of losing money in the stock market. The 1929 Great Depression, the Great Financial Crisis, and numerous other deep drawdowns from the past strike terror in those that lived through the events. Fortunately, and unfortunately, I have lived through a period in time where the markets have not corrected deeply, and over prolonged periods of time. Rather, we have seen quick drawdowns followed by sharp recoveries. In other words, it looks like the letter ‘V’.  This has left many of my age bracket with the mistaken belief that ‘buy the dip’ is the best course of action in any drawdown. But why do we still panic and sell?

The book, The Nature of Fear, Survival Lessons from the Wild written by Daniel Blumstein, may shed some light on the situation. Guided by millions of years of natural selection in the extremely harsh conditions of the Sahara, the feeling of fear, has kept our ancestors from becoming something else’s lunch or falling off a cliff.  Whether the reaction of running like a madman for ones life, hiding behind a rock, or slowly crawling away, humans have evolved complex behaviors. However, those behaviors that were fine-tuned over millions of years do not serve humans well in modern situations, particularly those involving finances.  Instead of run, hide or crawl, we now must decide buy, sell, or hold.  

Humans, it turns out, have some pretty cool hard-wired functions built in. Some may call them bias. For example, recency bias, where we have evolved to think the good times will keep going, and the bad times will keep getting worse. We are wired to think whatever recent trend we see will persist. But history tells us otherwise, that market routs eventually end and similarly that market rallies falter over time.

Through more than 30 years of research, the author has concluded that fear preserves security, but comes at a great cost. Fight or flight. Take a pigeon in the park. The bird expends valuable energy if it flys away at every movement from a squirrel or human jogger. And it loses the food source it left behind. Conversely, if it doesn’t fly away, it may be a predators meal or become injured. So a cost-benefit calculator is built into all of us to determine what we think is the best action.

Another example is that with a giant clam. Giant clams protect themselves from closing their shells when a shadow passes by above (e.g., it may be an attacking bird causing the shadow movement).  But when the shell is closed, the clam is unable to conduct photosynthesis and therefore loses its ability to grow. 

I selected this book to learn more about myself and human nature. With each trade, each position view, each P/L for the day and YTD report, I could feel the palpable sting of fear and the drive to push more from the emotion greed.  I could see myself thinking that the rocket like rise of a stock would surely keep on going forever. And similarly, the unrealized loss from a day’s natural, occasional stock movement down, would surely keep compounding and ruin me.   Photos of 1930 dust bowl enter your mind. And you get a strong feeling to cut the losses, stop the hemorrhaging, and just sell. And that loss, the pain it causes one, then slows your ability to re-enter the market and buy back in.  

From my prior blog entry, I shared a ‘2 and 20’ model I developed for cash management, that helps manage this fear.

Specifically, if you have two years of cash for your operating expenses, then you won’t need to sell anything for at least 24 months. 2 years buys you time, valuable time, needed to recover from drawdowns that may naturally take place. That’s the 2 in ‘2 and 20’.

The twenty is an additional 20% cash.  20% cash to buy assets when they are depressed. 2 years of operating cash and 20% additional cash to flip your mindset from being fearful as the market draws down, and instead be greedy by putting your twenty percent additional cash to work buying discounted assets.

I understand that some may feel this is too much cash. Well, that may be fine for them, but the ‘2 and 20’ helps me manage my fear and sleep at night.