The investors dilemma: overreacting to inflation

June 9, 2022

Topics: Inflation | Market Volatility

Media type: Article, Podcast

The investors dilemma: overreacting to inflation

4.8 minute read • 

June 9, 2022

The Investors Dilemma: Overreacting To Inflation

Many investors are concerned about the possibility of a recession. Typically, with talk of a recession comes the thoughts of withdrawing money from the stock market and placing it elsewhere. This can result in capital losses, and later, when the stock market recovers, investors regret selling their stocks out of panic. This article focuses on what is commonly referred to as the Investors Dilemma, which is to overreact to inflation and sell their stocks at a loss.

Stephen Kovach, Chief Investment Officer at Global Advisers, suggests that investors look at historical data before making rash decisions about their investment capital. The first estimates indicate that the U.S. economy shrank for a second consecutive quarter, during the period of April–June. According to Kovach, “if you’re an investor trying to decide whether to make changes to your portfolio because you fear a recession, you may want to look at historical data for guidance. During economic downturns, stock prices often begin to rise again as investors anticipate a recovery in economic activity and company profits.”

Investor confidence returns before economic downturns finish.

Looking at the performance of the the S&P 500 Index, which is largely considered the most useful gauge of the U.S. stock market, is a good place for investors to help them make this decision. Throughout the period 1973-2001, the US experienced seven recessions of varying length and severity. Going back even further, between 1929 and 2008, the United States succumbed to three major financial crises, and at least fifteen different recessions lasting between eight and forty-three months. Put differently, during that period, the U.S. economy has been in a state of recession for fourteen of those years, or 17.5% of the time. Given that the average lifespan in the U.S. is approximately eighty years, this means that the average U.S. citizen lives approximately one-fifth of his or her life under the economic hardships typically associated with a recession, such as high unemployment, inflation, and uncertainty about the safety of the money and investments. It’s easy to see why investors panic when this type of data manifests.

A dataset spanning decades that includes economic and market statistics is vast, and while some investors may feel overwhelmed when trying to assess a large amount of historical and statistical stock market data, the key takeaway is that each time the US stock market has declined in response to inflation and/or recessionary data, it has rebounded, and come back stronger.

It’s extremely important to understand that the results of the past do not guarantee the results of the future. However, the historical performance of equities during recessions teaches us many important lessons. For example, soon after a recession begins, the stock market begins to rebound. In the previous fifty years, the stock market has recovered from a recession only two months into a short economic slump. This suggests that investors who sell when they hear bad economic news are often left with capital losses and feelings of regret when the markets begin to recover.

Second, while most investors have time horizons that are shorter than the average recession, we suggest clients who invest in the stock market adopt a long term perspective with the money they commit to equities. This is because recessions during the last seven years ranged from short periods of two months in 2020 and 2008’s global financial crisis to longer ones of up to 18 months, but then rebounded to new high levels.

To be clear, the current data suggests that a deeper recession is not necessarily ruled out by recent events. Moreover, investing in the stock market is fraught with uncertainty, and there is no way to predict how long a recession will persist or how long it would take for the markets to recover. When the National Bureau of Economic Research (NBER), which is largely considered the key economic reporting organization, releases data on recessions, that data is, in fact, retroactive. Put differently, by the time the NBER offically announces that the US economy is in a state of recession, the economy has already been in such a state for weeks or possibly months before the announcement is made. Conversely, the difficulty economists have in gauging growth in real time indicates that a recession may terminate before it has been officially announced, just as a recession will begin before an official announcement. To the average and no-so-average investor, this means that by the time they learn that a recession has ended, it actually ended weeks or months earlier. By that point, historically, the stock market has already begun to rebound, usually because professional investors who understand the consequences of panic selling have begun buying equities at lower prices, and buying at this level causes prices to increase. Investors who sold in panic now face another dilemma: do I buy back (at a higher price) that which I sold (at a lower price).

The solution to this problem is often clouded by emotions. The tenets of behavioral finance assert that people should not make decisions about their own investment capital because they are emotionally attached to the money (largely because it is their money) and thus, they will eventually make such decisions based on emotions, not on fact, data, or logic. We suggest investors seek professional advice to help them make these and other important decisions. According to Kovach, “when it comes to the financial markets, making one wrong decision can be very costly.”

Galleon Wealth Management is a long-term registered investment advisory firm that encourages clients to embrace a long-term perspective on their investment capital. We suggest investors take their time and assess data as it happens, rather than make quick decisions about long-term capital. Contact us at 1-844-GALLEON to learn more.