The markets have been spiraling downward for eight straight weeks. As we write, for the year the Dow is down 24.22%, the S&P 500 is down 32.04%, the Nasdaq is down 38.17%, and the Russell is down $27.33%. All indices have now dropped below the September 21, 2001 lows.  In fact, the S&P is now 38% undervalued, a level which in the past has lured bargain hunters into buying beaten down stocks. Investors either remain on the sidelines or are raising cash to preserve what's left of retirement accounts in advance of a perceived final capitulation.  Reinforcing this behavior is the unusual fact that stocks typically lead us out of a recession while the economy follows in its wake. Currently, however, the economy is perking up--growing at what appears will be a 3% rate this year--while stocks continue to plunge lower. 

It is all too easy to point to external reasons for a failed market recovery: fears of terrorism, the inability of Israel and Palestine to come to the peace table, low earnings visibility, and accounting scams and mistrust in corporate America. In addition to external factors, however, which are usually short-term phenomena, it may be helpful to look at some of the internal, psychological factors that are inhibiting investors’ return to the market. For as Charlie Munger once said,   “...not enough attention is given to the lollapalooza effects coming from combinations of psychological tendencies.” Hence here are some psychological factors contributing to the market’s continued declines and investor malaise. 

A Waning Sense of Hope 

The motivation for all investing is realistic hope. Whether on the long side or the short side, investors must possess a strong, reality-based feeling that the market will validate their stock picking judgments. Realistic hope, as Ernest Schachtel once pointed out, “has an activating effect.” In other words it helps mobilize the energy required for any activity. Therefore, hope in the market not only motivates us to actually invest; it also energizes us to think about the possibilities, what we might invest in when the time is right, what conditions might be necessary for the market to change directions, what strategies are best to meet our goals. Even when we suffer a loss in the market and our confidence wanes, if hope remains alive, we will have the capacity to pursue our goals.

The mobilization of hope can be damaged greatly by a sense of basic mistrust, characterized by an ongoing feeling of uncertainty and unpredictability. Such emotional states of doubt and randomicity usually follow periods where the predominant feeling has been one of magical hope, “a wishful expectation and anticipation that somehow things will change for the better.” The technology bubble, which was characterized by magical hope, confirmed for many investors that their grandest wishes would be magically fulfilled without any effort on their part. Thus when the bubble collapsed, it became enormously difficult to maintain realistic hope. Investors had no idea what changes would be necessary to renew their faith in the market. As realistic hope waned, we experienced the September 11th tragedy and subsequent Enronitis. The ability to remobilize realistic hope was postponed. 

Depression and Anxiety 

Talk to most investors in the market today and you will come away recognizing most folks are feeling either anxious, depressed, or both. Prolonged anxiety and depression inevitably lead to a pervasive pessimism where investors discern a bleak future for the market. Worries about retirement, sending children to college, and a ten-year period where the market goes nowhere are frequently expressed concerns. 

Anxiety as an emotional state negatively affects the way we think. As I’ve pointed out in the past, there are two major consequences of anxiety. First, it stimulates a change in our thinking processes from one of connecting words and thought by logic to one in which words and thoughts are connected by emotion. You can capture this quality most readily if you imagine the first word that comes into your mind when you think of the word red. For most people, their first association to red is an emotion rather than a dictionary definition of the word such as a color on the spectrum. Red is often associated to excitement, danger, or other heightened emotional states (not to mention the predominant color on our computer screens). When we think in emotions rather than logical connections, we are much more prone to make judgments based on emotional stories in the media, stock message board rumors, and friendly advice from our relatives rather than on any rational understanding of fundamentals.

The second consequence of anxiety is that it promotes jigsaw puzzle thinking. This is a thought process where, instead of being able to look at a whole picture, we can only see fragments of the picture, pieces of the puzzle that may or may not be relevant to the whole. For example, Tyco’s CEO Dennis Kozlowski’s resignation and indictment for possible sales tax evasion dominated the headlines recently. Investor talk shows and market-focused television shows were hammering away at management's lack of integrity. While there are indeed several high profile cases of what appear to be blatant dishonesty in corporate America, the whole picture leads to a very different perspective. Most of the public companies are honestly going about their business.  The combination of jig saw puzzle thinking and emotional cognition lead us to believe we are in the middle of an Enronitis epidemic that requires we quarantine the market. These thoughts force investors to ignore all the signs of an impending recovery. Even more importantly, the same jigsaw puzzle thinking occurs when making decisions about individual stocks. We spend weeks studying a company's fundamentals, technicals, management, product and services before buying a stock; but when the stock retreats and we feel anxious, we tend to make sell decisions based on one or two variables, often price or volume without regard for the total picture. 

A Sluggish Sense of Time 

Time is both an objective and subjective phenomenon. Objectively we define time as the duration of seconds, minutes, hours, days, months, years that can be clocked and measured according to some agreed upon standards. We all know that a week consists of 7 days. However, if you tell your two year old that you'll be gone for a week, he or she will have no conception of the length of your absence because his sense of time is not highly developed. Once you leave, your child may experience the week as eternity, which brings us to subjective time. We all experience time differently, depending on our developmental stage and emotional state. Vacations pass quickly; the work day drags interminably; time occasionally stands still; time passes more slowly for children than for adults. Subjective time can be defined as the distortions of clock time inherent in each of our own psychic lives.

When we feel optimistic and hopeful, time passes all too quickly. Recall how you felt during the tech bubble. We could buy over-valued stocks for the long run without giving it a second thought. We’d be rich overnight, even if overnight meant a couple of years. When we feel depressed or despairing, however, time moves very slowly. During a market downturn, there is a pervasive feeling of “in the doldrums forever.” To consider buying stocks during this period with a two-year outlook on the market is next to impossible for many.  The combination of depression and lack of hope vitiates our psychological ability to imagine a near term future. As Pascal once said, in this state “...we never live, we only hope to live; and, in awaiting and preparing ourselves for happiness we inevitably never are happy.”  When time moves so slowly, and we don’t live, time forces human emotions to move contrary to our economic interests by interfering with long term investing. As long as we experience time as moving so slowly, investors will find it difficult to move money back into the market. 

Lowered Self Esteem

We know that investors use the market to validate and enhance their self-esteem. We feel good about ourselves when we pick stocks and the market confirms our skills and judgment by sending our stocks higher. We feel good about ourselves when we follow others’ recommendations and succeed because we have joined them in a shared sense of power and knowledge--buoyed by a connection with the discoverer of a lucrative investment.  We feel good about ourselves when we are part of a group that uses a successful strategy--be it fundamental analysis, technical analysis, momentum investing, short selling, etc. 

When the market fails to validate our self-esteem, however, we begin to lose both our confidence and our joy in participating. For example, if we’ve followed the recommendation of an admired market guru and his or her recommendation fails to perform, we often feel let down and suspicious. We begin to devalue the guru, advisor, or security analyst. This devaluation of others and the market in general fuels our pessimism while preventing us against mobilizing hope too quickly. In combination with our hopelessness and depression, it is this devaluation that evokes the feeling nothing will get better any time soon. It is in part this devaluation that causes bear markets to continue well below reasonable valuation levels. 

Complex Adaptive Systems: Why Emotions are so Troubling for the Market

At first glance we can argue the above emotional reactions to the market--lowered self esteem, a sluggish sense of time, depression and anxiety, a waning sense of hope--are normal and exist in both bull and bear markets. This is generally true, and such emotional reactions are specifically responsible for many investor mistakes. When we begin to apply them to the market as a whole, they take on a life of their own. Peter Bak, in his book How Nature Works, describes what has come to be called a complex adaptive system. Suppose we have two people in the same room expressing emotion. The dynamics of the interaction will not be particularly interesting unless you’re a psychologist. If we add another dozen people to the room, we now have a group with many interactions that begin to take on a life of their own. 

Bak would say the individuals in the group now transition to a complex adaptive system. In other words, a group of interactions are more complex than the people who comprise the group. This transition from individual emotion to group is called “self-organized criticality” and is “self organized,” meaning the individual emotions expressed have evolved into a group feeling without input from any outside agent. As Bak states, “The state is established solely because of the dynamic interactions among individual elements of the system: the critical state is self organized.” This means: 1) the resulting group expression is greater than the sum of its parts; and 2) the system is out of balance such that minor events may lead to major changes (called avalanches). The changes that take place can no longer be understood by studying the individual’s emotions because the sum of the emotions have become larger than the sum of their individual expression. 

The group, or to make a leap to capital markets, the herd is now a complex adaptive system that is out of balance and subject to major changes as a result of the cumulative expression of otherwise minor emotions. Hopelessness, depression, anxiety, a sluggish sense of time, and low self-esteem are no longer separate emotions belonging to individuals. They now combine to form a complex adaptive system that takes on a life of its own. Bak’s analogy to this process is a pile of sand, which, as we continually add individual grains, changes the nature of the sand pile from static grains to a dynamic system in which a small change--adding one more grain of sand, can lead to an avalanche in the pile.

As emotions become a complex adaptive system within the herd, very small changes--such as Tyco’s CEO resigning or Intel lowering its revenue projections for a quarter--can have major effects on the market. As Bak put it, “...a thought (in our terms an emotion) may be viewed as a punctuation, i.e. a small or large avalanche triggered by some minor input in the form of an observation or by another thought” (emotion). 

We are in the midst of many such small avalanches being triggered by world socioeconomic and political events. The usual smooth progression of the market has been punctuated by minor emotions that have taken on a life of their own, complex and unpredictable. It is during these periods that the survival of individual investors depends on understanding how to navigate through these critical states.

What is important to understand now is that self organized criticality of emotions is the market’s way of taking a large step over a relatively short period of time while driving from the market those who react rather than anticipate and respond to the new complex adaptive state. The only way to survive this step is to remain in the market, knowing that as a result of the complexity a new and different bull market will be born. If we can anticipate and plan for this new bull market, while avoiding being sucked into one of the avalanches, we will find ourselves in exactly the right place when it resumes. 

So what do we do now from a practical point of view? 

The overwhelming majority of investors are feeling anxious, pessimistic, hopeless, and apathetic. These are natural emotions in the face of the worst market conditions since the Great Depression. Remember, the Nasdaq is down over 80% from its high! If you’re not feeling some of these emotions, you’re in complete denial, or you’ve been profiting on the short side. The trick of dealing with these feelings is to allow yourself to experience them without allowing them to determine what you actually do in the market. One caller told me that when she opened her latest brokerage statement, she wanted to sell everything and hold onto the minimal cash that remained. Then she realized that if she acted on those feelings, she would have no way of making up her losses. While you don’t have to make up for losses using the same portfolio of stocks that precipitated the losses, if you’re not in the market you will be likely to miss the first 30%-40% of the new bull market when it arrives.

There are a number of activities that will help you cope. First, think back to the things you have done correctly in this market. You may have performed some excellent research and been absolutely correct about your choices, only to be blindsided by the market’s retreat. Because you didn’t sell in a timely manner this doesn’t mean your stock picking skills have disappeared.  Second, begin to analyze the mistakes you did make. What was it that caused your failure to sell on time? Did you miss an important clue from an individual company? Were you too carried away with your own magical hope to realize the bull market was coming to an end?  The more you can analyze your mistakes, the less likely you are to repeat them. For example, if you realize that you got carried away with magical hope on the upside, chances are you will get carried away with irrational pessimism on the down side; therefore, you should be making a concerted effort to look forward rather than at yesterday’s headlines (e.g. Corporate mistrust is now an old issue and is already discounted in the market).  Third, engage your analytic, cognitive processes to begin to think about the market. What would you buy or sell if the market turned around tomorrow? What factors are most likely to influence the market going forward? What strategies work best for you? What sector of the market has the best fit with your personality? Becoming actively engaged in market analysis will re-energize your hope and confidence in yourself without having to act on your plans yet. Fourth, begin discussing the market with a small group of trusted others. Investing in an interpersonal context, where others can challenge your ideas and expand your ways of looking at the market and individual stocks, helps you use emotion to enhance rather than undermine performance.  Finally, begin to test out your plans by putting one foot back in the market. Research a couple of stocks and buy a few shares. Beginning to apply your strategies again will re-invigorate your enthusiasm for real life investing.