Highlights:

• Investors’ emotions follow a cyclical pattern similar to those of the business cycle and the market cycle.

• It has been suggested that active investors can capitalize on the behavioral cycle by buying stocks when other investors are panicking, and selling stocks when other investors are most exuberant. This is much easier said than done.
• Recognizing the stock market’s behavioral cycle can help investors avoid the very costly mistake of buying high and selling low.

“The more emotional the event is, the less sensible people are.”

• Daniel Kahneman, 2002 Nobel Prize Winner for Economics

I spent one of my high school summers putting up big-top tents for fairs and carnivals. Many of these featured a roller coaster. The higher the roller coaster rose, and the sharper its descent, the more popular the ride. Personally, I never enjoyed the sudden changes in direction. 

In an earlier post, I discussed the economy’s tendency to follow a roller-coaster pattern that is commonly referred to by economists as the business cycle (a.k.a. the economic cycle).  As illustrated below, the business cycle consists of four stages: expansion, peak, recession, and recovery.

Financial analysts have observed that the stock market tends to also travel in a roller-coaster pattern that corresponds to the business cycle. 

As the preceding graph illustrates, the stock market cycle tends to lead the business cycle. There are two principal theories as to why this appears to be the case.[1]

• The first theory is that investors favor stocks when corporate profits are expected to grow, and prefer other assets when corporate profits are expected to fall. Corporate profits are a major component of the economy, and consequently, if investor’s expectations materialize, stock prices should rise ahead of an economic expansion and fall ahead of a contraction.

• The second theory is referred to as “the wealth effect.” The idea here is that rising stock prices makes investors wealthier. This new-found wealth encourages investors to spend more, which stimulates the economy. Alternatively, when stock prices fall, less-wealthy investors become more frugal, and the economy suffers as a result.

Behavioral economists have theorized that investors’ emotions also follow a cyclical pattern that mirrors the business cycle. 

The business cycle reflects the tendency for investors to chase performance — buy when markets have risen and sell after markets have fallen. As a result, the behavioral cycle tends to lag both the market cycle and the business cycle.

The rationale underlying the behavioral cycle theory goes something like this:

• Rising stock prices and an improving economy triggers investor optimism about the stock market’s direction. Early adopters begin to buy stocks, and the stock market drifts higher as a result.

• As stock prices move higher, optimism turns to enthusiasm. More investors decide to take the plunge, in hopes of cashing in.

• As the market continues to rise, enthusiasm turns to exhilaration. Normally clear-thinking market participants pile into stocks (even though prices have risen to exorbitant levels) and ignore leading economic indicators that point to a weakening economy. Instead, they heed the advice of market prognosticators proclaiming “This time is different!” 

• Eventually, signs that the economy has taken a turn for the worse become too obvious to ignore. Investors become fearful and begin to sell, and the stock market reverses direction.

• As stock prices drop, fear turns to panic, long-term investors morph into traders, the selling escalates, and the stock market plummets.

• Eventually, the markets bottom out, and prices have nowhere to go but up. However, the sting of recent losses causes many disheartened investors to sit on the sidelines, licking their wounds during the initial stages of the new bull market. 

• It’s only after the market has risen significantly that beaten-down investors regain confidence to once again dip their toe in the water.

• And on it goes…

So how can knowing about the behavioral cycle help you make better investment decisions? That depends on the type of investor you are.

If you are an active trader, you may be able to capitalize on the behavioral cycle by doing just the opposite of what most market participants are doing; that is to say, buy when most are panicking and sell when the majority are enthusiastically buying. Warren Buffett put it this way: “Be fearful when other investors are greedy, and be greedy when others are fearful.” 

Unfortunately, bear markets can last longer, and bull markets can be shorter, than history implies. The resulting uncertainty creates doubt. Ultimately, active traders fall victim to the same harmful emotions that drive the behavioral cycle. As John Maynard Keynes, the father of Keynesian economic theory, famously stated: “The market can stay irrational longer than you can stay solvent.” 

By comparison, rules-based tactical asset allocation strategies can position an investor to capitalize on the business cycle. One such strategy is rebalancing. 

Rebalancing involves establishing target percentages for the various asset classes in an investment portfolio, and then periodically adding to or subtracting from the allocations as needed to bring the portfolio in line with the target weights. In other words, if one asset class performs better than others, rebalancing will reduce the amount invested in that asset class and the proceeds would be reinvested in an asset classes that has underperformed. The result is to sell what others are buying, and buy when others are selling, and thereby capitalizing on the behavioral cycle.

The extensive research and market data that underlies sensible, rules-based, investment strategies can provide the discipline and confidence needed to stay calm as the emotional roller coaster rises and falls. As this video shows, that’s more than can be said about the feelings some get when riding a roller coaster, including yours truly.

[1] Critics of the theory that the stock market is a leading economic indicator point to historical instances when each took a divergent path, due in part to unrealized expectations regarding corporate profits.