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How to Invest in a Bear Market According to Behavioral Economists

Debbie Carlson

Are you panicking over the wild price swings in the stock market?

You are not alone.

March's drop in stock market value marked the swiftest descent into a bear market ever, causing strong emotional reactions from many investors as they scramble to preserve their savings. The rush to hang on to profits, dump investments and hide money under the mattress can cause just as much, if not more, damage to your 401(k) as any swipe from a bear market.

Behavioral economists -- who study the psychological, emotional and social factors of people's economic decisions -- and financial advisors focused on the markets say this kind of anxiety is normal during a stock market downturn, and there are ways to combat these feelings.

[See: 8 Stay-at-Home Stocks Beating the Coronavirus Blues.]

It is harder to make rational decisions about investment strategy when markets are in turmoil, says Emily Bouchard, strategic wealth coach at Ascent Private Capital Management of U.S. Bank Wealth Management, who coaches people through the emotional and psychological processes of investing. While it is harder to counteract fear now, it is not impossible.

Here are the most common emotional reactions to bear markets and how to regain control:

-- Fight herding behavior by rebalancing. -- Fight recency bias by looking at the long term.
-- Fight knee-jerk reactions by preparing for the future.

Fight Herding Behavior by Rebalancing

Samantha Lamas, behavioral researcher, and Steve Wendel, head of behavioral science at Morningstar, both say people tend to look to others when they are not sure what to do.

"A lot of the things I've been hearing right now from friends and family are things like, 'Everyone's getting out of the market. Should I be doing the same thing?'" Lamas says.

This is known as herding behavior, and bear market conditions can trigger it in full force. Mark Matson, founder of Matson Money -- who coaches investors and financial advisors about behavioral approaches to money and works with behavioral economists as part of an academic advisory board -- says he's also seeing a lot of panicky herding behavior.

"Herding works great for zebras on the Serengeti. It works really bad for investors," he says.

In everyday life, people know to take action when something bad happens, Wendel says -- but these normal action biases do not apply to investing or managing a portfolio.

To fight herding behavior while still taking action, investors should look for tax savings, rebalance their portfolios and, if possible, increase their savings rate, Lamas says. You can partake in tax-loss harvesting by selling enough losing positions to get a potential tax write-off when you file next year's taxes.

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Rebalancing and increasing your savings rates might feel like psychologically challenging tasks right now because they involve selling profitable positions or those that are down less than other assets, like fixed-income holdings, and buying losing equities. But this can help with long-term goals, Lamas says, because you can take advantage of mispriced assets as you get your portfolio's asset allocation back to where you set it before stock prices fell.

It's also emotionally hard for average investors to rebalance or increase savings now because markets could always fall further, Wendel says, and it is important to keep this in perspective. Investors are unlikely to rebalance right at the bottom, but if you try to time the market, it's likely you will miss much of the rebound.

"We all want to know where the puck is going, and none of us know. None of the pundits on TV, etc. Nobody knows. We can only look where the puck is now," he says.

Fight Recency Bias by Looking at the Long Term

When a bull market ends, people fear that stock prices will never stop falling. This is an example of recency bias, Matson says, a tendency to forget events that preceded recent history. Recency bias and herding behavior often go hand in hand, which gets investors into trouble.

Bear markets do not last forever. Sam Stovall, chief investment strategist at CFRA Research, notes that since the end of World War II in 1945, the S&P 500 Index has experienced nine bear markets, which he defines as a drop in stock prices by 20% to 40%. On average, it took the S&P 500 14 months to come back to break even from its lowest level.

"Take a look at a long-term chart and see if you can find the 1987 crash. People will be very surprised as to how small it is in the grand scheme of things," Stovall says. He recommends investors refrain from looking at their portfolios daily as a way to fight recency bias.

Bouchard says herd mentality and recency bias are why it is difficult to be a true contrarian investor. "People who can (be a contrarian) are extremely successful and are able to take advantage of the bear market," she says.

Bob Schneider, wealth advisor at Johnson Financial Group, says recency bias afflicts people no matter the time frame. He notes that early in the year, it was difficult to get clients to rebalance by selling equities after a strong performance in 2019. For investors wanting to take action that will yield future benefits, he suggests converting some traditional individual retirement account assets to a Roth IRA so that the converted assets will rebound tax-free.

Fight Knee-Jerk Reactions by Preparing for the Future

People are dealing with a lot of uncertainty today, says John Riddle, chief investment officer at 361 Capital. They wonder when cases of COVID-19 might peak, if the recession will worsen or when the markets will stabilize. Uncertainty like this is different from risk, he says.

According to Riddle, "You can manage risk by using different securities and derivatives, but managing uncertainty is really hard because you can't really weigh the costs and the benefits." He adds that this is when professional investors must re-examine their long-term objectives.

[READ: How to Prep Your Portfolio in a Recession.]

Volatility is part of investing. People can't control price swings, but they can control how they react to them. Matson says now is a good time for investors to review their risk tolerance. When people fill out risk-tolerance questionnaires during a bull market, it is difficult for them to imagine what state their brain might be in during a bear market, he adds. Now is the time for investors to contemplate the purpose of their investments and write down their goals.

Lamas and Wendel say it is a good time to start writing a plan or a precommitment letter when investors are feeling calm.

"Write a letter to your future self. Write down what you plan to do during market volatility, but also write down why you're investing in the first place," Lamas says. "What are your values? Why are you going to all of this trouble to invest and save for the future?"

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