OB Report
February 2019
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Fear Creates Opportunity

Murray Leith By Murray Leith CFA, Executive Vice President & Director, Investment Research
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Air travel plummeted 30% following the 9/11 terrorist attacks, and it took three years to recover to previous levels. The tragedy made travellers fearful of flying due to a heightened awareness of potential terrorism. While that behaviour is completely understandable, it wasn’t rational. The risk of hijackings actually declined meaningfully following the horrific event because of the significant increase in security measures. According to the Aviation Safety Network, hijackings actually declined from 27 in 2000 to just one in 2005.

The odds of dying in a plane crash are massively lower than the chances of dying in a car accident, yet it’s much more common for people to shake and sweat when a plane takes off than when they get into a car. In a 2008 article, Psychology Today magazine explained that fear strengthens memory and causes us to overestimate the odds of dreadful but infrequent events and underestimate the riskiness of ordinary everyday events. After September 11, 2001, 1.4 million people changed their travel plans to avoid flying, choosing to drive instead. Sadly, that resulted in an estimated additional 1,000 auto fatalities.1

While stock market corrections won’t kill you, they can definitely damage your financial health – if you overreact. The irrational fear of flying is similar to the way investors overreact to stock market setbacks. When stocks fall, investors perceive greater risk, much like travellers who overestimate the chances of a terrorist attack or plane crash.

The media sensationalizes market declines to leverage our fearful instincts and capture our attention. They cite factors like increased stock market volatility as evidence that stock market risks have increased. In fact, the spike in stock market volatility was one of the reasons CNN’s Fear & Greed Index registered “Extreme Fear” towards the end of 2018.

The frequency and magnitude of price fluctuations – what we call volatility – is the commonly accepted academic measure of risk, but we don’t believe this is logical. For instance, using volatility as a measure of risk implies that the U.S. stock market was riskier at the bottom of the Financial Crisis in 2009 (when volatility was high) than at the top of the market in late 2007 (when volatility was low). But, there is more to lose and less to gain when stock prices are high, and less to lose and more to gain when stock prices are low. For the long-term investor, risk should be thought of as the odds of losing money over a reasonable investment horizon of three to five years. From this perspective, the chance of losing money goes down as prices fall and prospective returns go up.

Over the last 30 years, stock market volatility has matched or exceeded the levels it reached in early and late 2018 only 10 times. All but one of those times proved to be an excellent buying opportunity. The spike in volatility in 2001 was the exception, as the bursting of the Technology bubble had a longer lasting influence on the stock market.

While it’s perfectly natural to feel nervous when stock prices decline, investors should consider the wisdom of Warren Buffett, the world’s most renowned investor. Mr. Buffett advises that, “Investors should be fearful when others are greedy and greedy when others are fearful.”

With investors fearful and pessimistic, and stocks down accordingly, we are actually more optimistic regarding opportunities to make money in the stock market. Whether or not the recent correction is discounting an economic slowdown or a mild recession, the businesses we favour are attractively priced relative to their earnings power looking out over the next few years. Some are valued as if a nasty recession is around the corner, and that is highly unlikely in our opinion.

Moreover, the stock market decline itself may alter behaviours in ways that diminish economic risks, much like how increased safety measures reduced the risk of terrorism in the airline industry. Indeed, the U.S. Federal Reserve seems less inclined to raise interest rates following the recent turbulence in financial markets. Similarly, President Trump might be motivated to negotiate a trade deal with China and compromise with the Democrats regarding the wall and recent government shutdown, given that many are blaming him for the stock market slump. We hope our clients will think like Warren Buffett and see market volatility as an opportunity, not something to fear.

"10 Ways We Get the Odds Wrong," by Maia Szalavitz, Psychology Today, January 1, 2008.

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