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Economic, Business and Emotional Cycles.

I was chatting with a client last week and she mentioned “the looming economic recession lurking in the bushes, waiting to jump out.”  Her comment stuck with me, she was expressing anxiety – anxiety of a recession and what it could mean for her family and future.  We addressed her concerns but it prompted me to write this article.

Emotions have a powerful role On Our decision-making and understanding our emotions may be one of the most important tools to making informed and intelligent investment decisions.

At the top, we feel successful, accomplished and hopeful it will last forever. The positive feelings allow us to underestimate risk associated with an investment.  At the bottom, we feel depressed, despondent and foolish.  The negative feelings allow us to stay on the sidelines where it feels safe.  Both extremes feel indefinite when in reality, neither is true. Economies grow overtime and undergo the highs and lows of cycles.

Let’s break it down further:

Economic growth in developed countries like ours usually ranges from positive +4% in great years, to negative -2% during recessions (measured in GDP).  Then layer on businesses, the majority of businesses do much better when the economy is strong, and struggle when the economy struggles creating business cycles because most use leverage (debt) as a tool to grow profits.  Using leverage magnifies profits both positively and negatively - creating more dramatic swings in their profitability. A company’s profits are reflected in their stock price.  When companies are performing positively, the stock market goes up and vis-versa when companies are performing poorly, resulting in stock market swings downward.

But that’s not all.  Markets are also made up of humans and our emotions further magnify the swings of cycles.  Optimism fuels excitement, thrill, and euphoria as the balance of accounts climb.  When people chase that feeling, by not acting prudently, it pushes the price up further. At some point it has gone too far and the cycle tilts downward.  At this point, we can experience disappointment which fuels anxiety, denial, panic, and depression as the cycle continues downward. But without fail, after some time, the cycle swings back toward hope, relief and optimism.  

To be a successful investors, we need to have a firm understanding and awareness of how emotions impact our decision making in order to control our reactions.  At either extreme, high or low, it is difficult to act rationally but if we don’t, regrettable decisions are often made.  At the top, we put more money toward an investment that doesn’t have appreciation potential or at the bottom, we sell because we fear there will be nothing left.  As I mentioned before, neither is usually true.

What we can do to counteract emotional investment decisions?

1)   Be prudent in decision making.  If something sounds too good to be true, it is. It’s usually not different this time.
2)    Investments fluctuate in value.  Being aware of the typical range of fluctuation may be helpful in setting expectations
3)     Examine your cash flow needs and put enough aside in both cash and safe investments to ensure when we encounter a difficult economic time, you feel confident your needs (and then some) are met.

For the client mentioned at the beginning, we reallocated her portfolio to a more conservative allocation, not big moves but adjustments to capture opportunity for the future while protecting her in the short run.

Sources:  Howard Marks -Cycles, Ray Dalio 

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