How to use psychology to profit in a downturn.
People’s response to bad news is usually more extreme than to good news, which provides an opportunity. What this is saying is that people are more upset about a 5% decrease in one-day than they are happy about a 5% increase, causing a partly irrational sell-off. This reflects a kind of negative predisposition in humans. The key to profiting in a downturn is to have faith in that psychology (ironic, eh). Assuming the markets will recover, this is the time to buy.
The 12th March marked the second biggest fall of the FTSE100, ever. It fell 10% which is further than the worst day in 2008 which was a response to a vast and systemic financial crisis.
While a humanitarian tragedy (which I think we all have a responsibility to help contain), I don’t believe the economic impact of coronavirus matches that of 2008. The FTSE100 (and most other indices) had fallen by about 30% from their recent peak as of yesterday afternoon and I believe that is a considerable over-reaction by the markets. Coronavirus is unlikely to be a massive issue in a year’s time. In two years, we may well have a vaccine. There’ll be ongoing economic disruption from the virus but I think these are easily overestimated. We have a way of muddling through these things.
Since most investors, like me, are investing for the long term, we essentially invest on the basis of future cash flows. For a company like EasyJet, they will have a terrible year this year but their share price is down 40% and I don’t think that’s a fair reflection of future cash flows. All else being equal, business should return to normal in 6–24 months. If they take on more debt to sure up their business, they’ll pay interest on it which will eat into profits, but not by much.
I bought EasyJet this morning because I think it’s a clear opportunity, but roughly the same logic applies to the rest of the market, albeit in a less extreme way than the 40% decline of EasyJet shares.
The shares I’m looking to buy are those which have fallen by more than the market, but which won’t bear many ongoing negative knock-on effects from coronavirus. I would avoid companies where there’s major supply chain risk, like Apple, which could take some time to get back up to speed. Software and internet focussed businesses are a good bet since they can probably operate fine with most of its workforce remote, and their revenue shouldn’t be hurt too much, especially if it’s largely from long term contracts.
I’ve bought FTSE100 and S&P500 tracker funds. From down c30%, I will make c43% if they recover to their pre-crash price. I think this will be in a year or two which constitutes a great return.
The most important thing in my mind is to develop a strategy, and then stick to it. It’s too easy to let your emotions and biases influence your decisions midway through the strategy. If you let that happen, you almost always end up trying to be too clever, as I’ve done a few times — mostly during Brexit, but I was certainly tempted yesterday too. But, with markets down over 25%, now is still a good time to invest for the long term.
To reduce risk, you could buy into the market in stages. Put perhaps 20% of your spare cash into equities every week/2 weeks/month — something like that — depending on your risk tolerance and view of the market. This will average out your buying price.
