“Mistakes present a choice: whether to update your ideas, or ignore the failures they’ve produced and keep believing what you’ve always believed.” – Shane Parrish, Clear Thinking
Receiving feedback with positive intent is a blessing.
We can correct our behavior and improve our outcomes.
But, what if we are making mistakes, but do not receive any feedback?
Worse yet, what if we are making mistakes and receive false positive feedback?
This is a dangerous dynamic; engage in the wrong behavior and get rewarded for it.
This phenomenon often plays out in bull markets.
It’s been said that no one learns anything in a bull market. In other words, a rising market can cover up a lot of portfolio warts.
Taking too much risk? Doesn’t matter.
Making huge, concentrated bets? Those go up too.
Buying garbage such as the meme cryptocurrency Fartcoin? Print money.
Performance chasing high flying technology stocks? All good.
Bull markets can cover up even the most egregious investment mistakes.
During bull markets, when stock prices are rising steadily, investors often exhibit behavioral biases that can lead to blind spots, overconfidence, and misleading feedback. Here are some of the most common…
- Overconfidence: In a bull market, even novice investors feel “invincible” due to consistent gains, leading them to believe they have mastered the art of investing.
- Herding Behavior: Investors tend to follow the crowd, buying into the market hype without proper risk management or diversification.
- Lack of Diversification: Investors often concentrate their portfolios in the best-performing sectors or assets. This lack of diversification exposes them to higher risk, which becomes an afterthought as the concentrated bets continue to rise in value.
- Fear of Missing Out (FOMO): In the later stages of a bull market, investors who were previously hesitant to participate start buying in, driven by the fear of missing out on further gains.
- Euphoria: The final phase of a bull market is often characterized by a sense of euphoria, where investors become overly optimistic. This leads to projecting the current conditions will last for the foreseeable future.
These behavioral biases, combined with the easy gains made during bull markets, can prevent investors from learning and developing more disciplined, long-term investment strategies. As a result, they may be ill-prepared to navigate the inevitable market downturns that follow.
Famous investor Warren Buffett noticed this phenomenon early in his career…
“Only when the tide goes out do you discover who’s been swimming naked.”
The quote is often used to describe how market downturns can expose the weaknesses and vulnerabilities investors carry that were hidden during periods of prosperity. Those that have been taking excessive risks will be exposed when the favorable market conditions disappear.
In many cases, the landmines were there in plain sight, but it’s easy to become blinded when everything is going up in value.
A recent example occurred in 2021, coming off a prosperous year many investors felt they couldn’t miss. The calendar turned to 2022, and the market broke down quickly, eventually posting a loss of ~20%. Technology stocks fared even worse.
One of the common themes from prospective clients we spoke to was, “I didn’t know I was taking so much risk!”
Here are a few check-up questions to ask yourself during a bull market…
How did your portfolio hold up during the last difficult market?
Did you make any emotional investment decisions trying to avoid losses?
Are you concentrated in any individual stock, industry, or sector?
Do you get excited when talking about your best investment idea?
Are you thinking about what could go wrong?
Are you placing great emphasis on recent market action?
Are you checking stock prices on your phone every 15 minutes?
Do you have a plan for when the market environment shifts?
The takeaway is that investors should be wary of deviating from their investment personality and sound risk management principles during good times. They should focus on building resilient, well-diversified portfolios that can withstand both favorable and unfavorable market conditions. Preparation beats prediction.