This week’s dramatic market movements, with major US stock indexes down over 3% Tuesday as fears over the reported Chinese trade agreement details, Brexit related news coming out of the UK, and a partial inversion of the yield curve for US Treasury Bonds made many investors feel like their investments were sliding out of control. It’s the same helpless feeling you get when your car slides on ice when trying to negotiate a turn in winter. Unfortunately, the natural human reaction to both types of scenarios tends to be the wrong one, potentially leading to a crash.
To explain what I mean, let’s start with a review of what’s actually happening when your car refuses to turn and continues going straight despite a turned steering wheel. For those of us living in the Northern Mid-West, it’s a common occurrence in winter when roads get icy. On the racetrack, it’s even more common and can be caused by weather affecting the available grip, or just going too fast. Regardless of where it’s being experienced, it’s a phenomenon known as understeer.
So what’s happening here? Your tires only have 100% of their capability to give at any time towards any actions, based on the available friction given road, car and tire conditions. You can be using 100% for maximum braking, or 100% for maximum acceleration. You can use 50% for braking and 50% for turning. You can do any combination you’d like so long as you don’t go over 100%. As soon as you ask the car to go over the 100% threshold, physics won’t allow the car to respond as you’ve asked.
In the case of understeer, the driver is asking for more than 100% of the tires’ current capability to make the turn. The effect is a plowing of the front wheels where, despite a proper turn of the wheel that would normally have worked, the car continues moving straight. The tires have given up because you’ve asked too much of them.
So what does this lesson on vehicle dynamics have to do with financial markets? The answer is in the way people instinctively react to understeer. An untrained driver will almost always try to correct for understeer by turning their steering wheel more. Instinctually, it makes sense. You want the car to turn left, but it’s going straight. Therefore, turn more to the left and the car should follow. However, what did we just learn about the physics of what’s happening? The car is telling us that it can’t turn to the left the way the driver wants because it would require more than 100% of the available tire grip. Asking for more turn means asking for more grip from tires that are already beyond maxed out. Instead, the correct action is to let the tires gently scrub off speed (get off the gas, don’t jump on the brakes) and unwind the steering wheel until the tires get back to below 100% and start to grip. After the car is back under control you’ll be able to make the turn. Ask less to do more. It’s very counter intuitive.
Investors face a similar dilemma during periods of market turmoil, which can be just as scary as sliding on ice. As my colleague Eric Laumann, CFA wrote in his recent blog post “The Year Nothing Worked”, 2018 has provided plenty of these driving on ice type situations for investors. Just like the untrained driver, untrained investors tend to have the wrong initial reaction to sliding markets. In an effort to protect their portfolios, many investors sell in to market weakness with the justification that at least the values won’t go any lower. Doing so, however, only realizes the lost value of the securities in your portfolio. This investing understeer leaves you out of the market for the eventual rebound in prices. It’s incredibly difficult, if not impossible to routinely time markets like that. Instead, build a strategy that is appropriate for your risk profile and ride through tough periods, thereby giving your strategy time to work and using those periods of volatility to your benefit by buying when securities are on sale rather than selling. This is one way a professional advisor can add value, by keeping you from making the wrong instinctive correction. Let your advisor be your traction control when things get icy.