In the age of turbulence...

It is challenging enough to keep a cool head in an environment of negativism when a growing chorus of industry pundits are suggesting the end of the world is near. Now I am not suggesting that a major correction is not in the cards, what I am trying to point out here is how difficult it becomes for a portfolio manager to stay the course when turbulence hits with full force. An environment of elevated psychosis in which emotions are running high frequently leads to a situation in which managers lose focus of long term objectives (a key feature of modern portfolio theory), and instead concentrate on playing cat and mouse so to speak. In the current environment where uncertainty reins, one may be tempted to switch into cash and just stack it under a mattress. But what happens when things return back to normal? More specifically, without hindsight, how can we be sure that normalcy has returned?
To illustrate these important points let's take the October '87 crash. On a single day the S&P 500 lost around 20% of its value. Emotions where running very high at the time and a lot of investors decided to take the plunge either by liquidating their positions and switching to cash or bonds. But who would have guessed that just a bit over 3 months later, 90% of that loss had been recouped. Those that had ceded to panic had not only lost 31% of the value of their investments (if we take the drop from it's peak), but failed to capture any of the upturn (bonds had already peaked before the stock market crash).
Again, I am not suggesting that staying the course in turbulent times is an easy task. On the contrary, it can be extremely challenging. If there are any lessons to be learnt, however, it is that ceding to emotions can prove to be an extremely costly endeavor in the long run as we have seen with the example and there are plenty of studies out there that support this view.