“You’ll hear a lot of managers say, “Hey, I bought the market in the financial crisis,” but they’re probably not going to get on TV and say, “and I threw up in the trashcan for it.” – Dan McMurtrie

If you’ve been an equity investor over the last year, you have been experiencing stress. If you haven’t, then you simply aren’t paying attention. But it is important for equity investor to appreciate what exactly it is that they get paid premium returns for in the first place. In our view, those premium returns come from the successful management of anxiety.

While academic research suggests that the source of equities’ long term return premium is a function of equity market volatility, in this post we will argue that this is wrong. The premium rate of returns generated by equities over the long term is a function of the elevated level of anxiety that equity owners must manage relative to bond investors.

First, we want to make clear the difference between anxiety and stress. Stress is a function of external issues. Stress can be relieved by resolving those external issues. But anxiety is a particular reaction to stress that is related to internal issues or how a person reacts to stress.

According to the Mind Mental Health institute, “anxiety is what we feel when we are worried, tense, or afraid – particularly about things that are about to happen, or which we think could happen in the future. Anxiety is a natural human response when we feel that we are under threat.”

In the book The Upside of Stress: Why Stress is Good for You and How to Get Good at It, author Kelly McGonigal argues that stress itself is not bad. Rather it is how people react to stress that determines whether they take a path towards a good or bad resolution of the external stressor. McGonigal makes the case that stressors are a natural part of life. Stress is simply a catalyst that triggers people to react to external events that threaten them in some way. And reacting to threats helps people lead happy, productive lives.

But because stress is uncomfortable, and persistent stress can lead to anxiety, humans often react to threats in ways that are unhelpful. This unhelpful behavior is a function of people seeking to end the stress and anxiety as quickly as possible no matter the cost, rather than managing their stress and anxiety as they seek to take steps to appropriately react to the external stressors.

Investing is an activity that triggers stress. Money in general is an area of high stress for most people. Investing is the act of taking money you’ve earned and exposing it to potential loss in exchange for a potential gain. Even though stocks generate higher rates of return over the long term, they also run the risk of generating significant losses over the short term.

While academics cite this volatility as the reason why stocks earn high rates of returns, it is important to recognize that the volatility is just an external issue which is likely to trigger stress, and may trigger anxiety, but it is the successful management of anxiety, not the volatility itself, for which equity investors are paid premium returns over time.

The chart below shows the high, low, and average annualized rate of returns of stocks and bonds over 1, 5, 10 and 20 year rolling periods since 1950.

Over short term time periods of one year, the returns to equities can be decidedly negative and much worse than bonds. But over 10 year periods, equity investors rarely earn lower returns in stocks than in bonds, and when they do, the underperformance is relatively minor. Over 20 year periods, stocks are less risky than bonds in that their worst returns have been significantly superior to the worst returns earned by bonds. In fact, over this longer time horizon, the worst return for stocks has been better than the average return for bonds.

Most equity investors say that they are long term investors. If you are investing in stocks, you should have an investment time horizon of at least 10 years before you need the money back to spend. For time periods shorter than 10 years, while stocks are likely to do better than bonds, there is a significant potential that stocks will do worse. Due to this, we would argue that investing in stocks for periods of less than 10 years is a form of speculation and your returns will be dependent at least in part by how lucky you are. So, to be clear, our argument in this post relates to long term investing.

Let’s use a quick example to illustrate the degree of risk in stocks vs bonds over a 20 year time horizon. Using the 20 year rolling returns from the chart above, a $100,000 investment made at the beginning of each of those 20 year periods in either stocks or bonds would have grown to the level displayed in the grid below.

	Best	Worst	Average
Stocks	$2,310,000	$321,000	$882,000
Bonds	$965,000	$122,000	$309,000

 

As you can see, while conventional wisdom holds that stocks are riskier than bonds, in fact, over 20 year periods stocks deliver better average returns, dramatically better returns during great periods, and yet still deliver better returns under the worst outcomes.

But along the way, equity investors are faced with a multitude of external stressors. In this next chart, Michael Batnick of Ritholtz Wealth Management illustrates the many stressors that investors faced over the 10 year period from 2009 to 2019, during which time the stock market delivered an average rate of return of 19.5% a year.

Source: The Irrelevant Investor

Each of these external events was a stressor. These stressors demanded that an investor process the new information and try to determine what it meant and how they should react. But anyone who has invested for long knows that there will be periods, much like the period we are in today, when these external stressors begin to accumulate and our ability to process them degrades.

If investors do not proactively seek to effectively manage their reactions to these stressors, they tip into a stake of anxiety. If this anxiety goes on long enough, it can lead to investors feeling “worried, tense or afraid – particularly about things that are about to happen, or which we think could happen in the future.”

The fact is every investor who has been at this work long enough has experienced bouts of anxiety. After all, “anxiety is a natural human response when we feel that we are under threat.” And the world is full of things that over time can threaten the financial status of an investor.

Thus, the goal of investors should not be to never feel stressed. Stress has real upsides in that it focuses attention and triggers investors to work extra hard to identify, analyze, and seek to mitigate threats to their financial status. And it is inevitable that sometimes this stress will snowball into a state of anxiety, where investors begin to feel deeply worried and even afraid about what may happen in the future.

But the key thing for investors to recognize is that they get paid premium long term returns in exchange for successfully managing their anxiety.

Conventional academic researcher argues that equity investors earn a “risk premium” and claims that the volatility of an investment is the best measure of risk. They argue that stocks are riskier than bonds due to their higher volatility, and thus investors demand to be paid a premium to take on this risk. But we can see clearly that the risk of equities only exists over short time frames, which are more consistent with speculation. Over the longer term time frames consistent with investing, there is no record of risk that stocks will deliver lower returns than theoretically “lower risk” bonds.

But what does exist over both short and long term time frames is the requirement that equity investors manage their anxiety. It is anxiety management for which equity investors get paid. Or as hedge fund manager Dan McMurtrie memorably put it in a podcast titled Resilience, Recovery, and Longevity in Investing:

“You’ll hear a lot of managers say, “Hey, I bought the market in the financial crisis,” but they’re probably not going to get on TV and say, “and I threw up in the trashcan for it.”

In the introduction to this podcast, host Frederik Gieschen said he wanted to interview McMurtrie on this topic because:

“If you study great investors and traders, you’ll find that when they end their careers, there is a lot of cases where burnout or just sheer physical and mental exhaustion seems to play a role… this isn’t discussed in public [because] professional investors are inclined to project strength to their peers and to their investors. And so, they’ll shy away from this topic, at least in public.”

We get it. We know we get paid for managing anxiety. Having managed the Ensemble investment strategy through the financial crisis, all the sources of worry listed in Michael Batnick’s chart above, through COVID, and now an inflation crisis unlike anything seen in the US since the 1970s, we are intimately familiar with stress, the risks of anxiety, the incentives to project strength, and the need to work aggressively and proactively to remain rational under conditions of extreme uncertainty.

Back in May of 2022, in an interview recorded just two days from the bottom tick of our strategy’s worst relative performance streak in our 19 year history, I offered a peak behind the curtain on how we attempt to manage the delicate balancing act of reacting appropriately to stressful new information, while not spiraling into the very anxiety that we get paid to manage.

In the interview the host asked me, “how are you thinking about decision making in a volatile environment and keeping your wits about you?” This is an extended excerpt from my response [lightly edited for clarity]:

“I think this should be one of the most important considerations that all investors should be thinking about right now. Not just what decisions do you need to make, but how should you go about making decisions. That’s something that we’ve spent the last 20 years thinking about and trying to figure out.

For instance, we’ve published extensively on our position sizing framework. In conditions like these, if you don’t have a framework for making decisions about position size, you are going to be run over by the volatility as you try to make gut calls. This is an environment in which your gut is wrong. Now, you might make a gut call and be right for a week, right for two weeks, and maybe even get lucky longer term. But the human gut is not designed for market conditions like these.

The fight or flight response is something that everybody is exposed to. And just as damaging to investors is the also common reaction of freezing up in reaction to stress. So, it might be better called the fight, flight, or freeze response.

You might think, “well, I know about that so I can avoid it.” It’s just not the case. Your brain is going to dump chemicals into your body that trigger a fight, flight, or freeze response and your only choice is how you manage that chemical reaction.

We’ve built structured processes for doing just that. It doesn’t mean we’re going to get it right every time. It just means that we have these guardrails around ourselves that help us make decisions even under conditions of extreme stress, when fight, flight, or freeze responses are going off in our brains like they’re going off in everybody’s brains.

It is important to think about how you inoculate yourself to some degree against that fight, flight, or freeze response. It’s just like how to think about cognitive biases in general. Many people think that if you read about them, then you are inoculated against them. But it’s not the case. A psychologist will tell you that, “you can know about cognitive biases and that will help you mitigate them, but only a little bit. You’re still plagued by them.” And so, you need a process for making decisions that considers the faulty way that human brains make decisions when under conditions of high anxiety.

One thing that our firm has been doing a lot of for the last couple months is recognizing that you can’t sprint a marathon. You can sprint, and pause, and sprint, and pause, and you can do that for a very, very long time. But you can’t wake up every morning well before the market and just go a mile a minute all day and night long and do that for months and months at a time. You’ll end up making terrible decisions if try to do this.

We ran this business all through the financial crisis. It was a two and a half year, 56% decline from top to bottom. You never could have sprinted through that whole process. Just like a performance athlete recognizes that to achieve their best performance, they need periods of rest. You need to get a lot of sleep, you need to eat well, you need to keep doing all your routines and keep up your mental health. I think that’s critical for investors at just this moment in time. And so, both personally, as individuals, but also as a team, we’ve been doing structured work around how we manage stress and anxiety.”

One of the myths of investing is that good investors are unemotional. But as one of the all time great investors Seth Klarman has said, “People don’t choose to invest with emotion – they simply can’t help it.” In fact, an investor who was able to bottle up their emotions and ignore them would be a terrible investor.

Investing demands empathy because the act of investing is the act of forecasting how other people (companies, their customers, and competitors) will behave and this can only be done if you seek to understand the perspective of those other people. Humans are soaked in emotions and an investment process that does not seek to understand the emotional drivers of business activity will fail completely.

Pretending that emotions can be removed from the analysis of economic activity is the original sin of the field of economics. One of the key reasons that economists are so bad at making forecasts is that for much of the field’s history, the entire discipline was based on the faulty assumption that economic actors always act rationally and always act in their own self-interest. Only someone who has never met other people could make such a silly assumption.

Similarly, investors must not assume that they have any ability to exclusively act rationally and in their own best interest. Instead, they must accept that they cannot choose to invest without emotion. Once you accept that emotions are an unavoidable, and in fact critical, part of investing, the only solution to making the best decisions under conditions of high stress and anxiety is to fully recognize and accept the challenge, and then build a process that supports you in making the most rational judgements and decisions you possibly can.

Feelings of frustration, surprise, anger, betrayal, and even outright fear are common emotions that investors experience during challenging market environments. Labeling these feelings, recognizing that they are real and valid, but also seeking to understand that they are part of a fight, flight or freeze response cycle, is one of the most important jobs of investors. To avoid this difficult work is to abdicate the responsibility for the very work that equity investors get paid premium returns for doing. You can’t earn the equity anxiety premium, and generate strong, long term investment returns, without actively engaging in this sort of self-analysis and self-care.

Luckily for investors who take on this challenge, they are competing against other human investors who face the same challenges. To be successful over the long term, investors must make accurate forecasts about the future fundamental success of the companies in which they invest. And they must accurately value those future fundamentals and then make sure they pay less than that amount for the stocks they buy. Both activities must be done repeatedly during periods of intense uncertainty, stress, and anxiety.

This is what equity investors get paid for. They get paid premium long tern returns without taking on increased long term risk. But to earn those returns, they must successfully manage their anxiety and successfully make forecasts and decisions even when everyone around them is letting their anxiety get the best of them.

For more information about positions owned by Ensemble Capital on behalf of clients as well as additional disclosure information related to this post, please CLICK HERE.

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