Alan Greenspan: What history shows us about market volatility and human nature
According to former Fed chief, financial markets ultimately fall into predictable patterns, helping to calm investor fears (Schwab Trading Services event, 3/19/16).
Stock returns, interest rates, and economic growth—what do they all have in common? According to former Federal Reserve Chair Alan Greenspan, they all ultimately revert to historical norms because of one immutable force: human nature.
Alan Greenspan knows a thing or two about dealing with volatility. As chairman of the Federal Reserve from 1987 to 2006, Dr. Greenspan oversaw U.S. monetary policy during one of the most tumultuous times in U.S. financial history, a period that encompassed the stock market crash of 1987, the dot-com boom and bust of the late 1990s and early 2000s, the Asian financial crisis of 1997, and the September 11, 2001, terrorist attacks. Despite having to manage through two U.S. recessions, Dr. Greenspan was at the helm of the Fed during the longest official economic expansion in U.S. history.
"Fear is a far more potent force than euphoria, and you can see it in markets, you can see it in the economy."
Former Federal Reserve Chair
Advisors recently had the opportunity to learn more about Dr. Greenspan's perspective on markets and the economy at an event hosted by Randy Frederick from Schwab Trading Services. The former Fed chief and author of The Age of Turbulence shared his views on the role that human nature plays in market movements and economic activity.
Dr. Greenspan believes that human nature—fear, in particular—helps explain why stocks and other assets can experience short-term, immediate declines that are nearly always followed by a gradual return to long-term trends. "Fear is a far more potent force than euphoria, and you can see it in markets, you can see it in the economy," Dr. Greenspan said.
Understanding investor behavior, including emotional reactions to market swings, is essential for advisors seeking to guide clients through volatile episodes. In his remarks, Dr. Greenspan pinpointed three long-term trends that are rooted in irrational decision-making.
Trend #1: Fear helps explain stock returns
Dr. Greenspan said that the one tried and true strategy he has seen investors employ successfully over the years is maintaining an "upward bias" for stocks. Equities' consistent track record of outperforming other assets over long periods is in part explained by the "risk premium" that investors place on stocks in the first place. In short, investors fear losses from stocks; the more risk averse they become, the higher the risk premium and the higher the potential returns.
"So when you set up a portfolio, and as I said, risk-adjusted, you start off with a bias for more equities than debt instruments."
The equity risk premium "will never get arbitraged away because it's essentially built into human nature," Dr. Greenspan said. "All constants that relate to human nature are the only things you can depend on."
The risk of meaningful losses from equity investing is the reason the equity risk premium exists, and it's what helps stocks generate excess returns above the returns of risk-free or lower-risk assets over the long term. "So when you set up a portfolio, and as I said, risk-adjusted, you start off with a bias for more equities than debt instruments," he said.
Trend #2: Interest rates always return to normal range
Around the world, interest rates remain near all-time lows, and have even dropped below zero in parts of Europe and in Japan. Central bank policies have had a lot to do with that, but Dr. Greenspan believes that rates will eventually return to their historical range. The reason? Human behavior. He pointed to the yield on 10-year Treasury notes or their historical equivalents. "That number hasn’t changed since ancient Greece," he said. "You go back to ancient Rome, 5% to 8%."
Dr. Greenspan argued that present-day interest rates will likely come back to that level, at least at some point. He pinned part of the blame for today's ultra-low rates on inadequate or inaccurate economic forecasts, which may be undercounting productivity gains.
"The current suppressed interest rates are not going to hold at these levels because eventually human nature is going to turn out to be overwhelming ," he said.
Trend #3: Human nature is likely behind sluggish economy as well
Dr. Greenspan observed that U.S. gross domestic product has been low for some time by historical standards, averaging about 2% since the last recession. He pointed to labor force participation as one likely culprit, noting the significant number of people who are retiring or going on disability. "We are running out of people to join the labor force," he said. "Slow productivity and [reduced work] hours make for a slow economy in the U.S. and around the world."
"People are far more sensitive to fear, in other words, they frighten much more rapidly."
Still, he likened the economy's current plight to that after the Great Depression of the 1930s. One of the era's most famous economists, Harvard's Alvin Hansen, worried that the economy had entered a period of "secular stagnation," or a permanent decline into a lower long-term growth trend. Instead, the economy made a spectacular recovery. "He turned out to be wrong," Dr. Greenspan said. 'He wasn’t able to identify that we'd be able to come back to where we did."
The reason we may again doubt the resiliency of U.S. economic growth is, according to Dr. Greenspan, our natural emotional impulses. "People are far more sensitive to fear, in other words, they frighten much more rapidly," Dr. Greenspan said. Often, it can take much longer for that fear to dissipate as conditions return to normal. For example, he pointed to the unemployment rate, which tends to go up sharply and down very slowly as businesses first pull back on hiring and then add incrementally. The perception of a poor job market is likely to remain far longer, even when the job market recovers.
"That's largely because of the imbalance in the way human perception behaves, and because it's human nature, I don't presume it's going to change very much at all," Dr. Greenspan said.
We're hoping these insights help you address your clients' concerns during the next bout of market volatility. Your Schwab Relationship Manager can point you toward other Schwab resources to strengthen your client communications strategy.
Schwab events provide access to deep insights on industry trends and connect advisors from across the country with industry icons, entrepreneurs, leading academics, and analysts. Alan Greenspan spoke at an event hosted by Schwab Trading Services on March 19, 2016, and the content in this article was based on that presentation.