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We are seeing a number of investors turn to fear and panic to take the wheel, guiding investors toward decisions that might not be in their best interest. This is particularly true when regional banks go under, when the average consumer starts to feel the effects of stagflation, and when East/West tensions rise (note that we no longer invest in China or Russia).
It is normal to feel worried when faced with all of this. After all, we are human. However, does this fear justify making drastic portfolio changes? Or does it only lead to more harm than good?
The Biology of Fear and its Impact on Investing
The fear of loss, (known as loss aversion), is a powerful emotion that can significantly influence one’s decisions. This fear is hardwired into our brains, originating from our early human ancestors who needed to avoid risks to survive. One innately knew to run from big cats, large birds of prey, wolves, bears, and other predatory animals.
While this evolutionary trait was once advantageous, in today’s financial markets, it can lead to overly conservative investing behaviors, which can cause long-term underperformance. In extreme cases, fear can prompt investors to sell their stock portfolio in an attempt to prevent further losses.
Loss Aversion Bias: The Invisible Puppeteer
Nobel laureates Daniel Kahneman and Amos Tversky demonstrated the extent of our loss aversion through a simple coin-toss experiment. The results showed that the pain of an investment loss feels twice as strong as the pleasure of an equivalent gain. This bias can negatively affect investors’ decision-making, especially during turbulent market periods. It might lead an investor to be overly conservative for fear of losing money or cause beginner investors to hesitate in investing altogether.
Investor behavior is often driven by the emotional pendulum swing between fear and greed. The temptation to follow the crowd – ‘herding’ – can be quite powerful, especially during times of market uncertainty. Investors often choose to cut losses by exiting the market or to hold their positions hoping for a reversal.
These reactions are driven by fear – the fear of losing more or the fear of missing out.
Selling Out of the Market
Selling out of the market can have disastrous consequences. Staying invested, despite the volatility and the uncertainty, is certainly a much better strategy.
Let’s say that you started with $100,000 in 2003 and you invested in the S&P 500. If you were to do nothing and simply wait 20 years, your portfolio would’ve grown to $647,854.
If you were to panic and sell out during the five best days, your portfolio return would drop to $409,182! Missing 10 days, 15 days, and 20 days would result in even more disastrous results.
This fear, especially during a market downturn, can be detrimental to your portfolio’s performance and your financial well-being. It often results in panic selling, which can have three significant costs:
1. Panic selling means realizing losses at a terrible level
Attempting to time the market is pretty hard. Panic selling during a downturn often locks in losses, and it’s challenging to determine whether the downturn will be a minor correction or a full-blown bear market. The urge to liquidate investments usually peaks when the market hits rock bottom, and the financial news is at its bleakest. This is arguably the worst time to sell as it maximizes losses, derails long-term investment strategies, and has a significant impact on portfolio performance.
2. Missing out on a sharp and unexpected rebound in equities
Market recoveries often occur swiftly and unpredictably, retracing substantial portions of previous losses. If you’re not in the market because of panic selling, you’ll miss these rapid rebounds. Morgan Stanley’s research highlights that a buy-and-hold strategy from 1980 through February 2022 would yield a 12% annual return. In contrast, an investor who sold during downturns and waited for two consecutive years of positive returns would have an average 10% return annually. Over time, this difference in returns results in a vast disparity in wealth accumulation.
3. Losing discipline will result in erratic trading and panic buying
The aftermath of panic selling can lead to panic buying, another dangerous practice. Feeling like the market tricked you into exiting your investments, you might try to make up for lost ground, possibly even investing more at higher prices to benefit from the momentum. This erratic trading behavior not only incurs transaction costs but can also lead to further losses and compromise your disciplined approach to investing.
Warren Buffet famously said, “Our goal is more modest: we simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.” This contrarian approach to investing offers valuable insight: instead of yielding to fear and panic, consider objectively analyzing the situation and making decisions based on data, not emotions.
Remember, U.S. stocks are by far your best bet when building long-term wealth, and selling out of them during a ‘crisis’ usually results in a net loss.
Here are a few strategies to improve the chances of your investment success:
1. Maintain investment discipline: Follow your investment plan and manage risks accordingly. Know your risk tolerance and make sure your investment portfolio aligns with this. Also, ensure that your investment time horizon is aligned with your portfolio. If you need access to your assets within a year a two, it is probably a terrible idea to have these funds invested in equities or something similarly risky.
2. Maintain a big-picture view: Education is key. Not understanding how the markets and economy work can lead to disaster. The fear of the unknown and all of that. If you understand how money supply affects interest rates and how that can impact corporate earnings can go a long way.
3. Have a well-defined investment strategy: We put in a lot of time when crafting our investment philosophy. We found that picking individual stocks is pretty hard, so it is probably not wise to do so. Buy index funds instead. However, we think it wise to tilt towards companies that are quite profitable and cheap.
During times of crisis, we also think it makes sense to underweight asset classes of high risk and overweight those of low risk. Think of this as a more data-driven approach of being fearful when others are greedy and being greedy when others are fearful. This typically happens during market extremes, which we are not experiencing today.
While fear is a natural response to market volatility, it’s essential to manage it effectively to prevent detrimental investment decisions. The key to successful investing is not predicting market movements but maintaining a disciplined approach, staying invested for the long term, and managing your emotional responses to market swings. The next time market jitters tempt you to act out of fear, remember that the greatest investment risk is not the market volatility but our reaction to it.
There are always going to be reasons to sell. But the market has a fantastic way of climbing the wall of worry.
Remember that investing is not a game of certainty but of probabilities. By sticking to a disciplined approach, making data-driven decisions, and managing our emotional reactions, we can turn the ‘fear factor’ from a liability into an asset. So confront your fear, stay the course, and trust your investment strategy. Your future self will thank you for it.