Panic Selling: What causes investors to panic and what you can do about it

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Reading Time: 8 minutes


“So, what would you have me
do?” “Nothing. Sometimes nothing is the hardest thing to do.”

If you are reading this, you are most likely a human being. And humans are not programmed like computers. We are emotional beings. Most of our decisions are driven by emotions, not logic. Panic selling is the result of our emotional turmoil.

Imagine you are in your 50s, planning to retire in a
couple of years…or you have been investing for over a decade to save for your
daughter’s wedding. The Big Day is on the horizon.

You wake up one morning and check your investment portfolio. It is down 10%! One of the stocks in your portfolio has tumbled as much as 35%.

You check business news on your smartphone. The talking heads seem pessimistic. The economic indicators are weak. The government is not doing what it should to revive the economy.

You reach your office and start working. But your mind is stuck on the market volatility. The portfolio is down by only 10% so far. You tell yourself, “It’s OK. The market will bounce back. Everything will be alright soon.”

But part of you is also wondering, “Will the markets decline further?” It could sink 20% or 30% in the next few days or weeks. The pundits are saying the same thing: there is only one way the market can go from here. Down.

Should you sell your stock holdings? If you sell right now, you’ll realize only 10% loss. You’ll still be able to retire in two years…or pay for your daughter’s wedding. What if the portfolio sinks another 20%? That will do some serious damage to your retirement fund or daughter’s wedding fund.

You have been investing so that your money could grow over time and make it easier for you to achieve your financial goals. You never wanted your investments to decline. Losses are not what you expected. This shouldn’t be happening in the first place…especially to your investments.

And now you don’t know if or when the market will
rebound. It’s better to sell right now. At least you’ll still have 90% of your
money. Your mind wants to preserve what is left.

You know the rule is to “Buy low, sell high.” But now
your own money is on the line. It’s more important to preserve the hard-earned
money than to follow the rules and risk losing a bigger sum. You want to get
out of equity markets with little regard for the price obtained.

This panic selling costs investors big time. When
markets fall, the average person starts losing their self-discipline. We are
tempted to sell our stocks, ETFs, index funds, and mutual funds to get out of
the market.

Most of us are not that stupid…or at least that’s what we want to believe. So, why do we panic and end up doing the dumbest of things? There are two main reasons.

1- No emotional resilience

Emotion gets people to sell at the bottom…just as it gets them to buy at the top – Howard Marks

If we are in the markets, managing the volatility of our emotions is more important than the volatility of the markets, which you can’t manage.

Our greed and fear make us do irrational things. Behavioral psychologists have found that the pain of losing money is twice as strong as the joy of gaining the same amount.

Nobel Prize-winning psychologist Daniel Kahneman and cognitive psychologist Amos Tversky proposed the Prospect Theory in 1979. They found that gains and losses have a different impact on investors’ behavior. The losses feel twice as painful as the joys of gaining. Investors make their financial decisions based on the impact of gains and losses on their mind.

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When the markets go up, our greed doesn’t want us to miss out on the rally. We feel jealous when we hear others’ stories of how they made 30% or 40% gain in just a few weeks. We are tempted to chase high returns. It increases the chances of us investing in wrong assets or at the wrong time.

When the markets are going down, we are panicked and we
fear losing more of our money. We take action to protect whatever is left of
our investments.

Our brains are not wired to accept losses. So, our natural
reaction to losses during a market downturn is flight, not fight. Panic selling
is driven by fear, market sentiment, and short-term noise.

“Individuals who cannot master their emotions are ill-suited to profit from the investment process”- Benjamin Graham

Instant access to all the world’s information catalyses our fear and greed. There are thousands of newspapers, hundreds of news channels, and hundreds of apps. All of them are publishing/broadcasting news 24/7. There are analyst reports, brokerage insights, tips from your friends and colleagues, expert commentary on Bloomberg, anonymous tips via messages, and more. Too much noise!

Only a tiny fraction of that information affects our
lives. But it does influence our emotions, decisions, and actions. It heightens
our reaction mechanisms, causing us to make stupid decisions.

Even when there is a small sell-off, the news media goes
into frenzy. When NIFTY index falls 400 points, all the talking heads are like:

NIFTY crashes!

Budget fails to excite the
markets

Is this the beginning of the
next recession?

Monday’s NIFTY crash wipes
out $60 billion of investors’ money!

We see these kinds of headlines everywhere. You’ll never
see or hear them say something like:

NIFTY closes Tuesday at the
same level it was 9 days ago

That’s not exciting. That won’t scare investors. And
that won’t boost consumption of their content. Just turn off CNBC and tune out
the noise. That way, you’ll be able to keep calm, maintain your temperament,
and make sensible decisions.

Most people who fall victim to panic selling check their
statements and the performance of investments too often. The more frequently
you check, the more tempted you’ll be to take action – some action, any action.

Of course, you should review your portfolio from time to time, but not more than four times a year. You need to learn how to sit tight in times of volatility.

2- Little conviction in our investments

Those of us who don’t have a strong conviction in their
investments are highly likely to make irrational decisions in times of
uncertainty and volatility. Borrowed conviction never stands the test of time.

Before making an investment, we need to do an extensive
research about the business, its financial statements, growth opportunities,
risks, management quality, and valuations. We must know why we are investing in
a particular security before putting money into it.

If we make an investment based on tips from our
colleagues, friends, or Twitter, the market volatility will shake our
confidence. Unless you are extremely lucky, you’ll end up selling the
investment at a loss.

Carefully evaluate the business. Never compromise on three things – quality of business, quality and trustworthiness of the management, and valuations.

How to minimize the chances of panic selling

We are likely to sell in panic when the markets are falling. The best time to minimize panic selling in the future is right when you START investing.

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What you do at the beginning will have a huge impact over the long-term. So, do these things to minimize the chances of panic selling in the future.

1- Understand the equity markets

There is no such thing as a market…only a bunch of people who trade – Howard Marks

Most of us don’t have a good understanding of the equity
markets. We read a few blog posts, watch a few videos, and read some tweets
about long-term investing. And then we think we are smart enough to invest in
equity markets and reap all the rewards!

Soon we start picturing ourselves as a billionaire. Some
of us have even calculated how much money they should invest every month and
what kind of returns they must earn to get richer than Warren Buffett. This is
going to be so exciting! Until you lose some money.

Stocks are merely paper assets. Their value is in the
minds of market participants. And there are dozens of different types of
participants…each with their own set of objectives and time horizons.

Speculators care only about short-term price movements. Some are there mainly for the dividends. Some hold on to their favorite stocks for decades. Some are nearing retirement and rebalancing their portfolio accordingly. Some are forced to sell to cover loans. Some focus only on shorting stocks. Some are passive investors. And some geniuses have figured out a secret strategy to make 10x return in twenty-three minutes!

The actions of all these participants will affect our portfolio. What they do with a particular stock is driven by three things – their own plans, fundamentals of a business, and external factors such as economic slowdown, wars, trade tensions, etc.

Remember that there will always be the possibility of wars. There will always be companies missing earnings estimates. There will always be experts predicting market collapse. There will always be companies going bankrupt. But equities have gone up in the long term despite all that.

Factors beyond our control are always at play. At some
point, they will affect our investments. Remember the 2008 US financial crisis?
It was the real estate market that triggered the collapse. But stocks of
businesses that had little to do with real estate or financial services were
also hammered.

Due to factors beyond our control, equity markets tend
to be highly volatile. We can’t separate equities from volatility. There are
periods of high returns, low returns, no returns and negative returns. You have
to embrace all these phases to get good returns in the long-term.

Most of us make the mistake of looking only at the
upside when investing in equities. We pay little attention to volatility and
downside. The more optimistic we are in the bull market, the more panicked and
disappointed we will be when the bear market rears its ugly head.

Market corrections are part of the process. Over the
last 100 years, the US stock market has declined 10% or more every 11 months on
average.

Understanding and embracing the market cycles will not only give us peace of mind, but also help us make the right decisions.

In fact, if you are prepared for it, a downturn could be a wonderful opportunity to buy great stocks at attractive prices to boost your long-term returns. The unprepared get panicked, missing the opportunity to benefit from volatility.

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2- Build a financial foundation

Most of times, people are forced to sell at inopportune moments because they didn’t build a strong foundation before investing in equities.

They don’t have enough money in emergency savings. The
money they need for a goal less than 3-5 years away is entirely in equities.

Ideally, you should have enough money in cash and cash
equivalents (high-interest savings, liquid funds, etc.) to cover at least six
months of your household expenses. The amount you need for a goal less than
five years away should be in a bond-heavy fund. Equities are for goals 5-50
years away.

Have a solid foundation before you start putting money into equities. It will help you endure the volatility and crashes without panicking.

3- Build the right portfolio based on your risk tolerance and timelines

We want high returns on our investments. And the possibility of high returns is accompanied by greater risk. You have to find the right balance between risk and reward based on your risk tolerance and how far your goal is.

You’ll minimize the chances of panic selling in the long run if you have the process and approach to mitigate risk.

Many of us think we can do it all by ourselves. We think we fully understand our risk tolerance. But here is the truth – most of us don’t! Unless you have lived through at least one major financial crisis (2008 or the 2000 dot-com bust), you don’t understand your own risk tolerance.

Figuring out your risk tolerance the hard way could f*ck you financially. So, do yourself a favor – seek the help of a trustworthy fee-only adviser to construct a portfolio that suits your risk appetite and goals.

The financial adviser will work out an asset allocation plan consisting of stocks, bonds, and other assets based on your unique risk profile and needs. Unless you are an experienced investor, you’ll also need the help of an adviser along the way to rebalance the portfolio from time to time.

When you have a balanced portfolio that suits your risk appetite, a turbulence in the equity markets will not feel as panicky to you as it would to other investors.

Of course, there is the question of risk/return trade-off. A lower risk means you’ll get a relatively lower return.

But remember that the most important thing is to be able to comfortably meet your financial goals. A relatively low-risk, low-return scenario is fine if you are investing enough money month after month to meet your goals.

Conclusion

Stock market drawdowns and crashes can be mentally
devastating. Panicking when the markets fall and selling at the bottom is the
worst thing we can do to our investments.

Most of us are not Warren Buffett or Charlie Munger. Our emotions will influence our decisions. But if we have built an emergency fund and our portfolio is in sync with our goals and timelines, we are far less likely to panic sell when there is blood in the streets.

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Vik Shukla
Vik writes about financial wellness, investor psychology, and market risks. His aim is to help people make better financial decisions.
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