Despite advice to the contrary, some investors are prone to panic selling. They sell off a large portion of their risky assets when the stock market tanks.
In other words, they freak out.
Freaking out is not without benefits, according to the authors of a new paper, When Do Investors Freak Out? Machine Learning Predictions of Panic Selling. It can protect investors during a crisis.
But there is a downside: Investors who freak out often “wait too long to reinvest” and that causes them to “miss out on significant profits when markets rebound,” wrote the authors of the research, one of whom is Andrew Lo, a finance professor and director of the Laboratory for Financial Engineering at the MIT Sloan School of Management.
Who’s prone to freaking out?
According to Lo and his co-authors, here’s a demographic profile of investors who have a heightened tendency to make panic sales:
· those above the age of 45;
· investors who are married or divorced;
· males are slightly more likely than females to freak out;
· those who have dependents;
· those who say they have good or excellent investing experience; and
· those who list their occupation as self-employed, owners, and real estate.
So, what should those prone to this behavior do given the findings from this research? What can freak-outers do to avoid waiting too long to reinvest, which causes them to miss out on significant profits when markets rebound?
Lo, who is also co-author of In Pursuit of the Perfect Portfolio, offered the following suggestions:
How much can I afford to lose?
“Recognize that all of us, no matter how much or little training we have in investments, are capable of freaking out under certain conditions,” said Lo. “Therefore, we should prepare for those situations by asking ourselves, ‘How much does the stock market have to drop before I decide it’s time to sell some/all of my investments?’”
This type of what-if scenario planning, Los said, is best done when markets are calm so that we can think more rationally — as opposed to emotionally — about how we would like to respond to various types of financial distress.
When do I get back into the market?
Once you have a plan regarding the decision to reduce your risk, you then need to do the exact same scenario analysis for the opposite, said Lo. Ask yourself: “After I sell, how much does the market need to recover for me to decide to get back in?”
“Deciding on a plan to get back into the stock market is even more important than the decision to get out because once we get out of the market, it’s all too easy to think about other things and not watch the market as it recovers,” said Lo. “So, when we get out of the market, that’s the time to ‘increase’ our attention to our finances and make sure we don’t stay out too long.”
Others agree that having a plan is the right thing to do, but it’s perhaps easier said than done.
Some people who panic think they are being really smart and selling as a decline deepens thinking they will be able to get back in at a better price,” said Eben Burr, president of Toews Asset Management. “What (the research) shows is that those who do this do not have both a sell and buy discipline that they stick to, and has proven to work. It is easy to sell on the way down, but terrifying to buy at the right time. Others are taking profits from good buys they have made, but again do not have the discipline to repurchase.”
Spend more time managing your investments
Asking yourself about how much you can afford to lose and when to get back in the market implies that you have to spend more time managing your investments, said Lo.
And that’s just the reality of a more complicated financial world that we now live in. “It’s the same trend that we see in other fields, like medicine,” said Lo.
“Decades ago, the typical advice people received about their diet was ‘eat to your heart’s content,’ but today we have to worry about carbs, cholesterol, ketogenic diets, staying hydrated, and so on because we have more medical knowledge,” Lo said. “Similarly, we have to spend more time on our financial health because we now know more about volatility spikes, GameStop-like short squeezes, Fed interventions, and the like.”
For investors who simply don’t have the time or expertise to take on these challenges, working with a financial adviser may be a good alternative, said Lo.
“I would recommend a fee-only adviser so as to reduce the potential conflicts of interest, and even then, not all financial advisers are equipped to address the freak-out factor so it’s important to shop around and find someone that can address the emotional issues of investing as well as the rational,” he said.
Access, education and planning
There may be too much access to trading for our own good.
“For most people, it would be better to have a lobster trap account,” Burr said. “The money can go in, but can’t get out until it is needed.”
And in order for the lobster trap to work there needs to be a portfolio designed to have elements that will shine in different kinds of markets.
“One needs things that are designed to prosper in declining markets so that the emotional impulse to make changes is muted and the portfolio has less fluctuation over all markets,” said Burr, who noted Toews’ research that showed that only 10% of people would not give up some upside to not participate in all of the downside.
People also need to know the history of market declines. “They are usually followed by strong rebounds,” said Burr. “If they know that there is some part of the portfolio that is designed to prosper in a decline and the part that just got hit will likely participate more in the rebound then they may be more likely to be able to wait it out.”
And lastly, it’s important to have a plan that takes into account that historically there have been two 37% declines per decade on average.
“If we know that these emotionally and financially challenging events are going to occur, why not have a plan in place for when they hit,” said Burr.
Try to retrain one’s self to see it as a sale; know the history; know how one is likely to feel and engage in a little metacognition to see that the feeling may be out of line with the reality of investing history in spite of what your news provider is saying to sell advertising,” he said.
“Have a plan for what you are going to do when scary markets occur. Fire drills work.”