Panic causes tunnel vision. Calm acceptance of danger allows us to more easily assess the situation and see the options.
The COVID-19 pandemic brought a precipitious drop in the stock markets. Even though the markets have rebounded somewhat, as of the time that I am writing this article, April 10, 2020, the S&P 500 is still down 13.7% since the beginning of 2020.
With that drastic and rapid drop, it’s probably tempting to sell everything, hide in quarantine, and wait for everything to get back to normal.
Typical investors tend to sell at the bottom and buy at the top of the market. As the chief investment strategist of Loring Wand, Joni Clark, shows in her research, fund flows were most negative at the lows in the market during the Great Recession and higher at the higher points of the market. This means that investors were pulling money out (selling) at lows and putting money in (buying) at highs.
While the maxim may be “buy low, sell high,” the typical investor does just the opposite.
Part of this response is the herding effect. As IHEC’s Ahmed BenSaïda’s research shows, investors accelerate market trends well beyond what the underlying asset valuations should justify. In other words, if you see the market drop, you’re much more likely to want to sell for fear of the market continuing to do in that direction. Just as COVID-19 cases being reported are lagging indicators of exposures and infections that probably happened 7-10 days ago, what you see happen in the market at any given time probably reflects what’s already happened and is being priced in. As Mike McDermott in Rounders (#aff) said, “If you can’t determine who’s the sucker in the first 5 minutes of sitting down, then you are the sucker.”
So, when the market drops 20%, by the time it’s done so, you’re probably too late. The best time to buy (or sell) likely remains in the rearview mirror, which is why averaging into the market (I prefer value cost, but dollar cost works as well) is my generally preferred method of investing (except for moonshots).
But, that doesn’t mean it’s not tempting to get out. Save the 80% that you have left, because, what if the market drops ANOTHER 20%? Answer: you’d had 64% of what you started with.
How to Fight the Urge to Panic Sell
While I wrote this about the COVID-19 pandemic and the market drop that has happened as a result of it, the advice is applicable to any market drop in which you were caught up, unawares, and are sweating out staying the course.
There is one psychological trick that can help you to fight that urge and the dyspepsic reaction that keeps you up at night.
Why You Want to Sell
Earlier, I mentioned the herding effect as a driver for why a lot of people sell at the bottom of the market. That is one driver.
However, there is another, even stronger driver to behavior in a down market.
That behavior is called loss aversion.
As Daniel Kahneman and Amos Tversky researched, people are more emotional about not losing more money than they are about winning an equivalent amount of money.
Simply put, if you lose $20, you’re more upset than you are happy if you win $20.
As a result, you’re willing to gamble more to avoid losses than you are to make gains.
In this case, it’s to sell to protect yourself from losing further.
You focus on the downside, not the upside.
How to Slow Down Loss Aversion
I was first keyed into this idea while reading the fifth book of Nassim Taleb’s Antifragile: Things That Gain From Disorder (#aff). In it, he outlined that people are much more upset if you tell them that they lost $10,000 than if you tell them that their portfolio went from $785,000 to $775,000.
As we have previously seen, our brains much more readily comprehend percentages than they do raw numbers.
In this case, $10,000 seems like a big number. However, $10,000 is only 1.3% of $785,000. 1.3% is a small number.
Research by Bar-Ilan University’s Dr. Eldad Yechiam supports this. While we all fall prey to loss aversion, when we perceive the loss to be small, our reactions are much lower than when we perceive them to be bigger. The behavior shows concavity, meaning that we get disproportionately more emotional the more loss we perceive. So, for example, if we rank emotion at a 2 for losing $100, we’d rank it at a 5 for losing $200, and at a 9 for $300. The reaction grows exponentially for linear losses.
Therefore, the key to not overreacting in a market downturn is to frame your losses as percentages rather than amounts.
Let’s say that you had $100,000 invested in the market. The market drops 20%.
If you think “I lost $20,000,” then you’re much more likely to be emotional, as you perceive that number to be large.
However, if you think “I have $80,000,” you’re less likely to be emotional, as you’re focusing on a larger number.
Remember, safe withdrawal rates have held true through the Great Depression, the dot com bubble, 9/11, and the Great Recession. Although I have no crystal ball and can’t guarantee anything, they’ll probably hold true for the coronavirus pandemic as well.
How have you held your nerve during the COVID-19 pandemic? Let’s talk about it in the comments below!