“The fault, dear investor, is not in our stars — and not in our stocks — but in ourselves…” – Ben Graham
One of the greatest sources of edge is the one and only thing you have any power over – your own behaviour. If you can keep your head, while everyone else is losing theirs, then you can be there to exploit the mistakes of others and scoop up what is being left on the table.
Behavioural biases are the most persistent source of advantage in financial markets. Yet they are the most difficult to exploit. These biases have always been present and always will; human nature doesn’t change after all. We may think that we have evolved into smart people, capable of coldly calculating the odds of a market crash occurring and bailing out before the first signs of trouble. Unfortunately, our brains are still running with the same software that our ancestors had, thousands of years ago.
This article looks at the most common emotional biases influencing our propensity to panic sell. It then goes on to identify the demographic characteristics of investors most likely to be afflicted, and finally the knock-on effect of panic selling on investor behaviour.
Having a plan doesn’t prevent you from panic selling, but it might make you a little more prepared. When asked whether he was worried about Evander Holyfield and his fight plan, Mike Tyson famously quipped that “Everyone has a plan until they get punched in the mouth”. Understanding where you might be vulnerable helps put your emotions in the right context, avoiding the worst mistakes and maybe even enabling you to benefit from the mistakes of others.
Panic selling is most likely to occur during periods of volatile price movements. This could be caused by investors overreacting to certain negative information or event (macroeconomic, political or asset specific). Large negative price movements reinforce the negative sentiment causing investors to panic sell.
What are the main emotional biases that lead to panic selling?
Emotional biases are where our feelings (hopes, fears, desires, etc.) distort our ability to make decisions rationally. It is these types of bias that particularly influence whether we panic sell or not.
- People typically overcompensate to avoid taking a loss. Loss aversion as its known suggests that people typically feel the pain of a loss twice as much as an equivalent win.
Investors that arrive late to the party are those most likely to exhibit loss aversion, especially those that are using leverage to juice their returns trying to make up for not being in the market earlier.
- The pain of regret from a poor investment decision is very powerful. An investor is said to be suffering from regret aversion bias when he/she refuses to make any decision because of the fear that the decision will turn out to be wrong and then may later lead to feelings of regret.
However, there tends to come a point where an investor cannot stomach losses anymore. The fear of further losses weighs inexorably that they finally capitulate and panic sell.
Playing the players
Poker is a game where you can still win, even if you have a poor hand. For it’s not about the cards you are dealt, but how you understand and take advantage of the other players at the table. The same principle applies to investing whether it be bankrupt or similar sounding companies on the stock-market or controversial collectable asset markets. In a letter penned to his shareholders in 1987 Warren Buffett remarked, “If you’ve been in the [poker] game 30 minutes and you don’t know who the patsy is, you’re the patsy.”
With that in mind it’s important to know who is sitting around the table, and who is most likely to fold at the first sign of trouble. Using a novel dataset of 653,455 individual brokerage accounts belonging to 298,556 households, researchers from MIT attempted to answer this question by documenting the frequency, timing, and duration of panic sales during the period 2003 to 2015.
They define panic selling as a decline of 90% of a household account’s equity assets over the course of one month, of which 50% or more is due to trades. Unsurprisingly perhaps they found that a disproportionate number of households panic sell when there are sharp market downturns. The data showed that only 0.1% of investors panic sell at any point in time, but they occur at up to 3 times the baseline frequency when there are large market movements.
According to the research the demographic group who are most likely to panic sell are “males, or above the age of 45, or married, or with a greater number of dependents, or who have declared themselves having excellent investment experience or knowledge”.
The report doesn’t ponder as to why that demographic group are most vulnerable, but it isn’t difficult to see why. They are overconfident. They feel the pain of loss more than others given the opportunity cost of the money foregone. They face tremendous regret aversion. How for example do they explain to their spouse why the holiday is cancelled this year?
Younger, less emotionally shackled investors may be less experienced but they have less to fear from sharp market falls. They have more time for markets to rebound in the future to make up for short term losses.
The pain of past losses can linger for years leading investors to avoid investing in certain markets. Closely related to regret aversion, this bias is known as the snake-bite effect. Here an investor that has a bad experience with an investment becomes overly conservative in their investment decisions going forward, negatively impacting future returns potential. The research by MIT found that almost one-third (30.9%) of the investors who panic sell never return to reinvest in risky assets. However, of those that do return to invest, more than half (58.5%) reinvest in the market within six months.
Being able to keep a clear head when everyone else is losing theirs is a persistent source of alpha in any asset market whether that be commodity markets, equities or something else. It’s during these periods of market stress where you need to focus on your own game plan, and not those of everyone else.