The psychology behind panic selling, and the way investors try to rationalise their decision to sell, is a pertinent topic. As soon as the markets go down, you’re sure to see a number of investors sell their investments to try and limit their losses. After all, if the value of your plan falls isn’t it better to put a temporary end to your investment journey? Well, maybe not, as selling during market downturns will make your losses real. If you remain calm and resist the urge to sell, your losses will remain hypothetical – it’ll only be a number on your dashboard. But, if markets go back up, you could see your investments increase in value and you could end up with a healthily profit at the end. Unfortunately, most of the time, fear is greater than reason, and investors will follow the crowd and hit the ‘sell’ button. Here’s why.
Why investors panic sell
The most popular and commonly known answer to why people panic sell can be found in Prospect Theory, an economic theory developed by Dr Kahneman and Dr Tversky in 1979. Within Prospect Theory, they uncovered something called Loss Aversion, which is the belief they eloquently described as “losses loom larger than gains”. Why is this relevant to panic selling? Because what these theories imply is that when it comes to stock markets falling or the chance of losses, investors act irrationally in an attempt to ‘play it safe’ The fear of making losses outweighs the potential of making gains, which they use to rationalise their decision to sell, even though that’s how their investment losses become real.
What makes investors act irrationally? The answer is simple: fear. Fear is a feeling created by a part of your brain called the amygdala. Back when we lived in caves and used stones for tools, the amygdala would come in handy against physical threats as it triggers the fight or flight decision, which would help protect us against dangerous things like sabre-tooth tigers. In modern society this flight or fight decision-making operates the same as it did thousands of years ago, but the threats we’re facing are different. Instead of sabre-tooth tigers, it’s stock market performance that keeps investors awake at night.
Panic selling is a natural reaction to a threat and is exaggerated by the fact that people fear losses more than they enjoy gains. But, knowing that in itself doesn’t always give people enough comfort to change their behaviours.
To help, here is an example of a conversation that could happen between a panic seller and an investment manager.
A chat between an investment manager and an investor
Investor: My investments have gone down 20% since January due to the coronavirus, I’m worried that it is going to go lower. What do you think?
Investment Manager: When investments decline by 20% it’s a standard reaction to want to sell and it is certainly a valid option, one that would remove any chance of further losses and emotional pain. Another option for investors who do not need the money tomorrow or in a few weeks would be to try and ride it out by remaining invested over the long-term. The final option available to investors after such a decline is to buy some more. What option is right for you only you know.
Investor: I understand that but what if it goes down another 20%? I can’t see this getting better anytime soon.
Investment Manager: It is up to you to decide what decision is best for you., Nobody is able to predict the future and there’s no guarantee markets will recover, however, we can learn from the past. And historically, most stock market declines have eventually been followed by a stock market recovery. For example, the S&P 500 declined c50% in 2008, since then then it’s up c400% since the decline in 20081.
Investor: What if it is different this time and my investments go to zero?
Investment Manager: You own a diversified portfolio of funds that invest in thousands of large companies worldwide. For your account to go to zero, the shares in every single company held in your portfolio would need to go to zero, for example in a Wealthify Confident investment Plan, there are about 14,000 underlying investments held. And this is something that has never happened in the entire history of stock markets.
Investor: What if I sell now, then buy back in when the market is lower?
Investment Manager: That is an option and one many will be trying. We leave trying to pick the bottom or the top of a stock market to the more adventurous investors. History suggests that it is incredibly hard to call the absolute low and high of a stock market move. Investors who try to sell and buy back in lower down may miss out on returns they would have potentially received if they had remained invested. However, it may and will work for some. But that is not something we would do at Wealthify.
Investor: So, what should I do when markets fall?
Investment Manager: It is your decision; everyone’s circumstances are unique. But it’s easy for investors to let their emotions get the better of them when markets are volatile or falling – after all investors are only human. At Wealthify we strip out the emotion and look at the facts coupled with our objectives, that way we can make educated decisions.
This is an example of what a conversation may look like since COVID-19 caused the markets to fall. It may not relate to you, but it does show a fraction of the questions investors are asking themselves and anyone else who will listen! Some people view it as an opportunity, while others are scared of seeing the value of their investments drop any lower.
Perhaps the answer to panic selling is simply support? Knowing that you’re not alone in your thinking but being given more information about the markets and their impact. And that’s what we aim to deliver at Wealthify. So, if you’re concerned about your investments or want to know more about your Plan, just let us know and we’ll do what we can to help.
1: Data from Bloomberg
Past performance is not a reliable indicator for future results.
Please remember the value of your investments can go down as well as up, and you could get back less than invested.