Investors’ and market psychology is actually one of the most important things when it comes to investing.
So, understanding investor’s emotions and behavior is definitely a key to be successful in your investing activity.
First, by understanding the psychology behind market fluctuations and start to reason with a broader perspective you can really position yourself in order to take advantage of these dynamics because they create opportunities for long-term investors.
Market Crash Behavior
As we are approaching a period with high uncertainty and rising volatility, we should ask ourselves the following question:
How to Behave in the Current Market Environment and How the Market Is Going to Behave?
While I can’t predict the future, I can tell you that financial markets, like the economy, show defined and specific patterns that repeat over and over again through the years.
Even if everytime is slightly different, you can identify some sort of pattern that is followed by stock market crashes and involves pychology, herd behavior, fear and emotions.
When there is panic, everyone rush to the emergency exit. But if you realize what is going on, you really don’t need to rush and risk your investments.
To give you evidence of what I am talking about, here’s what happened during the 2008–2009 market crash.
How things played out in 2008–2009?
Since the peak in October/November of 2007, the volatility started to increase: you can see swings around 10% for some months with a market that was still strong but very volatile.
This was a period of rising uncertainty, very similar to the period that we are running into nowadays, but there was still some degree of confidence.
Only during the second part of 2008 panic came into play and market psychology showed its effects, along with increased volatility.
Why Didn’t People Sell Before?
Many investors got out of the market between the end of 2008 and the first part of 2009, in the worst moment possible.
Few sold at the beginning of 2008, the majority waited to get out of the market later at a huge loss.
This is the effect of market psychology and loss aversion, that result into emotional patterns that show up in every market crash.
Stage 1: Loss Aversion and Denial
If you have to sell and register a loss, even if it is a very small loss that prevents you to a substantially bigger loss, it is hard for yourself to admit that you were wrong.
In the first part of the crash, when things start to turn around, there is just anxiety but no action.
“Why selling now?”
People convince themselves that it might just be a small correction of the market. So it’s good to wait for it to go a little bit up, at least it is possible to close at break even without losses.
Remember that market prices are the result of the expectation of thousands of single individuals and their sentiment. This sentiment changes dramatically over short periods of time.
When investors start to see that the market correction is taking longer than what they originally thought, doubts start to get serious and confidence goes away.
When you start comparing your perception of things with the reality it might be too late to get out of the market without a loss and hopes for improvements are going away.
This situation typically doesn’t last for a long time, uncertainty is at its maximum and as the sentiment shifts, we enter the second stage.
Stage 2: Fear, Panic and Capitulation
When the market is already down 30% or more people start to seriously worry about what is going to happen next.
“Am I going to lose even more money?”
Once all chances of making a profit are lost, investors become really concerned about saving what’s left.
The sensation of not having any degree of control on the situation, on your investments and on markets, brings to the capitulation.
After reaching their breaking point, people sell their positions at any price to avoid bigger losses.
This is what causes the market to drop 50% during crashes.
It is a self-reinforcing mechanism since the more investors sell, the more prices drop, the more investors rush to sell.
This is the point of maximum financial opportunity if you are willing to enter the market and buy with a significative discount.
What Can You Do?
The very first thing that you can do in order to protect yourself and invest successfully is the following:
Realize That Market Crashes Happen.
It is very easy to extrapolate the bull market trend of the last 9 year and expect that it can last for other 5–10, but it would be very inconsistent with empirical evidence.
This kind of pattern happens over and over again with any kind of financial crash. Being aware of that and recognize what is going on it is very important for two reasons:
- It prevents from making stupid decisions
- It helps you to take advantage of the opportunities
You may well recognize this trend, the key point that really makes the difference is your ability to be brave and take actions upon your analysis.
This is particularly hard because it implies going against the majority, this means that for a certain period of time you get ridiculed and maybe taken as a fool.
Is that easy or not? It depends on you and to what extent you feel comfortable to take actions that, at least in the first period of time, go against the majority (even if later you wish you weren’t part of the majority)
Probably the most important question to protect yourself is:
What am I going to do in case of […] ?
You decide your investing outcomes right now, when you can plan in a rational way, without strong emotions.
At the end of the day, the real key for thriving in a stock market crash is to
KNOW IN ADVANCE WHAT YOU ARE GOING TO DO.
Everything can happen in the markets. Imagine different scenarios and ask the tough questions that make the difference, like:
- What happens to my portfolio if the market crashes?
- If stocks fall 30%? What do I do?
- If interests rates go to 5%?
- And if they go negative?
- How my life would be affected?
Giving yourself an answer to all of this question and plan a strategy to go through those situations is like having an unfair advantage over the majority of market participants.
This article is for informational purposes only, it should not be considered financial advice. You can read the full disclaimer here.