Why do Average Investors Panic in a Market Downturn??
The title of this piece is not a facetious question. We truly do not understand why mature, average investors panic and make such horrible decisions in market downturns.
The above is one of our favorite charts from Doug Short over at Advisor Perspectives. We referenced his charts consistently during and in the period after the Great Recession.
In this piece we are talking about investing not trading. Investing is a long term approach that seeks returns in excess of those one can get in the bank. Trading is the pursuit of short term gains. Trading is synonymous with gambling. This piece is not about traders. It is intended for those who are investing long term goals like retirement, college, or creating a legacy.
The inherent nature of investing, one of its most basic rules, is that investing involves risk. No place you put your money is risk free. Buy stocks and your risk is the loss of principle. Put your money in the bank and your risk is rising inflation results in your money being able to buy fewer goods in the future.
A proper investment portfolio, like the ones our clients have, is well diversified. Why are we such big proponents of diversification? Because it reduces the severity of losses in down markets. Well diversified portfolios also tend to recover from down markets faster than the general stock market indexes. Why is that? Because a well diversified portfolio should not drop as much as a non-diversified portfolio that holds only stocks. Don’t fall as far down the mountain and it isn’t such a long climb back.
Now here’s the real rub at the heart of the title of this piece. Market downturns are common! They happen with regularity. Look at the first chart again. It makes special note of every drop in the SP 500 since the market high of 10-9-2007. There are 12 instances on the chart ranging from 5.76% to 56.78%. Go back further in time and you will see the same pattern. Here is the other chart we love to share. It is from JP Morgan’s Guide to the Market.
This chart goes back to 1980. From 1980-2020 there were only 2 years when the SP 500 did not experience at least a 5% drop. The average drop during a year was almost 14%. Yet, in 30 of those 40 years, the annual return was positive.
According to Yahoo Finance, the SP 500 closed at about 108 on December 31, 1980, it hit a high of 3386 on 2-18-2020 and closed at 2954 on 2-28-2020. It doesn’t take much imagination to understand the future gains that were lost to average investors who panicked and sold during any one of those downturns in the SP 500.
Both charts drive home the point that drops in the SP 500 are common and happen with regularity. Both charts also drive home the point that long term investors need to stay invested. That old state lottery slogan of “you have to play to win” holds true with investing…with one major exception. Your odds of success could be much better with a well diversified portfolio than with a lottery ticket!
So that brings us back to the title of the piece with an embellishment: Why do average investors panic in a market downturn and make such horrible decisions, when they should know that market downturns are commonplace events?
The answer is they fall prey to their emotions. They fall prey to the hype on TV because they rely on the cable news channels, people like Jim Cramer or some internet based newsletter/chatter room for information.
This is a crucial point: None of those sources of information have a duty to look out for the interest of the investor. Their only duties are to themselves and their employer. They have a duty to make sure you stay tuned in thru the commercials, buy their next book or renew your subscription to their website or newsletter.
Our responsibility is to put your interest ahead of our own.
Average investors have no one to turn to offer a calming voice of reason. No one to explain to them that “this too shall pass”. To tell them to turn off the TV and go do something fun. Go see the grandkids, take your honey out for dinner, go for a walk in the sun, or pursue some “retail therapy”. To explain that the worst decisions we can make are emotional. To explain that drops in the stock market are commonplace.
More specifically, most average investors are not working with seasoned, experienced and educated financial advisors who are duty bound to put your interests ahead of our own.
Therefore, the moral of this story, just like it always is (you get bored hearing this don’t you?!) don’t panic, this too shall pass. If the cable channels, the talking heads or the internet chatter rooms start making you nervous, just pick up the phone or shoot us an email.
PS: We can’t end this without telling you how proud we are of our clients!! Thru Friday 2-28-2020, we received a total of 3 calls about the recent market turbulence. One client did exactly what we advise. The TV was stressing her, so she called. We had a nice chat and she felt better afterwards.
The other two calls were from clients who understand that downturns present opportunities! They called to inquire about adding money to their accounts. They are putting the lessons of the past and the thoughts we have shared in years of special notices like this one into action. Or as Warren Buffet so eloquently stated:
“Be Fearful When Others Are Greedy and Greedy When Others Are Fearful”
The information contained is derived from sources believed to be accurate. However, we do not guarantee its accuracy. The information contained is for general use and it is not intended to cover all aspects of a particular matter. The views expressed are our own, and do not necessarily represent the views of The Investment Center, Inc. IC Advisory Services, Inc. or any other member of their staff. The information provided is not written or intended as tax or legal advice and may not be relied on for purposes of avoiding any federal tax penalties. Entities or persons distributing this information are not authorized to give tax or legal advice. Individuals are encouraged to seek advice from their own tax or legal counsel.
Past performance does not guarantee future results. Investing involves risk, including risk of loss. Diversification does not ensure a profit or guarantee against a loss. All indices are unmanaged, and performance of the indices includes reinvestment of dividends and interest income and, unless otherwise noted, is not illustrative of any particular investment. An investment cannot be made in any index.