Wednesday, 12 May 2010

The Stock Market "Crashes" (Again) - What to Do?

Last week's stock market declines due to nervousness about the faltering finances and social unrest in Greece prompted news writers to trot out scary words like contagion, default, domino effect, rattled, catastrophe, abyss. Individual investors may feel rising nervousness and worry as to whether another crash as severe as the 2008 sub-prime meltdown is about to unfold. What to do and how to react is the question of the day.

Recognize, Channel and Control Emotions - We humans are not just rational machines. Threats to our well being, financial as well as physical, provoke instinctive fear and flight responses that crowd out our ability to think straight. Step 1 is to be aware of this reality. Markets are not disembodied beings but the collection of humans who trade. Institutional investors are people too and just as prone to emotional reaction. The net result is that markets can get carried away and over-react downwards out of fear. The negative consequences of Greece's problems and possible ricochet effects on other countries may be real, but overdone. Our objective is not to try to ignore our emotional reaction since it will only fester and since it may signal a real threat we should deal with. Our goal is instead to avoid the reactive response - usually to sell in a panic - and to harness our rational self as a second opinion for a considered response.

Control Techniques
  • Develop a written investment policy and plan - having a plan such as described previously in a Written Investment Policy itself provides a psychological barrier to too-quick action. Your plan will, or should, take into account that stock markets are volatile and downturns, often significant, do occur. Explicitly envisage a downturn and think what you will do. Better yet, write down what you will do as that will help cement your commitment to actually follow the plan.
  • Create distance between yourself and the event - Sleep on it, defer a decision till tomorrow, go do something pleasant for a few hours, write down your feelings about the crash. Even something as seemingly silly as pushing yourself physically away from the keyboard apparently helps objectify the market event and allow you to deal with it with a cooler head. Ask yourself what someone else would do, or what you would do if you were managing someone else's investments. A tremendous book that talks about the effect of emotions and such techniques is Jason Zweig's Your Money and Your Brain.
Analyze the Threat - When the emotions have been calmed, it is possible to examine an event like a possible Greek sovereign debt default. Here are some factors to consider:
  • Sovereign debt defaults are nothing new, and seem to happen in cycles, as Carmen Reinhart explains in Eight Hundred Years of Financial Folly at Vox EU.
  • The 1997 Asian Financial Crisis (see summary on Wikipedia) was the last big crisis that caused fears of global financial meltdown. There was contagion to several countries. Though each crisis is unique and Greece could be different, note the size of the stock market "crash" through 1997 and 1998 in this Google Finance chart of the S&P 500. It looks quite small compared to the 2000 tech bubble bursting and the 2008 sub-prime crash.
  • 1998 also witnessed Russia defaulting on its debt and the collapse of gigantic hedge fund LTCM, prompting more concerns of financial meltdown. The lesson is that crises have occurred often in the past and the financial world has not imploded. There are options available and suggestions for arresting the Greek crisis from spreading to Spain, Ireland, Portugal and other highly indebted countries (e.g. Barry Eichengreen's It is not too late for Europe). To anticipate that it will be different this time and that financial Armageddon is nigh, one must almost suppose that public authorities will mess up through wrong actions or inaction.
Look at the Impact from a Portfolio Perspective - Investors who diversify have experienced much less loss because the market drop has primarily affected Europe. For instance, the average return since January 1st of a portfolio with these holdings would see a modest decline:
The market downturn may not be over yet as either the reality of countries' debt problems worsens or a possible market over-reaction runs its course. Nevertheless, managing our own emotions and building better expectations will help us get through this latest market nastiness more successfully.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

1 comment:

Anonymous said...

Envy shoots at others and wounds herself.