Systematizing investment decisions

Panic has proven to have a significant impact on our decision making. The fear of the unknown, and uncertainty of what’s to come, triggers a reaction that in most cases end up unfavorable. The sudden change from the norm causes an overwhelming feeling of fear that needs to be met with strategic behavior control steps. The current pandemic (coronavirus outbreak) reflects on people’s tainted decision-making ability during times of panic and uncertainty; it was seen in both the dramatic shifts in equity and credit markets as well as the ludicrous stockpiling of toilet paper.

Active portfolio monitoring is essential to keep up with the changing tides in financial markets. However, it is also essential that individual investors control the behavioral impulses of emotional buying and selling that may result from the ups and downs of the market. Investors seem to have a knack for piling and selling bottom-up investments, as it is not uncommon to get involved in advertising or media anxiety, buying top-of-the-line investments, and selling in the troughs of the cycle.

How can investors navigate volatile markets while maintaining balance and a diversified portfolio to achieve the best overall returns in all types of market environments? The key is to understand the motivations for emotional investing and avoid euphoric and depressing investment traps that can lead to bad decisions.

The recent volatility explosion analysis often focuses on changes in market structure, liquidity, and leverage from a financial market point of view. However, panic buying and selling is mainly a behavioral phenomenon – what are the leading causes?

Scarcity: Panic buying in most cases result from current or a perceived future lack of a product or service. The case of toilet paper accumulation is a problem caused by the self-sustaining scarcity, the scarcity itself being caused by other people’s perceptions. This type of panic can persist even if no one can remember the original causes. It feeds on itself.

While the scarcity problem with panic buying toilet paper is obvious, it is also evident in the financial markets. Its presence in the financial markets may not necessarily center around the availability of assets and security; it is seen in the ability to execute transactions at a specific price or any price. An assumed or actual restriction in marketability can trigger panic, like the cry of “fire” in a crowded theater. We fear that the exit will not be available to all of us.

Other people: Buying and selling panic is always about how we react to others’ behavior (and how they respond to us).

There are different forms:

The “wisdom” of the crowd: panic can be caused by the assumption that the behavior contains other information. The more people are involved in certain activities, the more we believe that they have knowledge that we don’t have. The problem is that the wisdom of the crowd tends to show up in situations where there is some level of thought and independence in the way the crowd came to the point of view. When panic buying or selling occurs, the opposite is the case. Group behavior is the result of people reacting to the same very limited information or merely following others. The wisdom of the crowd quickly turns to madness.

Thresholds: Similarly, we sometimes act simply because other people are, even if we don’t know what drives the initial behavior. Sociologist Mark Granovetter described a threshold model in which an individual’s decision to participate in activity depends on how many other people do it. Each individual has a different threshold for “mafia” behavior. This threshold is the point at which “the supposed benefit to individuals surpasses the supposed cost.”
Conventional Failure: The perception that our tendency to take the behavior of a massive group is related to some form of cost threshold falls in line with a subconscious decision to fail conventionally. In turn, this also guides the behavior of professional investors. Professional risk management and the desire to protect assets mean that the behavior of others is critical, regardless of whether we agree or understand it. Even if our behavior is extremely irrational from a fundamental investment perspective, it can be very rational for us as individuals. We are less likely to lose our jobs if we do what everyone else does. If you make a mistake, don’t make a mistake yourself.

Eliminate worries: Since panic is the result of fear and anxiety, the resulting measures are usually taken to alleviate them. Our decision-making focuses on one goal: eliminating concerns. The more uncertainty and lack of control, the more we feel the need to act. Panic buying and selling occur when many people share the cause of concern, causing many people to take similar steps. As with the other major causes of panic, these actions reinforce themselves: the desire of others to lessen their own worries serves to create and intensify fear in others.

How can investors easily reduce fear and uncertainty about the financial and economic impact of the coronavirus? Sell risky assets and keep the capital. While this can be a wrong long-term decision, it is offset by a noticeable short-term relief. Even with the confusing accumulation of toilet paper, similar factors play a role. Once we fill the garage with 600 rolls, we no longer need to waste energy to worry about the problem.

Setting time horizons: One of the most important features of stress behavior for investors is the contraction of our time horizons. Amid the panic, our concern is focused solely on what is happening. We cling to today’s fears and give up all thoughts about the future. While this can be seen as an adequate adjustment to achieve our long-term investment goals in certain life situations, such nearsightedness can be surprisingly harmful.

Emotional decision making: Its emotional awareness strongly influences our attitude to a particular risk. How we perceive both the likelihood and the extent of a threat can be dominated by its importance (or availability) and how we feel about it. As Cass Sunstein comments in his work on Neglecting Probability, we tend to ignore the likelihood of this risk occurring and focus on its potential impact (usually the worst-case scenario) when something triggers a strong emotional response. When we make decisions in a state of panic, the risks become about how we feel, and we don’t think.
Panic buying and selling are at the peak of lousy panic based decisions people make in times of stress and uncertainty. It is emotionally charged, short-term oriented, and is determined by the behavior of other people. While it can have adverse long-term damaging consequences for investors, satisfying that decision often offers the irresistible appeal that we immediately feel better and worry less. We must avoid such behavior, but by merely telling ourselves not to absorb the panic-driven decisions of others, we must prevent it by laying down concrete steps.

Here are steps to be taken in order to avoid panic based decision:
1. Have a clear and guided investment plan.
2. Use decision rules
3. Systematize your investment decisions; reevaluate and reinvest.
4. Predicting severe market conditions beforehand
5. Worrying less about your portfolios can help you avoid feeding into the fears that come with the uncertainty of circumstance.

These steps are not a guarantee that we will stay above panic based investment decisions, but they give us a fighting chance.