Uncertainty And Panic

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You’ve no doubt recognised that human psychology is a dominating factor when it comes to a company’s share price and the market in general. Key to this, of course, is both our own and the collective participants’ confidence in that market and our desire that stocks will always go up in price.

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Unfortunately you don't have to scratch too deeply into history to see the effect on individual stocks, sectors and the market when that confidence is shaken. At those times, stock prices plummet and we are surrounded by uncertainty. And as naturally as you expect the sun to rise in the east each day, panic follows closely on its heels.

People prefer certainty. Certainty comes when Mr Market is playing ball, the market indices are invariably gaining in value, and our share portfolios are producing great returns. The longer this happens, the greater our certainty will be that it will continue. People feel comfortable, assured, confident in their beliefs that things are going according to plan. It is in these times that people also often delude themselves into thinking they are great investors. "Look at my returns! They speak for themselves!"

Reality often bites hard, however, when Mr Market decides, for whatever reason to stop playing ball. In these situations, those same people have their confidence shaken; uncertainty reigns and many will find it hard to see a way out of the mess. It is quite often that in their desperation they will look to others to see what they are doing, and end up invariably following the crowd. Unfortunately, most of that same group of people are panicking themselves. It only takes one stone to start an avalanche, and the sad fact of the matter is that the crowd doesn't necessarily know any better. 

“In general, when we are unsure of ourselves, when the situation is unclear or ambiguous, when uncertainty reigns, we are most likely to look to and accept the actions of others as correct” Robert Cialdini

“Psychologists have demonstrated that the vaguer and more complex a situation, the more we rely on other people, both for clarification and as touchstones for our own views.  This helps us reduce our uncertainty toward our own beliefs”  David Dreman

“When people are free to do as they please they usually imitate each other.  We are social animals, influenced by what we see other people doing and believing.  We believe others know more than we do. .. We avoid what others avoid.  We imitate without thinking. Especially when many or similar people do it, when we are uncertain, in an unfamiliar environment, in a crowd, lack knowledge, or if we suffer from stress or low self-esteem” Peter Bevelin

"Man is extremely uncomfortable with uncertainty. To deal with his discomfort, man tends to create a false sense of security by substituting certainty for uncertainty. It becomes the herd instinct" Bennett Goodspeed

It is in our very nature to follow others and we often do it unconsciously. Have you ever walked past someone, or even a group of people on the street, who are all looking up at something and stopped to look for yourself? Sometimes we don't even stop to think before we imitate others.

“First, we seem to assume that if a lot of people are doing the same thing, they must know something we don’t.  Especially when we are uncertain, we are willing to place an enormous amount of trust in the collective knowledge of the crowd.  Second, quite frequently the crowd is mistaken because they are not acting on the basis of any superior information but are reacting, themselves, to the principle of social proof” Robert Cialdini

It is also human nature to place more weight on stories and anecdotes than statistical data. People's inferences and behaviour are much more influenced by vivid, concrete information, than by pallid and abstract propositions of substantially greater probative and evidential value.

In the book 'Human Inference: Strategies and Shortcomings of Social Judgement', Richard Nesbitt and Lee Ross define vivid information as information that is likely to attract and hold our attention to the extent it is (a) emotionally interesting, (b) concrete and image-provoking, and (c) proximate in a sensory, temporal or spatial way - characteristics that should be familiar to every investor!

The authors note the emotional interest of an event is influenced by the degree to which it affects the participants' needs, desires, motives and values. They conclude that "the most disconcerting implications of the principle that information is weighed in proportion to its vividness is that certain types of highly probative information will have little effect on inferences merely because they are pallid.  Aggregated, statistical, data-summary information is often particularly probative, but it is also likely to lack concreteness and emotional interest." 

Is it any wonder people panic when they read headlines predicting a market crash, they see and hear of other people losing money and selling or they read of a company's recent problems - all without considering the probability that the information has value or the company's problems will be resolved.

“In a crisis, carefully analyse the reasons put forward to support lower stock prices – more often than not they will disintegrate under scrutiny” David Dreman

When people panic, the shares price often becomes the 'news'. Other investors assume those selling know more than they do and decide to sell. A self-reinforcing cycle begins where selling begets more selling.

More often than not however, when everyone is aware of a risk, it is already reflected in the market or stock price.

"As a general observation, markets tend to over-discount the uncertainty related to identified risks. Conversely, markets tend to under-discount risks that have not yet been expressly identified" Jamie Mai

Having a solid understanding of what you own is a strong countervailing force against the crowd. In a market correction, investors who have no clue as to why they own stocks [outside of 'because they have/and will continue to go up'] or what the intrinsic value of the stocks they own are, use price as their guide in decision making.  They have no anchor upon which to assess the correct price for a stock. These investors sell in a non-discriminatory manner with no reference to value.

With the increasing popularity of ETF's and Index Funds it's likely even more investors in the future will be basing their decisions on the movement of 'market prices' as opposed to company fundamentals. If you've bought a biotech ETF for example, and have no idea of its composition or the underlying value of the constituent portfolio, how can you possibly know what the right price is to buy, hold or sell? It's no wonder, the CDO market went 'no bid' at the height of the Global Financial Crisis -  investors had no idea about the worth of the underlying assets sitting in the CDO's, let alone the CDO's squared or cubed!

“One way to think about panic is a general, nonspecific response to a poorly understood particular and specific problem.  As in the fight or flight reflex, sometimes this response is helpful, and sometimes it isn’t.”  Andy Redleaf

“In a situation characterised by uncertainty, said Keynes, our knowledge is based on a 'flimsy foundation' and is 'subject to sudden and violent changes'”  Frank Martin

Panic is provoked by information failure..  Ignorance is the father of panicIgnorance makes for credulous and overconfident buyers on the way up.  But it really takes over on the way down when investors suddenly realize they have not a clue what they ownAndy Redleaf

We all know that the worst times to make decisions are when we are stressed or emotional. Panic and uncertainty are both emotions that will inhibit our ability to rationalise a problem. Those people who say they make great decisions when stressed or otherwise emotional are lacking in fundamental self-awareness. Because people tend to follow others in times of panic, the crowd makes dumb decisions. So they all make dumb decisions. When there is panic and uncertainty in the market, ordinarily it is the time to BUY stocks, not sell them.

“The best bargains arise when there is fear and uncertaintyDavid Marcus

Uncertainty is actually the friend of the buyer of long-term values”  Warren Buffett

“Maximum panic usually coincides with minimum prices” Howard Marks

“To sell in a panic is not a winning strategy"  Francois Rochon

"If you are susceptible to selling everything in a panic, you ought to avoid stocks and stock mutual funds altogether" Peter Lynch

It's important in these situations to remain rational, and to always remember that the crowd is often doing the wrong thing.

“Losing your perspective in the midst of a market panic is equivalent to losing your money in that market” Jim Rogers

“Another valuable investment secret is that the owners of sound securities should never panic and unload their holdings when prices skid. Countless individuals have panicked during slumps, selling out when their stocks fell a few points, only to find that before long the prices were once more rising” J Paul Getty

If you've been part of the panic and sold out of your positions because of it, by the time the uncertainty has been resolved you will have largely missed the opportunity.

“High uncertainty is frequently accompanied by low prices. By the time the uncertainty is resolved, prices are likely to have risen. Investors frequently benefit from making investment decisions with less than perfect knowledge and are well rewarded for bearing the risk of uncertainty. The time other investors spend delving into the last unanswered detail may cost them the chance to buy in at prices so low that they offer a margin of safety despite the incomplete information.” Seth Klarman

“The uncertainty is what creates the opportunity. It’s the fact that nobody knows whats going on.  So our view is things will be fine, it’s going to get a little bit worse but you want to take advantage of that when there is great uncertainty.  Everyone whose nervous wants out so you can take advantage of that fact.” Marc Lasry

"If you wait for problems to disappear before investing in stocks, you'll never commit - or earn - penny" Ralph Wanger

“Political and financial crises lead investors to sell stocks.  This is precisely the wrong reaction.  Buy during a panic, don’t sell”  David Dreman

Markets have a tendency to correct themselves after a panicked situation. At the bottom, 'the bears have no shares'.

“A panic may bring a temporary collapse in the market price of an investment, but the stock is bound to recover if the company meets a genuine need and is under good management”  Bernard Baruch

“Declining stock prices can ultimately cause people to panic and sell.  But the moment they join the panic and sell stock, they also relieve the cause of their fears and become potential buyers.  The act of selling removes the anxiety, restores equanimity, and gives them the cash to buy”  Leon Levy

"Even though bad things happen to companies, industries, even the economy as a whole for a time, somehow society as a whole still moves forward. Problems usually get solved. Recessions end. Somehow the country stumbles on and companies continue to make a profit" Ralph Wanger

Understanding the psychology of crowds can provide an edge by giving you the confidence to step apart from the crowd.

"With a little help from an obscure Frenchman [Gustav Le Bon], years ago I concluded that investment success is more likely to come to those who have some clue about the counter-intuitive way that the thought processes and subsequent behaviors of crowds differ from individuals in isolation.  Individuals who submit to the will of a crowd are effectively hypnotized, and behaviours become emotional, impulsive, and difficult to terminate." Frank Martin

“It is always easiest to run with the herd; at times, it can take a deep reservoir of courage and conviction to stand apart from it.  Yet distancing yourself from the crowd is an essential component of long-term investment success” Seth Klarman

If you have done the work to understand you're own and crowd psychology, understand the companies that you own and their underlying values, you should embrace uncertainty. It is at these times that opportunities present themselves for the long-term investor.

"I came across a quote from Warren Buffett...and he says: 'We pay a high price for certainty.' In other words, when people are confident, asset prices escalate. That's a bad time to invest. The confident times feel like a good time to invest, but people who want to buy bargains should prefer uncertainty." Howard Marks

"You know the prose : "Maintain buying reserves until current uncertainties are resolved," etc.  Before reaching for that crutch, face up to two unpleasant facts: The future is never clear; you pay a very high price for a cheery consensus.  Uncertainty actually is the friend of the buyer of long-term values"  Warren Buffett

“It turns out that I've made some of my best purchases during crises” Francois Rochon

“We have usually made our best purchases when apprehension about some macro event were at a peak.  Fear is the foe of the faddist, but the friend of the fundamentalist”  Warren Buffett

A friend of mine has a saying. "When you're at work, leave your religion, politics and emotions at home. If you're a lawyer, then leave your conscience." Uncertainty, more than anything, creates panic. And following the crowd in a panic is an emotional response. If you know your market and the value of your stocks, then you need not panic and jump on the herd's bandwagon. Opportunity lies within these situations and letting uncertainty and emotions run their course will ensure you miss it every time.

Article by Investment Master Class

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