What 2020 Can Teach Us About the Perils of Panic Selling

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If you take away one key lesson from the Covid-19 pandemic it should be the fact that humans lose all capability of rational thought in a state of panic. The shortages of toilet paper in the US at the height of the pandemic fear is probably the best example of this phenomena. Humans tend to panic when the prefrontal cortex, the rational part of your brain, gets overwhelmed with emotions.  Our brains essentially prime us for fight, flight or freeze. Although this response may have helped our ancestors survive thousands of years ago, in today’s world it will definitely cause poor investment results. Panic selling is basically taking a significant portion of your equity portfolio and going to cash without regard for the quality, valuation or long-term prospects of your holdings. The hoarding of toilet paper doesn’t have many significant ramifications for your life or retirement. However, panic selling in your retirement portfolio could result in a significant delay in your retirement date and the quality of life you experience.

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Why Panic Selling Should be Avoided at All Costs

2020 was instructive year for investors globally. On December 31, 2019 the S&P500 stood at 3,230.78. The market crashed by 34% from a new all time high on February 19, 2020 to the pandemic low on March 23, 2020. That brief period of 33 days is considered the steepest decline in the market’s history. On many occasions investors are their own worst enemy. I fully contend that investor behavior has a greater material impact on actual long-term returns than portfolio construction or even asset allocation. There is no point to be heavily allocated to equities and then to sell in a panic at the first sign of economic trouble. By the end of 2020, the S&P500 ended the year up 16.3%. Clearly, nobody could’ve forecasted such a quick recovery but the key lesson is that selling after such a rapid decline is rarely the right answer. In most instances, the damage has already been done to your portfolio. Ultimately, the economy and stock market will recover. I speak from personal experience after having lived through both the dotcom crash of 2000 and the great financial crisis of 2008, that eventually the economy starts growing again no matter how bleak it may seem at the bottom of the recession.

If you’re sufficiently diversified, your portfolio will also most likely recover. If you own high quality blue chip stocks, like the ones we own in the Ashva Capital portfolio, the value of your portfolio will not only recover but likely go on to new highs. Volatility in the equity market is normal. Even the notional losses that your portfolio experiences during corrections, will eventually reverse if you don’t sell. The problem with panic selling is that you essentially crystallize the losses in your portfolio. You may have successfully stopped the bleeding, but you’ll never participate in the recovery.

If You Sell, When Do You Get Back In

The other problem that panic selling creates is what to do with your funds once you’ve sold. Naturally, most investors would choose to park their money in some form of fixed income security. However, the vast majority of investors haven’t really thought through when they will get back into the market. If the market declines another 10% would you be ready to dip your toes in the water? Or if the market rebounds sharply, few investors would be likely to invest so soon after liquidating their portfolios. Thus, most investors will simply freeze and not be able to pursue any kind of constructive behavior. By the time they feel comfortable, the market will have likely rallied hard off the bottom and be significantly higher from the point they sold. Most investors are reacting purely emotionally when they panic sell and thus don’t have a set of defined rules that will dictate how they reenter the market.  The delay in getting back into the market will in most instances be fatal for their retirement goals. They will either have to end up saving more or delaying retirement and most likely have to do both.

By going to cash an investor commits two market timing mistakes. The first mistake is selling at or near the bottom. The second and far bigger mistake is failing to reenter the market in a timely manner. In all likelihood, the investor will wait too long and miss the majority of the market recovery. The problem is that by selling you may save a few percentage point of losses in your portfolio but you’ll definitely miss the gains from any rebound. Naturally, you may think to yourself that this time is different. But my own personal experience is that ultimately the market will rebound and go on to make new highs. Jeremy Siegel in his excellent book, Stocks for the Long Run, has calculated that return on equities has been approximately 10% for close to a 100 years. The history of the US equity market should give you faith that the long-term trend will resume after the bear market ends.

What Lessons Should We Learn From Panic Selling

I think the biggest lesson that we should learn from panic selling is that you must have a plan. You may not follow it completely in the throes of fear but there is a zero percent chance you avoid panicking without one. The best solution that I’ve seen for any investor to avoid panic selling is to have at least one year’s worth of expenses in cash. Whether we get a repeat of the 2007 to 2009 bear market or a garden variety correction, knowing that you’ve got enough money in the bank to cover you and your family for at least a year will significantly reduce your chances of panicking. You must also maintain a long-term perspective in relation to the economic history of the US. Post World War II the economic expansions have become longer and the recessions relatively short and brief. If you can maintain composure through the downturn, your portfolio will likely recover and continue growing even before the recovery begins in earnest. The reality is that you don’t go to cash to earn a return, you go to cash to prevent further losses. All investors much eventually get back into equities if they have any hope of meeting their long-term retirement goals. Naturally, you must ask yourself the question did investors accomplish anything by going to cash? If you’re honest, the only correct answer is that panic selling and going to cash can only be detrimental to your retirement portfolio and retirement goals in the long-term. It’s difficult to remain rational when you see a large portion of your retirement portfolio drown in a sea of red, but taking a long-term perspective and maintaining a large cash reserve should be enough to keep you from panicking. You’ll still feel the fear but at least you won’t act on it.

Article by Ankur Shah, Ashva Capital