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Panic Rarely Pays

The unwinding of a bubble is a long, drawn-out, often torturous process. The drama is extensive because it takes time and evidence to convince all the classes of investors that the run-up in prices was not founded in reality. This unwinding is not over until the hard-core true believers capitulate. People never like to admit that they were wrong, and the deflation of a bubble is a most extreme example.

While there may be periods of panic in the bubble deflation process, panic is a very different beast. Panic is, by definition, a sudden, uncontrollable fear among a group of people that induces hasty or irrational actions.

 Three important points arise from this definition. The first is that it is sudden. Panics are driven by events that seem to come out of left field. Second, panics generate fear, fear of the unknown. Third, they affect a large group of people, the proverbial herd, and anyone familiar with herd behavior will tell you that it is impossible to predict the actions of a herd.

There is never a good time for disaster to strike. Whether that disaster is natural, such as a 9.0 Richter scale earthquake in Japan, man-made like a terrorist attack, or some combination thereof like a plane crash, disasters always seem untimely. The sudden onset of a disaster makes it difficult for market participants to put the event into context. Because these events have their origin outside the financial system, it may take time for investors to get up to speed on the issues involved. This gap in time between an event and the recognition of the likely outcome provides risk-averse investors all the excuse they need to panic.

It should be noted that not every panic starts out with some sort of calamitous event. The financial crisis of 2007–2009 was a prolonged affair with many significant events along the way. The failure of investment banks Bear Stearns and Lehman Brothers are obvious signposts, but there were any number of other events that played a role in the near total collapse of the global financial system. The seeds of that crisis were sown years, if not decades, earlier.

In the financial crisis, the gap between what was known and unknown was especially acute and played out over a long period of time for the markets. Few outside of the halls of power really knew how bad things were, how bad they could have gotten, and what steps needed to be taken to shore up the system. We are only now learning, three years later, the full extent of support the Federal Reserve provided to banks during the acute phase of the crisis.

 We humans fear the unknown. These information gaps force investors (and the media) to try and come up with explanations for the current goings-on even if they have to make things up. Our need for a sense of control forces us to grab at whatever plausible story presents itself.

A panic isn't recognized as such without mass participation. One person's panic attack isn't newsworthy; a society's collective panic attack is worth noting. The same could be said for an event's impact on the markets. To induce a significant market downturn, there has to be fear, fear of loss. In theory you could have a panic to the upside, but it would play on different psychological effects and biases.

Markets decline precipitously and suddenly because investors who would normally step up to buy an undervalued security recognize that when a market falls, there is no indication where it might eventually bottom out. Mebane Faber writes, “The difficulty with investing during drawdowns is that they can always get worse.”

 The ultimate fear of investors is that a security is going to go to zero. We have already mentioned the case of Enron, a once admired company that quickly went bankrupt. These cases of companies that eventually go to zero are highly salient to investors.

The other reason why investors are so wary of drawdowns — or more simply put, losses — is that they are difficult to make up. A 10% decline in a stock's price requires an 11% increase to return to break even. A 50% decline requires a 100% return to break even. The math of losses is unforgiving, especially for the large losses associated with periods of panic and disaster.

A recent paper that examined how markets react to aviation disasters helps show just how panicky a market can get. Kaplanski and Levy find that markets will price in losses an order of magnitude larger than the actual economic losses.

 Investors who panic and sell will generate losses that are offset by the brave (or foolhardy) who are willing to take the other side of the trade. In the case of aviation disasters, markets eventually bounce back, but the earlier panics do leave a residue of higher risk estimates.

Ultimately this discussion of panics is one about risk, or more accurately the misestimation of risk. These errors in risk estimation play out in three dimensions. The first is at the macro level. We all recognize that there is always a chance of natural and human-caused disasters. No matter what the cause, they are always shocking when they occur. This shock is because we have collectively misestimated the probability and/or the consequence of an event.

By extension, we misestimate the effect of these rare events on specific assets and our portfolio as a whole. In short, we have

 underestimated the risk, however temporary, of just such an event. Panic is induced because a stock falls farther and faster than we ever thought possible. An unmitigated fall in stock prices is often driven by sellers who must sell — in short they must sell at any price. Price-sensitive investors witnessing seemingly endless and relentless selling by the likes of margin clerks can easily get discouraged. This disconnect between expectation and reality makes hasty actions all the more likely.

Last, sudden events cause us to reexamine our own tolerance for risk. Many advisors use surveys to sort investors based on their tolerance toward risk. But no survey is able to accurately capture the emotional trauma of real-world events in real time. We don't make investing decisions using questionnaires; instead those decisions happen under pressure in real time.

Panic is an irrational act, and irrational acts rarely pay off. Panic, or at least hasty selling, is sometimes appropriate in the markets. Anything you can get for a stock that is headed for zero is a good sale. As well, if you have dramatically misestimated the risk of a stock, or your own tolerance for risk, then selling, however rushed, may make perfect sense. In other cases, selling into a panic is simply the result of our base instincts coming to the fore. A desire for control and safety takes over, and we take action, however ill advised, because in the moment it makes us feel better. Anyone interested in tranquillity should not be messing about in the financial markets in the first place.

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