Avoiding the Cost of Panic

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Investors lose massive amounts due to panic selling in down markets. More can be done about this perennial problem.

This article identifies one critical action that can be taken to stem panic-driven losses. That action is based on a full understanding of the timing, cause and prudent use of financial instruments that can avoid much of the loss.

To appreciate the solution, it is essential to agree on what the problem really is.

Understanding the problem

Understanding begins with knowing when the losses occur.

More than 70% of losses over the last 35 years originated in 10 very short crisis periods. Those crisis-period losses were then compounded in succeeding years because the loss lowered the investment during the crisis periods.

The timing of losses is evident from the increased withdrawal concurrent with each of these crisis periods, compared to market conditions that followed (measured by the S&P 500). These withdrawal rates all exceed the normal withdrawal rate of 2.70% per month. The normal 2.70% rate is sustainable by market appreciation and additional investments. The average for the crisis periods (5.16%) is not sustainable. The difference (2.46%) is driven by approximately 3.2 million households, or about three of every 100 clients who panic in each crisis.

The 10 periods that comprised the 70% of the losses were:

The historical data favors remaining invested in nine out of 10 cases. The prudent response to those crises was to take no action during the market turmoil. However, a panicked investor is more likely to focus on the exceptions:

  • October 1987: Markets continued to decline after initial loss; and
  • September 2001: Markets had not recovered after a year.

Even in those cases where withdrawal was wise, reentry into the market still carried unknown risks.