One of the fascinating things about behavioural finance is that its findings are often the opposite of what we would expect. A new study on which investors are most likely to freak out when stock markets tumble is a perfect example. You’d think that members of the clergy, business owners and company executives would be less likely to panic, but apparently the opposite is true. LARRY SWEDROE has the details.
Behavioural finance has documented a wide range of mistakes individual investors make that are caused by biases such as loss aversion, recency and overconfidence. My book, Investment Mistakes Even Smart People Make and How to Avoid Them, documented 77 mistakes individual investors make, many with behavioural causes and others due to lack of knowledge. One of the most common is that despite standard investment advice to the contrary, individuals often engage in panic selling, liquidating significant portions of their risky assets in response to large losses.
Daniel Elkind, Kathryn Kaminski, Andrew Lo, Kien Wei Siah and Chi Heem Wong contribute to the behavioural finance literature with their August 2021 study, When Do Investors Freak Out? Machine Learning Predictions of Panic Selling. They analyzed the investment activity of 653,455 individual brokerage accounts belonging to 298,556 households spanning the period 2003-2015. They defined “freaking out” as occurring after a portfolio value decline of 90 percent in one month and the investor selling half of the portfolio within that month. They defined re-entering the market as occurring when the portfolio recovered to 50 percent of its pre-liquidation value and the investor buys at least half of what was previously sold. Following is a summary of their findings:
- There were 36,374 panic sells by 26,852 household investors (9 percent of all households) across a period of 13 years between January 2003 and December 2015.
- While panic sales are infrequent, with only 0.1 percent of the investors panic selling at any point in time, they occur at up to three times the baseline frequency when there are large negative market movements — a disproportionate number of households make panic sales when there are sharp market downturns, the phenomenon of freaking out.
- Of households with at least one panic-selling event, 21,706 of them (81 percent) did so once within the sample period, while 3,081 (11 percent) did so twice.
- 31 percent of the investors who panic sold never returned to reinvest in risky assets. However, of those that did buy stocks again, 59 percent reentered the market within five months and another 13 percent returned within ten months.
- Investors who are male, or above the age of 45, or married, or have more dependents, or who self-identify as having excellent investment experience or knowledge tended to freak out with greater frequency.
- The occupational groups with the three highest risks of panic selling were self-employed, owners and real estate.
- Lowering the triggers for freaking out (they tested 50 percent and 25 percent drops in the value of a portfolio) increased the number of panic sales identified but did not change the general pattern exhibited by household investors.
Elkind, Kaminski, Lo, Siah and Wong also found that the median investor earned a zero to negative return after freaking out because while freaking out does protect investors during a crisis, such investors often wait too long to reinvest, causing them to miss out on significant profits when markets rebound. For example, an investor who liquidated at the start of the Great Financial Crisis and held out for more than 34 months after liquidation would have missed the post-2009 market rally and forgone potential profits. The bottom line is that freaking out is suboptimal behaviour. Of particular interest was that investors who identified themselves as having excellent investment experience freaked out more than twice as often as those who identified as having no experience — demonstrating that overconfidence is an all-too-human trait.
Elkind, Kaminski, Lo, Siah and Wong also used logistic regression and deep neural network techniques to develop machine learning models to predict when investors might panic sell in the near future. Their set of predictive features included the demographic characteristics of the investor, their portfolio histories, and current and past market conditions. Their best-performing deep neural network achieved a 70 percent true positive accuracy rate and an 81 percent true negative accuracy rate, “demonstrating that artificial intelligence techniques can assist in identifying individuals at risk of panic selling in the near future.” Among the most important predictive variables were:
- Being young or elderly decreased the risk of panic selling, as did being disabled or a minor.
- Declaring oneself a member of the clergy, an owner or an executive increased the likelihood of panic selling, as did having self-declared excellent investment experience.
- The likelihood of a panic sale increases with the percentage of daily trades made by the investor.
- An investor will be more likely to panic sell if options compose a larger proportion of the entire portfolio.
Elkind, Kaminski, Lo, Siah and Wong demonstrated that panic selling and freaking out are distinct behavioural patterns in finance that differ from other previously studied patterns. For example, in contrast to overtrading, investors who made panic sales did so infrequently. It would be interesting if the authors had been able to determine if there was a different rate of freaking out among investors with a written investment policy statement and those without such a statement that included recognition of the risks of severe bear markets and a policy that required rebalancing during such periods.
The takeaway for investors is to make sure you have a written plan that accepts the virtual inevitability of severe market declines and defines the actions you commit to take when they occur (such as rebalancing and tax loss harvesting). The evidence also provides a warning to make sure you stress test yourself and your ability to avoid panicked selling, as the findings make clear that overconfidence increases the risk of freaking out.
Important Disclosure: The information presented here is for educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is based upon third party data which may become outdated or otherwise superseded without notice. Third party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party websites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them. The opinions expressed by featured author are their own and may not accurately reflect those of Buckingham Strategic Wealth® or Buckingham Strategic Partners®, collectively Buckingham Wealth Partners. LSR-21-143
LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.
ALSO BY LARRY SWEDROE
PREVIOUSLY ON TEBI
CONTENT FOR ADVICE FIRMS
Through our partners at Regis Media, TEBI provides a wide range of high-quality content for financial advice and planning firms. The material is designed to help educate clients and to engage with prospects.
As well as exclusive content, we also offer pre-produced videos, eGuides and articles which explain how investing works and the valuable role that a good financial adviser can play.
© The Evidence-Based Investor MMXXI