What Do People Buy During a Stock Market Panic?

What Do People Buy During a Stock Market Panic? The Wrong Investments

July 05, 2024

It is often said that “fear sells,” this sentiment rings true, especially during a stock market panic. Investor behaviour during market downturns can be intriguing and, at times, baffling. Fear and greed are powerful motivators, and when markets are in freefall, these emotions drive decision-making. This can lead to a rush to offload equities and a search for safe harbours. However, is selling the best strategy, or are there opportunities to be found in the eye of the storm?

Today, we’ll explore investors’ buying behaviour during market panics, the psychology behind it, and potential strategies for navigating turbulent times. We will also examine the concept of contrarian investing and the wisdom of going against the crowd. Finally, we will provide an in-depth analysis of specific investment approaches that can be utilized during these periods.

The Stampede to Sell and Flight to Safety

The instinct to preserve one’s capital during a market downturn is natural. When stock prices are tumbling, it triggers panic, and investors tend to rush towards assets perceived as safe havens. This flight to safety is well-documented, often resulting in a stampede to sell equities.

Traditional Safe Havens:

Gold: One of the most traditional safe-haven assets, gold has long been a go-to investment during economic uncertainty. It is often seen as a store of value and a hedge against inflation and market volatility. For example, during the 2008 financial crisis, gold prices initially surged as investors sought safety, with prices climbing from around $700 per ounce in early 2008 to over $1,200 by the end of 2009.

Silver: Silver often moves in tandem with gold during market panics, although it tends to be more volatile. Its industrial applications can make it a hybrid safe-haven asset influenced by market sentiment and industrial demand.

Government Bonds: Sovereign debt, particularly US Treasury bonds, is considered low-risk. In times of uncertainty, investors seek the safety of government-backed securities, pushing up their prices. For instance, during the 2011 European debt crisis, US Treasury bond yields fell to record lows as investors flocked to their perceived safety.

Alternative Safe Havens

Swiss Franc and Japanese Yen: Certain currencies are also viewed as safe havens. The Swiss franc has long been a favourite due to Switzerland’s stable economy and its reputation as a safe haven for capital. Similarly, the Japanese yen is sought after during risk-off periods due to Japan’s substantial current account surplus and its status as a net creditor nation.

Bitcoin and Cryptocurrencies: In recent years, cryptocurrencies have emerged as a new safe-haven asset. Bitcoin, in particular, has been dubbed “digital gold” by its proponents. During the COVID-19 market crash in March 2020, Bitcoin initially fell in tandem with risk assets but soon recovered and surged to new highs, outperforming traditional safe havens.

The Psychology of Panic Selling

Understanding the psychology behind panic selling is crucial. When markets are in freefall, investors tend to make impulsive decisions driven by a mix of fear and herd mentality. Behavioural economics provides insight into why this happens:

Loss Aversion: People generally feel the pain of losses more acutely than the pleasure of gains. This can lead to a rush to sell equities to prevent further losses, even if it means locking in a loss.

Herd Behavior: Investors often follow the crowd’s actions, assuming others have more information or insight. This can create a self-fulfilling prophecy as more people join the selling frenzy.

Availability Bias: People tend to give more weight to recent, memorable events. During a market panic, negative news and headlines influence investors’ decisions.

Regret Aversion: The fear of missing out (FOMO) reverses during panics. Investors may sell to avoid the potential regret of not having sold at a higher price.

Contrarian View: Buying When Others Are Fearful

Several legendary traders and investors have advocated for a contrarian approach, going against the crowd during the panic. This strategy involves buying when prices are low, and the sentiment is negative and then profiting as the market recovers.

Jacob Fugger (1459-1525): The Italian merchant and banker Jacob Fugger, often considered the father of value investing, understood the power of mass psychology. Fugger would take advantage of market panics to buy assets at distressed prices, knowing that they would recover in value once the panic subsided.

Warren Buffett: Warren Buffett is one of the most famous proponents of contrarian investing. During the 2008 financial crisis, when bank stocks were free, Buffett’s Berkshire Hathaway invested billions in US banks. This move was initially criticized but paid off handsomely as the banks recovered, and Berkshire reaped substantial gains. Buffett is known for his calm and collected approach, often buying when others are fearful and selling when they are greedy.

George Soros: The billionaire investor and philanthropist George Soros is known for his successful bet against the pound in 1992. Soros understands that markets are driven by sentiment and crowd behaviour. He advocates cutting losses quickly when a trade goes against you and reinforcing winning positions. Soros’s approach involves recognizing when market sentiment has reached an extreme and then taking a contrarian view.

Buying Opportunities and Market Dislocations

Market panics can create dislocations and present buying opportunities for savvy investors. During these periods, asset prices can become detached from their fundamental values, creating a potential bargain for those with a long-term perspective.

Equity Bargain Hunting: Equity prices can fall across the board during a market panic, often indiscriminately. This creates an opportunity for investors to buy quality stocks at discounted prices. For example, during the 2008 financial crisis, stocks of fundamentally strong companies were dragged down with the broader market, allowing long-term investors to buy at a discount.

Sector Rotations: Market panics can also trigger sector rotations as specific sectors become oversold while others are considered safer bets. For example, during the COVID-19 market crash, travel and hospitality stocks were hit hard, while technology and healthcare sectors were viewed as more resilient. This allowed investors to rotate into undervalued sectors with strong long-term prospects.

Mergers and Acquisitions: Periods of market turmoil can also present opportunities for corporate consolidation. During the 2001 dot-com bubble burst, many tech startups saw their valuations plummet, making them attractive acquisition targets for larger companies with strong balance sheets.

Hybrid Options Strategy: Selling Puts and Buying Calls

A hybrid options approach is an exciting strategy during a market panic. This involves selling put options on stocks that you would not mind owning while simultaneously using the premium received to purchase call options.

For example, let’s say Stock X is trading at $54 per share, and you are interested in potentially owning the stock but would like to acquire it at a lower price. By selling a put option with a strike price of $50, you can collect a premium, say $6, which gives you a buffer against the stock price falling. If the stock price stays above $50, you keep the premium. If it drops below $50, you will be assigned the stock at the strike price, which is a price you were comfortable with.

Now, let’s take this strategy a step further. Using the $6 premium received from selling the put, you can purchase a call option on the same stock with a strike price of $60. This gives you upside exposure, allowing you to profit if the stock price recovers and surges past $60. Essentially, you have created a risk-defined strategy where you are either assigned the stock at a desired price or profit from a potential rebound, all while generating income from selling the put option.

Tactical Strategies for Navigating Market Panics

There are several tactical strategies that investors can employ during market panics to both protect capital and take advantage of opportunities:

Diversification and Asset Allocation: Maintaining a well-diversified portfolio across various asset classes, sectors, and regions can help smooth out the impact of market downturns. During a panic, reviewing your asset allocation and rebalancing can ensure you are not overexposed to any one area.

Stop Losses and Risk Management: Risk management measures are essential, but a market panic may not be the best time to sell. Setting stop-loss orders can help limit potential losses and provide guidance on when to exit a position.

Dollar-Cost Averaging: Dollar-cost averaging can be effective during a market panic when prices fall. This strategy involves investing a fixed amount at regular intervals, automatically buying more shares when prices are low and fewer when prices are high.

Technical Analysis and Support Levels: Using technical analysis to identify potential support levels can help determine entry points during a market panic. Identifying key support levels where buyers are likely to step in can guide when to buy.

Final Thoughts: Learning from History and Investor Wisdom

Market panics and crashes are inevitable, but they offer opportunities for prepared and level-headed people. By understanding the psychology of investor behaviour during these periods, we can avoid the pitfalls of panic selling and instead focus on strategic buying.

The wisdom of successful investors throughout history underscores the importance of maintaining a long-term perspective and recognizing the value of contrarian investing. By buying when others are fearful, we can benefit from the eventual market recovery.

Additionally, employing tactics such as the hybrid options approach can provide a nuanced way to generate income, acquire stocks at desired prices, and profit from potential rebounds.

In conclusion, market panics can be unnerving but also create opportunities. By learning from history, adopting a disciplined approach, and utilizing the above strategies, investors can navigate through turbulent times and potentially profit from the ensuing market recovery.

Remember, as Warren Buffett famously said, “Be fearful when others are greedy, and greedy when others are fearful.”