Wednesday, September 24, 2008

Managing Fear: A Primer for Investors

How do we manage our fear in these chaotic markets?

Below I'm reposting some questions from Asa Fitch, a reporter at in Abu Dhabi, followed by my responses.

The first assumption that is good to challenge is: "Is it good to buy on fear, or should we actually be selling on fear?"

>>> What's the prevailing thinking on this?

The truth is that most of the time it is a good decision to buy on fear. But sometimes, such as in the past year, it was bad to buy on fear (especially in financials, since they have dropped 90% since the overall fear level began to increase last year). Buying on fear in Japan for the past 18 years has also been bad.

This is why Warren Buffett has said: "We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful" And as Buffett knows, there is more to it than just the emotion.

In the short-term, it is almost always good to buy on fear. And if you are thinking of selling because you are afraid, wait several days before acting (the price will usually be better then).

As a trader, it is best to buy on decreasing fear. And if you know in advance what events are likely to decrease fear (such as the passage of the U.S. bailout), then it is good to buy on fear there.

So before learning to "stop" fear, we have to be sure that our fear is not justified. Sometimes we should be afraid! (E.g., the financial crisis last August was only the beginning).

>>> Are there psychological strategies investors can use to get past the overwhelming urge to move to cash?

Yes, there are several techniques they can use to manage fear:
1. Externalization -- see the fear around you so that you can distance yourself from your own fear. For example, look at how much fear others are experiencing by looking at the VIX (volatility index) or the MarketPsych Fear Index ( Then recall the Warren Buffett quote above (in 2007 he was the world's richest person, so he clearly knows what he is talking about). This quote "reframes" fear.
2. Reframing -- remember that fear is a buying opportunity. Turn from a "fear frame" to a "opportunity frame." The traditional Chinese character for crisis is comprised of two traditional Chinese characters. The second (bottom) one is "opportunity," and the first (upper) is "danger." [Corrected by Kay McCharles - Thanks!]
3. Fear is an anticipatory emotion -- it is about the future, while panic is in the moment (right now). Someone might be afraid of jumping off a pier into the ocean, but they are still safe. When they are in the water, if they are sinking, then they aren't afraid anymore - they are panicking. So changing perspective to a long-term view can be very helpful. For example, deliberately think of how happy you are in your life/family/overall finances before panicking about one small position in the markets.
4. Fear biologically induces a short-term, minute-by-minute focus of attention. We need to break that and remember the big picture. Think of long term goals, remember the justification for your current trading strategy.
5. If you haven't backtested your investment or trading system over many historical periods and examples, then you should be afraid and should not continue to use it unless you test it during a period similar to the current one -- past crises.
6. Of course, most people are long-term investors, and for them the best antidote to fear is diversification across countries, currencies, and industries. You won't get rich quickly being diversified, but you will better manage risk and volatility.
7. Comparisons -- if you are a long term investor having trouble holding tight, look at how you are performing relative to the worst sectors and funds in the market. It could always be worse.
8. Relaxation techniques -- You can use deep breathing and meditation techniques to learn to let go of the stress inducing emotions.
9. Exercise -- this is perhaps the most important technique for reducing stress and clearing your mind. Be sure to elevate your heart rate and sweat for at least 20 minutes continuously. You are demonstrating to your body (and your mind) that you can control and work through physiological "stress" -- in this case "good stress" induced by exercise.
10. Diet -- eat more whole grains, fresh and steamed vegetables, and cut out refined sugars, fried foods, and creamy desserts. Also consider an Omega-3 supplement (best is filtered fish oil) to take every day.
11. Do one thing you enjoy every day.
12. Dramatically decrease your information consumption. Most people find that they are reading several newspapers and watching many newsfeeds and technical indicators during the market day. Cut down your information consumption to the most essential 3 sources or indicators. This will help clear your mind and reduce confusion.

>>>>> Should you put your foot back in the water slowly to avoid the inherent reluctance to get back in after a big loss?

Yes, but be careful not to invest in the same areas. Many people repeatedly get in and out of the same stocks as they go down. If you sold out of your positions, and want to get back into stocks, then be sure to buy something completely different. let go of the money you lost. If you "play revenge" with the market by trying to prove that you were initially correct, you will continue to lose money.

>>>>>> Should you keep some small portion of your portfolio in cash to satisfy this urge to get out?

Yes, everyone should have some cash in different currencies for investing during crises such as the current one. The cash takes some pressure off and allows us to realize that there are many opportunities in this market. Having cash and not borrowing on margin for investments keeps us from losing everything during times like

I hope that helps!



Kay McCharles said...

If I'm not mistaken, the Chinese character for crisis is made up of TWO traditional Chinese characters. The second is opportunity. The first, however, is danger.

Kay McCharles said...

I loved the primer. I think it needs one slight correction, though. The traditional Chinese character for crisis is comprised of TWO traditional Chinese characters. The second (bottom) one is indeed "opportunity," but the first (upper) is "danger."