Does a Financial Crisis Really Affect Market Behaviour?

Do you remember the financial crisis of 2008 and the great recession that followed it? The aftermath of this crisis is still fresh in the minds of investors, especially those who saw their portfolios fall by over 30%. On 21st January, 2008, the Bombay Stock Exchange witnessed one of the largest drops in value and biggest erosion in investor health where the BSE fell by 1408 points, closing at 17605.

2016 also marked a decline in the performance of the stock market in India with BSE losing 1607 points in just 4 consecutive days in the month of February. It is shocking to know that by 16th February, 2016, the BSE had seen a drop of over 26% in the previous 11 months. What brought about this fall? Global weaknesses, global factors, and NPAs of Indian Banks had been the major reasons behind the crash.

November 9, 2016 witnessed the BSE crashing by 1689 points which was believed to have been brought about by the actions of the government against black money (eventually leading to frantic selling). During this phase, Nifty dropped by 541 points to a bearish condition of 8002 points.

From the situations explained above, it is evident that external factors, financial crisis and geopolitical sentiments have the power to bring about high volatility in the stock market. The behavioural trend in almost all the crashes that have occurred, indicate a frantic response to the various stimuli. However, smart investors and traders are able to ride the waves and adopt a high-risk, high-reward strategy.

What is a Financial Crisis?

By definition, a financial crisis is often associated with a panic situation where investors sell their assets or gather their funds as a result of a fear of the value of the assets dropping considerably. A financial crisis may be caused due to multiple causes. A crisis may arise generally of the assets or the financial institutions are overestimated, and these can be aggravated by the irrational behaviour of investors.

Factors Contributing To A Financial Crisis

The factors that contribute to a financial crisis are systemic failures, uncontrollable human behaviour which has been unanticipated, incentives for taking too much of risk or regulatory failures. If these are left unchecked, a crisis can cause an economy to enter into an economic depression or in simple terms recession. Even after taking appropriate measures to avoid financial crisis, they can still happen, accelerate, or worsen.

Instead of acting rationally during severe crisis in the markets, people tend to exaggerate and make matters worse. However, while many people get terrified or were compelled to sell assets at lower prices, a small group of patient and meticulous investors felt that the fall in the stock market as an opportunity for investment.

Investing during the crisis is undoubtedly risky, for the timeline and the chance of recovery is uncertain. Still, the investors who take the risk to invest during the crisis without capitulating to illogical fear and nervousness may reap enormous returns in the course of a revival.

Financial Crisis in the Context of Behavioural Finance

Investors generally do not behave as predicted by traditional financial theory, in which everyone behaves rationally to maximize utility. It is seen that when people behave illogically, they let the emotions come in their way especially when the economy is in some chaotic situation.

The emerging field of behavioural finance attempts to describe how people behave versus how financial theory predicts they should. Behavioural finance shows that people, rather than being merely risk-averse, are more loss-averse. This means that the emotional pain they experience is much more that the happiness they gain when they get a similar amount of profit.

Taking Advantage of a Financial Crisis

While most investors panic while asset prices plummet, those with a cool head can see the resulting low prices as a buying opportunity. Buying the assets from people experiencing emotional instability is like buying the assets at much lesser price. Due to the fear of losing the value of the asset, people tend to sell it at any given price which is as per their expected level in the times of financial crisis. If one plans to make profit during this crisis, it is absolutely important to have adequate patience, discipline, and funds.

When catastrophe hits, fear becomes the dominant emotion and stocks are penalized accordingly. But historically, when the crisis gets sorted, confidence returns and prices rebound to where they were, with markets retorting once more to underlying indicators rather than to apparent turbulence. The foresight of the market can help one to plan strategies so that he can make profit out of the falling market as well. Timing is obviously the main turning point in this situation. Buying, selling or holding assets at the right time leads to the maximum profit earning even during the crisis market.

Never Assume, Always Lay Your Trust On Backtested Data

A financial crisis is not a one-time event. Such events have occurred (and will continue to occur) globally. While there is nothing much one can do to avoid the crisis, we can always be prepared for it. A good way to start preparing is to consult with an investment advisor, especially when you feel that your emotions are getting the best of you. You can also analyse backtested data and check the trends as well as the aftermath of previous crises to understand the dynamics of such an event and the ways in which one can avoid falling into the emotional trap.

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