A panic situation is the most dreaded situation a that an investor must try and avoid. However, it is easier said than done. When we talk about avoiding panic, we must also understand the mechanism of investing. We talk about the business cycles and the market cycle. When we try and understand these cycles, we find out that these cycles come in multitudes. What needs our attention here is not the market cycle, but, the emotional cycle of an investor. We’re humans and of course we have emotions. However, when we talk about trading, it is usually our emotions that cost us. The cycle of emotional investing can be understood herein.
There are psychological stages that an investor experience. Let’s assume that an investor goes long at the beginning of the curve. We can see that the trader starts off with an optimistic view, he/she has a positive outlook towards the market in general. When the market is going up, the optimism changes to a feeling of excitement, he believes that the market is going to remain positive towards his investments. As the market moves upward, his excitement transforms into thrill. He is thrilled about his investment and feels like he has got a great trade now. Now, the stock he has invested in is all over the news. He feels euphoric about his investments. This is the point of maximum financial risk in the cycle. However, since everybody is buying this stock, it reaches a point of saturation.
This is where the market takes a nosedive. Since saturation is prominent in the stock, the market moves against the investor’s wishes. At first, we can say that he is anxious about his trade. However, he believes that this is a short-term effect and that it will be back on the upward trend soon. The market moves against his wishes even further. Now the investor is in denial about the sudden downturn his investment is subjected to. When the market does not bounce back, he starts to fear the market and his investment. Then comes the point of desperation. The investor is in over his head. He cannot understand what to do and moves towards panic.
In the panic zone the investor is emotionally triggered, and his emotions make him want to close a position without regard to the current market price or the market scenario. This is the most vulnerable stage in the cycle. He enters the stage of despondency where he loses all hopes and feels dejected. This results in the investor feeling helpless and in a state of complete panic, shorts his position and exits the trade. At the point of maximum financial opportunity, he cuts his losses and ends his trade.
The trader ends up in this position because he doesn’t have a risk management strategy. Had he planned his strategy with respect to the risk he is willing to trade, he would have placed a stop-loss at a level he could manage. However, since there was no stop-loss, the trader feels that the investment will bounce back and he could always make up for the loss he has already incurred. It is scientifically proven that when you are emotional, a different part of your brain is activated and thus, you no longer think logically.
Understandably, we all panic. However, when certain risk management strategies are in effect, the damage the panic situation creates can be minimized. In high value trades, the smallest of omissions in the risk management strategy can lead to the whole trading account to be wiped off. To many investors, this can mean the loss of their entire capital and a potentially ruining their careers.
Risk management strategies are not rocket science. A good understanding of the market is all that is necessary to employ a risk management principle to the benefit of your investments and overall portfolio. A Certified Investment Advisor can help you assess your individual risk appetite and help you plan your investments so that they are aligned with your long-term financial goals.