One of the best ways to confront our fears is to understand them.
(Basically, we are faced with the following fears: Fear of failure, fear of loss and fear of the unknown.)
In this section, we look at what generally happens in a crisis and some of the questions you should ask when a crisis hits. We will also look back in history and feature some events to draw out important lessons for the future. From this, you can figure out what actions are more likely to be productive and what actions are more likely to be counter-productive.
When a crisis hits
Take 9-11, for example. Now, imagine that it is the day after the destruction of the Twin Towers. Profound shock waves will be felt in New York and beyond, and this will send ripples through to the world economy for some time.
On the morning after, it is near impossible to know exactly how events will play out over the next few weeks or months. But there is a set pattern to how financial markets react to a crisis, historically, and there are a few things worth noting.
Firstly, the inital reaction will be shock. Financial markets hate uncertainty, and nothing creates more uncertainty than a sudden, shattering crisis. The result of the shock is typically a "flight of safety", as investors dump stocks in favour of bonds and cash. Stock prices will, therefore, almost always fall.
At this point, the greatest danger to investors is not shock or that prices are falling, but the urge to panic. When investors panic, they sell at low prices and end up buying back the same stocks later at much higher prices. This knee-jerk effect comes at a high cost for investors, who buy high and sell low.
The second reaction, which usually happens immediately, is increased volatility in the commodity markets. Will the terrorists bomb oilfields and stem supply? Will grain shipments be interrupted? Will demand for gold rise sharply? Uncertainties that affect basic commodities usually cause spasms in the markets.
A third reaction is over-compensation. The first shock wave of selling is often broad and steep. Then, when uncertainty dissipates, investors usually overreact in the opposite direction, sending prices back up to pre-crisis levels.
Things never seem the way they are during a crisis. What you should remember is that the impact of a crisis itself is typically a short-term matter. After a few weeks, calm usually returns. This is not to say that crises are inconsequential or insignificant. The tsunami disascter (26 December 2004) which caused tremendous destruction in Indonesia will require billions of dollars and many years of restoration work. Certain markets may stay depressed for longer.
Historically, what effect a crisis has on the financial markets depends on whether the crisis creates a long-term change in the fundamental nature of an economy. And in most cases (even in the case of the tsunami disaster), the fundamental structures of the affected were not subjected to drastic modifications.
To sum up, the typical pattern following a major crisis is this:
- first, there will be a wave of panic selling when the news breaks.
- Then, there will be a short period of instability,
- followed by an upward sweep once investors realise the crisis itself is not likely to have a long-term effect on the economy.
So, should you find yourself in the midst of a crisis in the future, remember:
- Do not engage in panic selling.
- Sit tight and stick to your strategy.
- If you are a long-term, buy-and-hold investor, do hold on.
- If you are an adventurous investor, follow your strategy to buy on dips.
Make sure your overall portfolio is designed to limit your potential losses during a substantial market decline. This is where you need to invest in many different things.
Ref: Make your Money work for you, by Keon Chee & Ben Fok
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