Many investors memories still remember the 2008 financial crisis and the great recession which followed. Individuals saw their portfolios losing 30% or more of their assets.
Older people saw their 401(k) plans to fall, and IRAs fall to rates that undermined their retirement plans.
Instead of behaving rationally on severe bear markets, many people appear to overreact and exacerbate matters.
The COVID-19 pandemic has led to another global market crisis, with many stocks crashing, companies being forced into bankruptcy and record levels of unemployment coming as a result.
Some service companies have been rendered almost useless, including restaurants that can no longer serve customers with everyone locked indoors. On the flip side, many e-commerce sites are booming, depending on the products they sell.
Amazon, for example, are selling in huge numbers. Companies selling items related to the home or garden are also experiencing overwhelming demand. Yet, other product categories such as drones are struggling as people can’t get out and enjoy the great outdoors.
Yet, while many people panicked or were forced to sell assets at low rates, a small group of patients saw the stock market crash as an opportunity for systematic investors.
No question investing in a recession is risky, because the timetable and extent of recovery are unclear at best. Double-dip recessions are a definite possibility, and it is mainly a matter of luck to seek and pick a bottom.
Nevertheless, those investors who can invest in a crisis without succumbing to excessive fear and anxiety will gain outsize returns during recovery.
Why Does a Crisis Impact Investors?
Investors do not necessarily behave as conventional financial theory suggests, in which each person acts rationally to maximize utility.
Instead, people sometimes act irrationally and let emotions get in the way, particularly when they encounter some turmoil in the economy.
The new area of behavioral finance is attempting to understand how people are behaving as opposed to how financial theory suggests that they will.
Behavioral finance shows that people are generally more loss-, rather than merely a risk.
That means people feel far more of the emotional pain of a loss than the enjoyment derived from a benefit of similar size.
Maybe so, but loss-aversion explains the propensity of societies to sell winners too early and hang on to losers for too long; when people are in the green, they behave risk-aversively, but when they are in the red, they are hazard-seeker.
Take a blackjack player at a casino. He will start playing more conservatively when he loses and bet smaller amounts to protect his winnings. However, if the same player is down money, he can take on a lot more risk by doubling or that bets on riskier hands to break even.
Investors do, likewise. Unfortunately, after suffering losses, taking on additional risk appears only to intensify the severity of those losses. Such emotional biases may continue even after a recovery has begun.
In a survey conducted by online broker Capital One Sharebuilder, 93 percent of millennials showed that they are distrustful of the markets and thus less positive about investing.
Even with historically low-interest rates, more than 40 percent of the income of this generation is cash-shaped. Because of the recession, young Americans are not gaining access to the stock and bond markets that helped older generations accumulate wealth.
How to Take Advantage of A Recession
When most investors are panicking as asset prices fall, the resulting low prices can be seen as a buying opportunity for those with a cool head. Buying assets from those fear-driven restless individuals is like buying them out on a sale.
Fear frequently pushes asset prices well below their core or intrinsic values, rewarding cautious investors who allow costs to return to their expected levels. Profiting from investing in a crisis requires discipline, persistence, and of course, a reasonable amount of liquid assets to make opportunistic purchases. Markets expect the worst when calamity hits and stocks are punished accordingly.
Yet generally, when the dust clears up, momentum returns and prices rebound back to where they were, with markets once again responding to fundamental signals rather than expected chaos.
Research undertaken by Ned Davis Research group looked at 28 global conflicts over the last hundred years, from the German occupation of France over World War II to terrorist attacks like those on 9/11.
Markets overreacted and dropped too far each time, only to rebound shortly afterward. Those investors who sold out on fear found themselves having to buy back their investments at higher rates while rewarding cautious investors.
The S&P 500 index dropped more than 4 percent after the Japanese attack on Pearl Harbor and managed to fall another 14 percent over the next few months.
After that, however, and through the war’s end in 1945, the stock market gained, on average, over 25 percent a year. In other geopolitical occurrences, the same trend may be observed.
A wise investor can buy stocks and other properties at bargain rates by accepting the fact that markets appear to over-react.
Right now, despite the Great Recession, the markets are in the midst of a six-year bull market. Many who didn’t panic saw their stock prices not only rebound but also increase their profits, while those who chose or were forced to sell, and waited for the bull market to re-enter in full swing, are still licking their bruises.
In a crisis, capital markets aren’t the only place to invest. The great recession also saw house prices fall as the housing bubble burst.
People who could not afford their foreclosed mortgages anymore and many houses were underwater, the mortgage balance owed to the bank exceeding the property’s equity value.
Homebuyers and those invested in real estate were able to pick up valuable property assets at lower than average prices, allowing them to reap decent returns as the housing market recovered and stabilized.
Likewise, so-called vulture capitalists were also able to benefit from taking over good businesses that were battered by a recession but had good prospects otherwise.
Wagering on a Crisis to Happen
Wagering that one will happen is another way to make money in a crisis. Short selling stocks or futures for short equity indices is one way of profiting from a market.
A short seller borrows shares they don’t own once to sell and then repurchase them at a lower price. Another way to monetize a down- is to use strategies of options, such as purchasing puts that gain value when the market falls, or selling call options that expire for zero if they expire from the capital.
Different techniques can be seen in bond markets and commodity markets. However, many investors are constrained by short selling or do not have access to the derivative markets.
We might also have an emotional or cognitive prejudice toward short sales if they do. If prices rise instead of dropping and margin calls are released, short-sellers will be forced to cover their positions for a loss.
Today, some ETFs give the investor short exposure to longs (holders of the ETF shares). So-called inverse ETFs will aim at returning + 1 percent of the underlying index returns for every negative 1 percent. Many reverse ETFs can also use gearing or leverage, returning + 2%, or even + 3% for each 1% loss in the underlying.
The ownership of a well-diversified portfolio, including positions in asset classes with low correlations, will help soften the blow for those individuals looking only to shield themselves from a crisis and not necessarily bet on such an event occurring.
Hedging techniques may also be used by those with exposure to derivatives markets, such as a defensive put or protected call, to reduce the extent of the potential loss.
Sometimes, economic crises happen. Occurring recessions and depressions. Roughly twenty measurable crises existed in the 20th century alone- counting global incidents such as conflicts or terrorist attacks, which have caused stocks to crash abruptly.
Behavioral finance teaches us that people in these situations are susceptible to fear, and do not rationally behave as the conventional financial theory predicts.
As a result, those with calm heads, patience, and awareness that traditional markets have always been rebounding from these events will purchase assets at bargain rates and reap excess returns.
Those with the foresight of an imminent crisis can follow short strategies to benefit from a falling market.
Time is everything, of course, and buying too early or too late, or hanging on too long to a short place, will help to compound losses and take away future gains.