Emotional Issues During A Market Downturn: How Investors Often Respond To Their Own Detriment

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Includes: DGRO, DGRW, DIVC, JTD, NOBL, PFM, RDVY, REGL, SDY, VIG
by: Henry Nyce

Summary

Four possible ways to deal with this market downturn.

Decisions based upon emotions can destroy the value of your portfolio.

This may the appropriate time to buy instead of selling some stocks that have bottomed out.

One of my friends a few weeks ago said, "Where is the nearest bridge for me to jump off of?" Of course the person was joking, but it was describing the kind of emotions that the current stock market losses are creating among those who are depending on the market to support their retirement income. Warren Buffett once said, "…what you need is the temperament to control the urges that get other people in trouble in investing."

When I look at my own investment losses, I can understand the sentiment expressed by my friend. One of the wonderful things that internet brokers provide is the exact losses or profits one's investments are incurring moment by moment. For example, I purchased 400 shares Wal-Mart Stores, Inc. (NYSE:WMT) last year and my portfolio app shows that I am sitting on a $4140.00 loss. I have 1200 shares of Ford Motor Co. (NYSE:F) and it is currently showing a loss of $2955.00. These numbers can alarm an investor and give him or her nervous indigestion. Furthermore they engender fear and anxiety for the investor with the ensuing concern about what to do next.

A dividend investor looks at these numbers and realizes that dividends of 2 - 4% won't make up these large capital losses. What should one do in view of what has happening and appears to keep on happening? What alternatives does one have in the midst of this?

Here are some of the alternatives with some pros and cons:

1. Sell out and move one's money into a savings account or into treasury bonds so one's remaining capital is insured by the federal government. There are several problems and 1 advantage with this solution:

  • The problems are:
    • One locks in the capital losses one has taken in the market.
    • One receives almost no return from the remaining funds since interest rates continue to be low.
    • One must pay all the fees associated with selling the stocks and bonds in one's portfolio as well as losing any forward dividends.
  • The advantage is:
    • No further deterioration of capital (no further losses)
  • The person who responds this way is self-handicapping because he or she lacks confidence and submits to fear.
    • This is the case where one feels inadequate to make good market decisions and things turn out badly because of emotional decisions.

2. Sell the losers and attempt to find stocks that will go up and make up for the losses. There are several problems and several advantages with this solution:

  • The problems are:
    • One locks-in the capital losses one has incurred from the losing stocks.
    • One incurs selling and buying fees from the brokerage house.
    • One loses whatever dividends one was set to receive from the stocks that are sold
    • One is not guaranteed that the new purchases will go up; some or most may even go down
    • One often does not work through what is going on with the stocks one chooses to sell and buy.
  • The advantages are:
    • One has gotten rid of the losers
    • One may move into stocks that go up and begin to make up for lost ground
  • The overconfident investor often responds in this way.
    • This person is a rapid trader and believes he or she knows more than everyone else.
    • Trading gives one the illusion of control; the more one buys and sells gives one a sense of power and command.

3. Stay the course and keep all the stocks in one's portfolio, both winners and losers. There are several problems and several advantages with this solution:

  • The problems are:
    • Some of the losers are not just going down with the tide, but there are legitimate concerns about the viability of some companies and one could lose everything with these stocks.
    • The losers in one's portfolio can continue to go south and one loses more by holding on.
    • There may be some winners that should be sold which would release funds to buy some good deals in the current bargain basement.
  • The advantages are:
    • One is not incurring any trading fees
    • One will continue to receive the dividends from all the stocks that are still paying dividends
    • Some of your losers have just gone down with the tide and they will once again bounce back up.
  • Brian Bloch calls this the anchoring trap:
    • That is, one has an over-reliance on what one originally thinks. One may be too confident one's stocks are a good bet and sit idly by as some of the companies go out of existence.
  • It could also be the sunk-costs trap:
    • One is protecting previous choices and decisions and has a difficult time accepting that one has made wrong choices.

4. Do a complete review of one's portfolio to consider the potential of each individual issue in spite of one's current losses and/or gains in each.

  • The problems are:
    • Determining which stocks to keep and which ones to sell. It requires time and research.
    • Keeping a proper perspective on each issue after extensive losses in one's portfolio.
  • The advantages are:
    • Cleans out the losers and allows one to reinvest in issues that will perform better.
  • Loss Aversion may become an issue when one does this:
    • Selling winning stocks to cover other stock losses
    • Problem of distinguishing between a bad choice as opposed to a bad outcome: May lead one to sell a strong company when one should buy more.

A few years ago Sean Hannon wrote an article suggesting that investors have 14 emotional stages. While we can't conquer our emotions, understanding them could help our response to them while dealing with market volatility. Here are the 14 stages he presented:

Source: Stocktrader.com

The chart shows that one starts investing with optimism and as stocks go up one gets excited and the thrill and euphoria lead to greater risk taking. Then as the market contracts, optimism turns to anxiety and denial. As the market contracts further denial turns to fear, desperation, panic, and finally to capitulation. Capitulation is where one sells stocks to avoid any future losses. At the points of despondency and depression one is avoiding the market and saying one does not want to buy stocks ever again. This is the point of maximum financial opportunity; that is, the market has bottomed out and is often the ideal time to buy.

Conclusion:

Market downturns are not the times to sell all of one's stocks but rather it's the time to examine each issue in one's portfolio and decide whether the company is worthy of keeping or selling. Currently if a company's fortunes are tied to the commodity markets such oil, gas, copper, and so forth, the capitulation point has probably been breached and if the company can survive the next 12 months, it is probably time to buy rather than sell. This may be the case for BDCs and mortgage REITs as well. This article was written is to help one keep perspective as the value of one's portfolio contracts. If one is holding a strong company and especially if it is paying a reasonable dividend, don't sell because of emotional exhaustion over the price of the issue but rather hold on to all your good stocks and collect your dividends as you await the rebound.

Disclosure: I am/we are long WMT, F.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.