Navigating through crisis situations by employing a strategy that offers high rewards but also comes with substantial risks – that’s the essence of this investment approach.
The financial turmoil of 2008 and the subsequent Great Recession remain vivid in the minds of many investors. Portfolios plummeted by over 30%, and retirement savings for older workers, housed in 401(k) plans and IRAs, were at risk. Instead of staying calm in severe bear markets, individuals often react impulsively, exacerbating the situation. Nevertheless, amidst the panic and compelled selling at rock-bottom prices, a select group of patient investors seized the stock market downturn as a lucrative opportunity.
Investing during a crisis undeniably carries risks, as the timing and extent of a recovery are uncertain. Double-dip recessions loom as a tangible threat, and attempting to time the market bottom is mainly a gamble. Nonetheless, investors who navigate a crisis without succumbing to unfounded fears and anxiety could potentially yield significant returns as the market rebounds.
How Crises Impact Investors
Contrary to traditional financial theory that assumes rational decision-making to maximize utility, investors often behave irrationally, letting emotions cloud judgment—especially in times of economic turbulence. Behavioral finance aims to explain the disparity between conceptual financial behavior and actual human behavior.
Behavioral finance reveals that people are more concerned about avoiding losses than seeking gains—a phenomenon known as loss aversion. This bias leads individuals to feel the sting of a loss more acutely than the joy of a gain, resulting in premature selling of winning assets and holding onto losing investments for too long.
These emotional biases can linger even after a market recovery commences, deterring investors from re-entering the market. For instance, post the brief Covid-induced downturn in 2022, BlackRock surveyed 1,000 individuals, with 45% of millennials indicating increased equity exposure and 49% planning further additions within six months of the survey.
Taking Advantage of a Crisis
While most investors panic amidst plunging asset values, those able to maintain composure view the reduced prices as an opportunity to buy. Acquiring assets from fear-driven sellers is akin to purchasing during a sale. Fear often drives prices well below their intrinsic values, rewarding patient investors as prices revert to expected levels. Success in crisis investing hinges on discipline, patience, and sufficient liquid assets to exploit purchase opportunities.
In times of calamity, market pessimism reigns, causing stocks to plummet. However, historical data shows that optimism eventually returns, leading prices to rebound. Markets tend to overreact, allowing astute investors to grab assets at discounted prices.
Real estate investments, aside from stocks, can flourish during crises too. The Great Recession saw a housing market crash, offering opportunities for acquiring undervalued properties. Investors in resilient real assets reaped rewards as the housing market stabilized and recovered.
Betting on a Crisis
Another approach to capitalizing on a crisis is by predicting and profiting from it. Short-selling stocks or equity index futures provides a means to gain from a bear market. Short sellers borrow shares to sell with the intention of buying them back at a lower price later. Option strategies, such as purchasing puts or selling calls, offer additional avenues for profit as markets decline.
However, not all investors have the capacity or inclination for short selling or derivative trading. ETFs now offer long exposure to markets with inverse ETFs providing short exposure. Hedging strategies, like protective puts or covered calls, can safeguard portfolios, particularly for those anticipating market downturns.
Where to Invest in a Crisis
To navigate a crisis successfully, evaluate investments’ fundamentals, including company financials and business models, to gauge their resilience and adaptability during turbulent times.
How to Make Money in a Crisis
To profit during market declines, consider employing short-selling strategies when prices fall.
What Stocks to Buy During a Crash
Identify companies with robust fundamentals, strong management, and a history of weathering crises to pinpoint stocks likely to survive and thrive post a market crash.
The Bottom Line
Economic crises, recessions, and even depressions are inevitable throughout history. Behavioral finance underscores the tendency for panic in tumultuous times, diverging from traditional financial expectations. Investors equipped with calmness, discipline, and historical market resilience knowledge stand to seize undervalued assets and generate exceptional returns.
Those foreseeing a crisis can leverage short strategies to benefit from a declining market. However, timing plays a crucial role—mistimed actions can compound losses and obliterate potential gains.
