To Panic, or Not to Panic, That Is the Question

Investing can be challenging, not because the concepts are difficult to master, but because we are emotional creatures.

The markets are merely collections of people who act according to their fears and desires of the moment. In 1841, an Englishman named Charles Mackay became interested in the psychological aspects of crowd behavior with respect to people's investment decisions. After analyzing several early widespread financial manias (such as the Dutch Tulipmania and the South Sea Bubble), he wrote a book that has become a classic: Extraordinary Popular Delusions and the Madness of Crowds. (For more on the subject, see A Short History of Financial Euphoria by John Kenneth Galbraith or Crashes and Panics: The Lessons of History by Eugene White.)

When you hear the details of these infamous financial episodes, it's hard to believe that otherwise rational people could get so caught up in a mass delusion. It used to read like ancient history; now it's more like reviewing a stack of last year's Wall Street Journals.

Because of human nature and our susceptibility to crowd influences, it isn't unusual for markets and stock prices to become overvalued (or undervalued) from time to time.

The graph below shows how investors' moods swing in predictable patterns as prices rise and fall.

1. At a bear market bottom, buying is triggered by an unexpected news event or financial report. The mini-rally is initially met with skepticism and caution.
2. As buying continues, there gradually develops an increasing recognition of positive factors that had previously been ignored. The rush to invest leads to the launch of a new bull market. Confidence returns.
3. As the bull market ages, optimism begins to outpace economic reality. Opinion overwhelms fact. A "buy on dips" mentality develops, reinforcing the uptrend.
4. Euphoria sets in. Negatives are overlooked. There is a growing feeling that the old rules no longer apply. With no fear of loss, greed leads to a kind of buying madness.
5. Buyers become fully invested. The bull market peaks.
6. Selling is triggered by an unexpected news event or financial report. The selloff is initially treated as a healthy corrective.
7. As selling builds, fear and doubt begin to surface. A growing rush to the exits leads to a bear market.
8. As prices continue to fall, pessimism begins to outpace economic reality. Emotion overwhelms fact. A "sell on rallies" mentality develops, reinforcing the downtrend.
9. Mental depression sets in. Positives are overlooked. There is a growing feeling that the old rules no longer apply. With no hope of gain, fear leads to a selling panic.
10. Everyone who wants to sell has sold. The bear market hits bottom.

From 2003 through 2007, we saw Stages 2 through 5 unfold and enjoyed the ride. For the past year, however, we've been on the downhill side. Stage 6 was reached last fall amidst growing concerns about the spreading financial damage being done by the subprime crisis. Stages 7 and 8 unfolded during the first half of the year, reaching official bear market territory in July.

It appears we could now be in Stage 9, where nary is heard an encouraging word. The country's largest mortgage lender (Countrywide) and two of the largest investment banks (Bear Stearns and Lehman Brothers) — all gone. Fannie Mae and Freddie Mac, holders of roughly half of American mortgages, taken over by the federal government. One of the largest insurers in the world (AIG), will be broken up and sold off. It's easy to feel that "the old rules no longer apply."

Those with a short-term focus head for the sidelines because they're worried about the curved line. Long-term investors, on the other hand, have the fortitude to stay committed because they're aware of the power of the dotted line.

Yes, the headlines have been dire, but ultimately, due to the underlying strength of the American economy, I believe those with a five-year (or longer) time horizon can invest in a diversified portfolio of U.S. companies with confidence.

Austin Pryor has three decades of experience advising investors, and is the founder of the Sound Mind Investing newsletter and website. Austin lives in Louisville, Kentucky, with Susie, his wife of 46 years. Two of his sons, Andrew and Matthew, work with him at Sound Mind Investing. A third son, Tre, is a Realtor® in the area.

• SMI Editorials page
• SMI Investing Principles page
• Upgrading Winning Streak Now at Nine Years and Counting
• Fund Upgrading
• The High Cost of Fear 

• The Human Foundations of Financial Risk [PDF]
• Extraordinary Popular Delusions and the Madness of Crowds
• A Short History of Financial Euphoria
• Crashes and Panics: The Lessons of History

Related Articles

SMI Editorials page

SMI Investing Principles page

Upgrading Winning Streak Now at Nine Years and Counting

Fund Upgrading

The High Cost of Fear 

Links

The Human Foundations of Financial Risk [PDF]

Extraordinary Popular Delusions and the Madness of Crowds

A Short History of Financial Euphoria

Crashes and Panics:
The Lessons of History

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