Let’s deconstruct the recession psychology and question the common assumptions and conventional beliefs that investors, institutional experts, and common people often cling to when recession worries loom large.
The Context
Are we there yet? This question has been echoed through countless news articles, reports, and expert opinions. Over the past two years, we’ve been extensively covering the signs and symptoms while swiftly preparing investors for an impending recession. If you’d like to catch up, you can click here to access our previous articles.
In the wake of the tumultuous events that unfolded in and after 2020, including global lockdowns, full-scale wars, a multitude of climate and political crises, various economic reforms and policies aimed at addressing economies, and even a recent outbreak of bed bug troubles in France, a lingering question remains: Are we witnessing an apocalypse, and, even worse, are we on the brink of a recession?
Whether we’re prepared or not, recessions tend to stir up anxiety among regular investors. Exploring recession psychology is a fascinating topic. Apprehension of economic downturns frequently prompts individuals to make impulsive investment choices, potentially leading to financial setbacks. However, with a clear understanding of the underlying factors that drive these behaviors and a well-thought-out strategy, smarter investors can not only navigate through recessions but also uncover opportunities for growth.
In this article, we will candidly uncover the common behaviors displayed by inexperienced investors when faced with economic uncertainty, backed by captivating anecdotes.
Recession Psychology 101
For every learned self-directed investor aiming for financial freedom, it’s crucial to grasp how most common investors tend to respond at the first signs of trouble.
1. Fear and Panic Selling
During a recession, one of the most common reactions we witness is the rush of fear-induced panic selling among investors. This often leads them to hastily offload their investments in an attempt to safeguard their capital, unfortunately resulting in locking in losses. We’re witnessing this phenomenon frequently these days, with many inexperienced investors in the accumulation phase of their investment journey liquidating their assets and adopting a wait-and-see approach. Some did so in 2020, others in 2022, and a significant number are currently following suit in 2023.
However, it’s important to recognize that recessions are inherently unpredictable. Assuming there’s a 50-50 chance of an impending recession, sitting on the sidelines essentially translates to a 50% missed opportunity, potentially forfeiting participation in what could be the most significant bull run India has ever witnessed.
Reflecting on history, during the 2008 financial crisis, numerous investors sold their stocks when market values were at their lowest, driven by the fear of a complete economic collapse. Unfortunately, this led them to miss out on the substantial recovery that ensued.
2. Herd Mentality
Despite the remarkable evolution of human society from hunter-gatherer days to the era of generative AI, certain behavioral tendencies are challenging to eradicate. Whether it’s rushing to acquire the latest must-have smartphones or following social media trends, investors frequently exhibit herd behavior, basing their investment choices on the actions of others. When a wave of selling begins, many join in without fully comprehending the consequences.
This phenomenon is particularly prevalent among individuals who possess professional qualifications but lack financial literacy. Their approach lacks mathematical or logical grounding; they buy driven by speculation and sell based on assumptions.
A painful example is the dot-com bubble burst in the early 2000s when investors poured substantial sums into internet stocks as their prices soared, only to witness the value of their investments plummet when the bubble eventually burst. A similar trend is unfolding today, with speculators eagerly investing in anything associated with the term-generative AI.
3. Overemphasis on Short-Term Gains
It’s one of those moments with a fly and a mesh light. Have you ever noticed those flies trying to reach the captivating glow, only to see some make it through unscathed while others meet with jolting sparks?
Now, if this analogy seems disconnected, let’s clarify that investing is far from being a game of chance. In the context of our present societal framework, many investors perceive themselves as victims of the system, and their response is often a quest for revenge, driven by a combination of greed and unwarranted confidence.
During recessions, these investors tend to become excessively fixated on short-term gains and losses. They lose sight of their long-term objectives and fall into the temptation of trying to time the market. Some investors who sold stocks during the initial COVID-19 market crash in 2020 missed out on the subsequent rapid recovery, as they were too fixated on avoiding short-term losses.
4. Neglecting Diversification
Many astute speculators adhere to a simplified notion widely promoted on social media that endorses the idea of buying during market dips. However, We must share a reality check – not every dip is an opportunity; sometimes, it’s like trying to catch a falling knife. Predispositions, unwavering beliefs, and misguided recommendations from financial influencers can lead even the savviest individuals to make irrational decisions that harm their capital.
If you find this hard to believe, consider the reality that in 2018, numerous investors continued to lower their average investment cost in DHFL stock, hoping for a recovery, only to see it eventually become worthless. In times of economic decline, some investors deviate from diversified portfolios and opt to place all their investments in a single asset, hoping for a swift recovery.
Another good example is the real estate market before the 2008 financial crisis, where some investors heavily concentrated their portfolios in real estate, assuming that property values would continually rise. When the housing market ultimately collapsed, they incurred significant losses. A similar pattern is currently emerging, with real estate exhibiting above-average yields since January 2023, raising alarm bells.
By now, you might be wondering how to navigate through the fear of a recession. Don’t worry; we’ve got some time-tested solutions to help you weather the storm.
Ideal Approach During a Recession
1. Stay Sharp, Not Panicked
Successfully managing investments during a recession necessitates staying sharp and well-informed about the economic climate while avoiding impulsive reactions. It’s more prudent to peruse news sources without fixating on particular biased keywords. Modern media consumption can sometimes have a hypnotic influence on susceptible individuals. What you glean from the news can occasionally resemble a distorted jest propagated by influential figures to implant ideas in unwitting consumers.
Remember, we live in a world where it takes just a few hours for entertainment news regarding Barbie-Oppenheimer to morph into tension between Canada and India. Instead of chasing every fleeting trend, it’s wiser to exercise personal judgment. Rather than resorting to panicked selling, consider adjusting your portfolio to align with your long-term objectives.
If you’re currently in the process of constructing your investment portfolio, don’t limit your focus solely to equities (stocks). Instead, contemplate channeling your investments toward alternative assets that typically exhibit stability during economic downturns, serving as a safeguard against potential market volatility. Options such as fixed deposits, gold, or bonds are worth considering in this context.
2. Diversify Wisely
Diversification remains a cornerstone strategy. Avoid simply pouring funds into every opportunity that arises. Instead, allocate your investments thoughtfully among a range of asset classes, including stocks, bonds, real estate, and cash. While achieving the perfect balance requires patience, practice, and trial and error, diversification plays a crucial role in reducing risk when the market experiences turbulence.
3. Focus on Quality
Consider investing in reputable companies with robust fundamentals. Seek out businesses that boast strong balance sheets, minimal debt burdens, and a track record of steady dividend payouts. Such companies often demonstrate resilience during economic downturns. On top, it’s a wise approach to analyze the historical responses of established companies to past recessions, periods of euphoria, and market panics through backtesting.
4. Long-Term Perspective
Investing is a patient, long-term endeavor that may lack excitement but offers substantial rewards. Maintain your focus on your long-term objectives. Throughout history, markets have consistently bounced back from recessions, and those who invest with a long-term perspective have reaped the benefits of this resilience. Exercise patience and steer clear of attempting to predict market timing.
5. Opportunistic Investing
Recessions and major market pull-backs present distinct investment opportunities worth exploring. Seek out stocks or sectors that are undervalued and poised for growth during the economic recovery. To put it simply, in the investment game, a recession often translates to discounts.
As Warren Buffett famously advised, “Be fearful when others are greedy, and be greedy when others are fearful.”
Following the 2008 financial crisis, astute investors like Warren Buffett made substantial investments in financial institutions when many were avoiding them. His commitment to a long-term perspective paid off handsomely. We also adopted this strategy in 2015-2016 and again in 2020, and it yielded impressive results.
6. Regularly Review and Adjust
Periodically review your portfolio and make adjustments as needed to stay aligned with your financial goals. This can include rebalancing, trimming underperforming assets, or adding new investments.
Conclusion
Investing during a recession can present challenges, but if you grasp the principles of recession psychology, there’s no need for excessive worry. By synthesizing and distilling the typical reactions of investors fueled by fear and embracing a rational strategy, you can effectively steer through economic downturns.
The essential tools for effectively managing both sector stocks and your broader investment portfolio during uncertain periods are diversification, an emphasis on quality, and a commitment to a long-term outlook. Keep in mind that while recessions bring difficulties, they also offer chances for those who maintain patience and adhere to a disciplined investment approach.
