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How to Avoid an Investing Mid-life Crisis
AI can predict which investors are about to blow up their portfolio
31% of investors who “panic sell” never invest in risky assets again.
That was the headline takeaway from a 2021 paper titled “When Do Investors Freak Out? Machine Learning Predictions of Panic Selling” from researchers at MIT.
In this article, I explain:
What panic selling is
Who is most likely to panic sell (which will explain the title of this article)
The devastating impact panic selling can have on your wealth
How to avoid making this costly mistake.
What is a “panic sale” anyway?
In the paper, “panic selling” is defined as a 90% decline in the balance of an investment account, of which at least 50% was due to the investor choosing to sell off assets.
Say you had $100,000 invested, and the stock market went down 20%—leaving you with $80,000. But then you started to freak out; “what if the market keeps falling?” So, you sell another $70,000. Leaving you with just $10,000 left invested and $70,000 in cash.
Despite its name, often, there appears to be a strategy behind the concept of panic selling. Many investors engage in panic selling to preserve capital and avoid further losses.
During the 2008–2009 financial crisis, the U.S. stock market dropped by 40%. Some investors looked at what was happening in the economy and their portfolios and made a panic sale, liquidating 90% or more of their portfolios. If they did this when the market was down 20%, they avoided the further losses coming in the months ahead.
Like any form of market timing, panic selling sounds good on paper, but the real-world results typically lead to the investor losing more money than if they had simply done nothing.
The difficulty in pulling off proper market timing is not knowing when to sell but when to get back into the market.
Most panic sellers wait too long to get back into the market and miss out on the rebound. Market timing is hard and often leads investors into the “sell low, buy high” trap. A concept I review in detail in my upcoming book, “The Investor’s Mindset.”
The only thing worse than selling low and buying high is selling low and never buying again.
The researchers found that 31% of investors who panic sell never invest in the stock market again. These investors do irreversible damage to their lifetime wealth accumulation in two ways.
They turn “paper losses” into real losses by selling during a crash.
The opportunity cost of never investing in the stock market again.
Panic selling is the mid-life crisis of investing
Now, I’ll explain how I came up with the title for this article.
The researchers used a five-layer neural network model to predict panic-selling events one month in advance.
Here’s the profile of an investor most likely to engage in panic selling:
A 45-year-old married man, with kids and who self identifies as having “excellent investment experience or knowledge”
AKA “The investing mid-life crisis,” where a middle-aged man nukes his portfolio instead of buying a new sports car. While both are terrible financial decisions—At least with the sports car, you get a shiny new toy.
Surprisingly young adults were less likely to engage in panic selling than more experienced investors.
At first glance, that might seem odd as you might expect young and inexperienced investors to make more mistakes. But, a middle-aged man who self-identifies as an excellent investor screams overconfidence.
As I discuss in The Investor’s Mindset, overconfident investors are more likely to trade too much. If one of those trades results in the majority of your portfolio getting wiped out, that overconfidence can quickly turn to fear.
How to avoid panic selling
Panic selling, market timing, stock trading, and other behavioral investing issues are all unforced errors.
The easiest way to avoid these types of errors is to use hire an investment advisor. A fiduciary who’s even mildly competent can help you avoid these behavioral investing traps, all of which feel like a good idea at the time but end up costing you money.
If you’re a DIY investor, remind yourself every time you think about making a change to your portfolio in response to a downturn or in an effort to generate Alpha that the smartest thing is to do nothing.
Buy the entire stock market and do nothing.
The stock market just dropped 40%? Do nothing.
The market is on a tear and looks like a bubble? Do nothing.
Your friend at work is giving you tips on trading stocks? Ignore them.
Changes to your asset allocation based on changing risk preferences or changes to your financial life are fine.
Making changes driven by fear or greed is an easy way to lose money.
The investor who buys the whole market and then does nothing avoids the pitfalls of panic selling and all the unforced errors that overly active investors fall victim to.
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This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.