Coping With Panic and Fear in the Markets

Financial Lobe columnist Michael Rosenwald was online on Monday, Sept. 29 at 11 a.m. ET with guest Dr. Richard Peterson, a psychologist and trader, to answer questions about how investors can cope with panic and fear in the markets and how they can avoid making mistakes they will regret down the road.

The transcript follows.

Dr. Peterson is the founder of MarketPsych, which trains traders and personal finance counselors on how to handle the psychological side of investing.

Read past Financial Lobe columns.

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Michael Rosenwald: Greetings! Thanks so much for joining us. Richard Peterson is here too. He's a psychiatrist, trader, and the co-founder of MarketPsych, which trains traders and personal finance counselors on the psychology of investing. He's also the author of "Inside the Investor's Brain." Pick up a copy. Note: We cannot speak to specific medical or financial advice, but we can talk generally about how the market causes us to behave certain ways. Now, on to the questions!

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Retirement funds vs. mortgage pay-down: So, six months ago, anyone would have said I'm in good shape: 50 years old, a fed, maxing out my TSP and Roth plans in a mix of funds. $75K left on my mortgage, at 5.25%, is my only debt.

But now, I'm worried about putting my retirement contributions into a black hole And I'm worried about whether there will be a big federal Reduction in Force (RIF).

My thought is to (temporarily) reduce my contributions to the 5% match, and use the extra funds (which would be around 10K a year) into the mortgage principal.

How bad an idea is this?

Richard Peterson: What I'm wondering is how much your fear due the current crisis is driving your line of reasoning.

In psychology we call it "framing" - we see the world very differently depending on whether we're in the "loss" frame (worried about losing our assets) or in the "gain" frame (excited about opportunities).

If you look at long term charts of the financial markets, it's usually a good long term plan to be seeing "opportunity" while others see crisis, and vice versa. That is, during most crises during the past 200 years, it was good to be buying stocks during a crisis.

One caveat: that was true in the USA, but not in many other countries (pre-war Japan, Germany, Argentina, etc...).

Of course, there's no need to try to time such events. When we're pulled into short-term thinking and evaluations of our investments (which happens when we're scared), then we're likely to do something rash and harmful for the long term.

To reduce risk, it's always a good idea to figure out exactly how much exposure you have to each type of asset. For example, you may have lots of exposure to equities in your pension fund, so diversifying into mortgages or real estate might be a good idea.

Also, before losing out on the tax advantages of a retirement savings plan, consider the many exchange-traded investment options besides equities -- REITs, corporate bonds, energy royalty trusts, that have decent earnings.

So I can't give specific advice but to be aware of whether you're considering this option due to "rational concern" (which is likely unbiased) or "fear" (which you might regret later).

In general, offsetting a 5.25% interest payment isn't a losing option.

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Shanghai, China: How will this panic impact trade between USA and China?

Richard Peterson: I imagine we're going to see a global slowdown, driven in part by the US slowdown. So combined with inflation in China, this will probably reduce the growth of trade between the USA and China, but it probably won't go negative unless the Yuan is sharply revalued (which is unlikely in the short term).

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Washington, D.C.: How do we know if this is just herd behavior or if we should really be hitting the panic button?

Richard Peterson: I think you are definitely seeing herd behavior, which is due to fear because:

1. Herd behavior happens when people don't take the time to do an analysis themselves, rather they watch what other are doing (via stock prices) and then react to that.

2. Herding is a kind of "mental shortcut" where we take our cues from others, and it is very common when we are afraid.

3. That said, it's important not to be run over by the stampede. In recent markets, the herd is all over the place, yet there are great buys out there for the disciplined investor with a long term view, as Warren Buffett has been demonstrating.

4. It's best not to ever hit the panic button on the spur of a moment. Always take a deep breath and think through the situation while you're calm, including your reaction to every possible contingency (what if the market falls another 10%? what if it rallies 10%? then what will you do?). Write down these answers IN ADVANCE, so that you have a plan.

Hope that helps,

Richard

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Bethesda, Md.: Nothing Bush has told us so far, most notably about Iraq, has ever worked out. Why should we trust him on this one?

Michael Rosenwald: Your question is an interesting one. What has fascinated me a lot about this whole bailout process is that while trust and approval in government is low -- from the White House to Congress -- Wall Street has so far seemed to trust that the government was doing things right with this plan. The most likely reason is that Wall Street seems to have no choice.

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Babylon, N.Y.: Is it me or with all the uncertainty, wouldn't we basically be better off taking our Social Security checks to Vegas? Or is there some stability that's about to emerge?

Richard Peterson: The uncertainty is a real problem. Part of the goal of the bailout plan was to end the uncertainty. Problem is, it didn't go far enough to that end and it may have been too late, and banks' share prices continue to fall dramatically (see WB and NCC today). Of course, Wells Fargo (WFC) remains strong for now.

That said, we're at a bit of a turning point.

Of course, the problem with Vegas is you won't be getting a return(but granted, you might find some entertainment).

Can you trust the financial system? That's the core question I suppose.

I personally don't think the crisis is over. That said, there will certainly be stability emerging - probably more towards late October, after earnings announcements are about half-way through.

If you're not a market timer, then probably best not to be looking at the short term.

Yes, stability will emerge, but things might get more challenging before then, and if you're likely to panic if things get worse, then that's something to consider planning for now.

A round-about answer, and I know the government is doing everything they can to provide confidence, and will continue to do so. But there may be a few short-term scared investors (and liquidating hedge funds) that will drive market prices down further.

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Falls Church, Va.: What's the status of Wachovia? They are saying it didn't fail, but the stock seems to have dropped by about 90 percent from the Friday close (at least in pre-opening numbers). It also doesn't seem to be trading right now - why is that?

Michael Rosenwald: The FDIC played matchmaker between Wachovia and Citigroup. We are reporting this on our web site...

By Binyamin Appelbaum, Neil Irwin and Howard Schneider

Washington Post Staff Writers

Monday, September 29, 2008; 11:27 AM

Citigroup has agreed to buy Wachovia bank in a deal backstopped by taxpayers and brokered by the Federal Deposit Insurance Corp. to avoid another major corporate failure in the midst of the ongoing financial crisis.

Citigroup will pay the Charlotte-based Wachovia about $2.16 billion, or $1 per share, for its banking operations. Wachovia will retain its asset management and brokerage operations. Citigroup, based in New York, also will become the largest bank in the Washington area.

The deal protects all deposits at Wachovia, the FDIC said in a statement.

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Sewickley, Pa.: I was a broker during the time when Paul Voelker drove interest rates to 24 percent and President Carter slapped an embargo on the old Soviet Union. We were seriously afraid at that time that the markets would be shut down and cease to function. I keep reminding myself that we made it through that. Am I fooling myself about the depth of our difficulties or am I using experience to reach a reasonable conclusion? The news seems to focus on all of the near term failures. It's difficult to keep reminding yourself that human beings are dynamic problem-solving opportunity-seeking entities who will rise to the challenges at hand.

Richard Peterson: That's a great observation. It has certainly been worse before, and we made it through. Many people forget that it was nearly impossible to get ANY mortgage in the early 1980s, even for 14% or more interest.

I think you are using experience to reach a reasonable conclusion.

Experience is the one factor that seems to improve investor decision making over time. Possibly by decreasing reactivity to short term events, often because you can compare the current events to a prior time.

Inexperienced investors can look at a chart of the VIX over time (or the MarketPsych Fear Index) and see that buying opportunities were often (though not always) best over the next 10 years from a very high VIX level and declining stock prices.

In my free online investor personality tests (www.marketpsych.com), the investors aged 55-65 have the highest market returns.

So that does seem to indicate that experience is helpful in riding out such a crisis.

Richard

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Menomonie, Wis.: Good morning. After 9-11, the Feds ordered Wall Street shut down. Granted, this is a different type of emergency, why can't the Feds do this again? It is the dumb mistakes of investors that got us into this mess in the first place, so why not shut down Wall Street again until a bill is passed? Also, instead of making us peons pay for the bail-out, why not just raise taxes substantially on those making more than a million dollars a year? I actually find it despicable that my tax money, when I am struggling, has gone and will go to fund million-dollar severance packages for untalented wealthy CEOs. Not only that, Congress quietly passed bills that refused to extend unemployment benefits, increase food stamps or Medicaid benefits or Head Start.

Mind you, I will be watching this vote very carefully. There are alternatives to bail-outs and those should be explored. If my senator and representatives vote for any form of bail-out, I do not intend to vote for them. Wealthy, untalented CEOs made this mess. Let them clean it up themselves instead of using my hard-earned tax dollars.

Oh, and I believe the "trickle down to Main Street if nothing is done" is just a scare tactic.

Thank you for listening.

Richard Peterson: Hi, I have the sense that the government is trying to contain the crisis of confidence on Wall Street and keep it from spreading into all areas of the economy. That's why the bailout -- if they don't do it then it will cost a lot more than $700 billion in lost productivity and hardship. That's the thinking anyway.

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Arlington, Va.: I know Buffett's famous words of "be greedy when others are fearful and be fearful when others are greedy" have always rang true in the past. Buffet has made many fortunes scooping up great business in depressed markets. Today I look at my portfolio and I see stocks that are down 70% and 80%. I know now is the time to buy and large-caps like Google and some really great small-caps are going at bargain prices but, it's hard to bring myself to buy more when every move I've made all summer hasn't worked. Any advice on feeling good about buying stocks today? I'm hunting for small-caps because they are supposed to be best to buy in down markets.

Richard Peterson: You're right, historically speaking now appears to be an excellent time to buy stocks for the long term.

Problem is, as you've noticed, it's easy to buy on the way down, too often. There's no need to time this type of market, but most of us feel that way as stocks decline - that we should be getting a great deal. Sometimes it's better to wait for an unbelievably cheap stock (as Buffett does). Historically many stocks have been cheap (traded with low PEs) for long periods.

Buffett has started buying - that's true. He often sits on a lot of cash waiting for times like this.

Some of the best stocks in these times are small cap, with high book to market ratios and low price to earnings ratios (value stocks). Also helpful if they have little to no debt. That said, they can stay down for a long time, so they are often better bought with a long term perspective.

Richard

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Arlington, Va.: All week we've heard pundits and politicians say that not passing the relief bill would have a catastrophic effect on the financial system. We haven't heard much more than that. Can you walk us through the counter-factual? That is, can you give us a "Christmas Carol" or "It's a Wonderful Life" type of glimpse into the alternate reality of no bailout in the near future? What types of events would begin happening in the financial sector and how (if at all) would it ripple into the US and world economies. How long would a shock last?

Richard Peterson: I think the counterfactual (no bailout) is that hedge funds, individual investors, and foreign investors begin to pull their money out of the stock market in a hurry. No one wants to be the one "holding the bag." Essentially a herd of sellers might overrun the markets.

One long term problem is that then pension funds would be funded under their mandates if stocks fall further, and their efforts to re-invest more money would put a further drag on the economy (because they have to take more from paychecks, or the Fed govt insurance will have to kick in and taxpayers might have to pay anyway).

Usually contractions last a long time because too many people were taking risks that they didn't understand, and as Warren Buffett and others have said (approximately): you know who's been swimming naked when the tide goes out.

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Princeton, N.J.: Hi, I am a mathematician. I am a firm believer that nobody knows how to make economic predictions. Even the Social Security guesses are projections which are based on assumptions which are absolutely unknowable since they depend on future events. If people would understand this simple idea, I believe they could have a more reasoned approach to the market.

I am not saying that there are not things one can do to try and protect oneself from the vagaries of the future, just don't be surprised if it doesn't work.

Richard Peterson: You're right -- I think part of the reason it doesn't work for most people is that they are driven by contagious emotions (greed, fear, attachment to stocks) rather than by reason. It may work well for people like Warren Buffett because of his patience and analytical skill -- but he's a grand-master, and most people are just trying to keep their heads above water, so timing is not good for them in general.

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Princeton, N.J.: Surely one of the worst of the many failings of this Administration is the lost of trust worldwide. I don't trust George Bush; I trust Barney Frank.

Richard Peterson: Trust is a really important issue -- seems most people are very angry that we seem to be bailing out Wall Street executives with their tax money.

There have been a series of interesting brain scanning studies that show people experience a surge of dopamine in their brain's reward center when they commit revenge. This is especially true for men.

Dopamine used to be called the brain's "pleasure" chemical, and it's the word from which "dope" was derived.

So we feel some pleasure when taking revenge on others, especially if we feel wronged.

Ironically, it's also a dopamine surge in the "nucleus accumbens" that drives us to optimistically invest in excessively risky assets.

So we feel pleasure when getting into stocks, and others feel pleasure when punishing us (or hoping that we are punished) after our risky bets go awry.

Richard

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Richmond, Va.: Okay, so the bill says that the compensation of CEOs, etc. will be curbed, but what does that mean? Ten million instead of fifty million in compensation? I, and lots of Americans, would like to know real figures, and if it is in the "whatever" millions, that is still a huge REWARD for what I think is bankrupting the American treasury now, and for our children.

Richard Peterson: As I answered another poster, it seems that we actually feel pleasure when we take revenge on others (or so the brain imaging data indicates) Is this schadenfruede?

Here's an interesting paper about it: "Behavior. Sweet revenge?" Brian Knutson, Science.

So we have to be clear that we're not overly vengeful. The system may collapse if we don't clean up the mess. We don't want to hurt ourselves out of spite for others ("cut off our nose to save our face"?), which is a real risk here.

Richard

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Michael Rosenwald: That's all the time we have. Thanks for the great question. And thank you, Richard, for your time. Richard's company can be found at www.markeypsych.com

Michael Rosenwald: Thanks for the great questions! And thanks for helping out, Richard!

Richard's company can be found at www.marketpsych.com

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