One of the first studies of the recent market splat found that the investors most likely to be crushed thought they were investing for the long haul, only to be forced into cashing out at the worst possible time. According to the study, cleverly titled “When Everyone Runs for the Exit,” there are only two good ways to react to a liquidity crisis: hold onto your portfolio and trust that it will recover, or fold immediately to limit your losses.
Folding is far from ideal, but if too much of your money is tangled up in the markets, it may be the best way to quickly extricate yourself before things get worse.
The professor refers to the investors between these extremes as the “strongest weak hands.” They end up losing the most money. These investors “initially think they have a strong hand,” he said, and hold on for a while as their losses become more severe. Eventually, they discover that they aren’t as strong as they initially thought – emotionally, financially or both.
They “are forced to sell at or near the bottom,” he said.
These findings may be particularly unsettling for some converts to buy-and-hold investing from 2002 to 2007, who held onto their positions for months as stocks became toxic in 2008, only to sell at a loss deep into the debacle. Professor Pedersen says these people probably would have lost much less had they never tried to become buy-and-hold investors and instead remained short-term traders.
Their outsize losses aren’t the fault of the buy-and-hold approach, the professor says. Instead, the problem is that they failed to appreciate how much patience and fortitude are needed to tolerate a liquidity crisis. Trying and failing leads to greater losses than not trying at all.
We wave goodbye to any money invested in the market. If it ever reappears, wahoo!, what a nice surprise. That’s the strategy that lets us sleep at night, but for other, better ideas, check out the post How Not To Panic About The Stock Market.