Personal Finance

The stages investors go through when confronted with disaster
By Ashley Redmond | 29/03/11

The largest earthquake ever recorded in Japan, along with the subsequent tsunami and nuclear crisis, likely constitutes one of the first disasters that young investors are being forced to deal with as it relates to their portfolio. For many, this is also their first sudden market shock.

About the Author
Ashley Redmond is a Vancouver-based freelance writer.

Exactly how you react to these events can seriously impact your investments. Some studies have shown that when devastation of this scale occurs, our reactions follow a series of psychological stages.

"Young investors are prone to the first stage, which is under reaction, because they haven't seen enough bad things happen, so they don't appreciate how horrific these situations can get," says Dr. Frank Murtha, co-founder of MarketPsych, a behavioural finance consulting firm.

Under reaction occurs when you don't realize the scope of a disaster. You believe the government will handle the situation and that stocks will go unharmed.

The next stage is reaction, where you realize that things are not good and you need to take action. Fund managers and do-it-yourself investors start selling stocks that are likely going to be affected by the disaster, and start buying shares of those company's that stand to benefit.

This was seen in the markets on March 14, the second business day after the disaster. Hitachi Ltd. and Toshiba Corp., both of which have divisions associated with nuclear energy, were down about 16%. However, Kajima, Japan's largest construction firm, shot up 22%. Generally, construction companies fared well that day, though by the time the markets closed the Nikkei 225 Index was down 7.8% from its March 10 close.

The third stage is over reaction, where you aren't sure what will happen and fear takes over. The stock prices are plummeting, and since you are afraid you sell stocks because everyone else is. "Crowd mentality is almost impossible for us to resist," says Dr. Murtha. By March 15, the Nikkei index was down more than 17.5% compared to pre-earthquake levels.

Dr. Frank Murtha

"The emotional reaction of individuals is like dominoes falling," says Dr. Murtha. "As fearful individuals react, it increases the fear of other investors, causing them to react. The cycle of fear perpetuates itself until the overreaction is manifested."

One important thing for young investors to remember is to not allow yourself to get wrapped up in the moment. "You have to create distance from the data. Investment opportunities are like an impressionist painting: if you stand too close to it you see dots and all the information is a bunch of noise. You need to step back far enough to see the entire picture," says Dr. Murtha.

One way to avoid getting caught up in the moment is to take a look at past disasters, and understand what they have done to portfolios in the long term. This is especially important for young investors in their 20's who have never dealt with a market meltdown.

For example, the Sept. 11, 2001 terrorist attacks shut down the American stock exchanges for four days. The aftermath was disastrous; the Dow Jones Industrial Average fell by 7.1% or 684.81 points, and by the end of the week it had fallen by 14.3%. Investors were scared, and they were selling.

However, by Dec. 31, 2003, the Dow had not only made up for those losses, but it was up about 8% over its Sept. 10, 2001 level. Investor confidence in the U.S. economy had increased and it was reflected in the markets.

"Take comfort in past disasters, in order to create long term perspective," Dr. Murtha says.

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