Investing In Crisis: A High Risk-High Reward Strategy

The financial crisis of 2008 and the great recession that followed is still fresh in the memories of many investors. People saw their portfolios lose 30% or more of their values, and older workers saw their 401(k) plans and IRAs drop to levels that threatened their plans for retirement. Instead of acting rationally during severe bear markets, many people tend to overreact and make matters worse. However, while many people panicked or were forced to sell assets at low prices, a small group of patient, methodical investors saw the stock market collapse as an opportunity.

Investing in a crisis is no doubt risky, for the timeline and scope of a recovery is uncertain at best. Double-dip recessions are a real possibility, and attempting to pick a bottom is largely a matter of luck. Still, those investors who are able to invest in a crisis without succumbing to irrational fear and anxiety may reap outsized returns during a recovery.

How Crises Affect Investors

Investors generally do not behave as predicted by traditional financial theory, in which each individual behaves rationally to maximize utility. Rather, people often behave irrationally and let emotions get in the way, especially when the economy is experiencing some chaos. The emerging field of behavioral finance attempts to describe how people actually behave versus how financial theory predicts they should.

Behavioral finance shows that people, rather than being merely risk-averse, are actually more loss-averse. This means that people feel the emotional pain of a loss much more than the pleasure gained from an equal-sized profit. Not only that, but loss-aversion describes peoples’ tendency to sell winners too early and to hold on to losses for too long; when people are in the black, they act risk-averse, yet when they’re in the red they become risk-seeking.

Take for example a blackjack player at a casino. When he is winning, he may start playing more conservatively and betting smaller amounts to preserve his winnings. If that same player is down money, however, he may take on much more risk by doubling down or increasing bets on riskier hands in order to break even. Investors behave similarly. Unfortunately, taking on excess risk when experiencing losses tends to only compound the magnitude of those losses.

These emotional biases may persist even after a recovery has begun. In a survey by online broker Capital One Sharebuilder, 93% of millennials indicated that they distrust the markets and are less confident about investing as a result. Even with historically low-interest rates, more than 40% of this generation’s wealth is in the form of cash. Due to the crisis, young Americans are not gaining the stock and bond market exposure that has helped older generations accumulate wealth.

Taking Advantage of a Crisis

While most investors are panicking as asset prices plummet, those with a cool head are able to see the resulting low prices as a buying opportunity. Buying assets from those restless individuals driven by fear is like buying them on sale. Often, fear drives asset prices well below their fundamental or intrinsic values, rewarding patient investors who allow prices to revert to their expected levels. Profiting from investing in a crisis requires discipline, patience, and, of course, enough wealth in liquid assets available to make opportunistic purchases.

When calamity strikes, markets fear the worst and stocks are punished accordingly. But historically, when the dust clears, optimism returns and prices bounce back to where they were, with markets responding once more to fundamental signals rather than to perceived turmoil. A study by Ned Davis Research group looked at 28 global crises over the past hundred years, from the German invasion of France in World War II to terrorist attacks such as that on 9/11. Each time, markets overreacted and fell too far only to recover shortly thereafter. Those investors who sold on the fear found themselves having to buy back their portfolios at higher prices, while patient investors were rewarded.

After the Japanese attack on Pearl Harbor, the S&P 500 index fell more than 4% and continued to drop another 14% over the next few months. After that, and through the end of the war in 1945, however, the stock market returned more than 25% per year on average. The same pattern can be observed after other geopolitical events. By recognizing the fact that markets tend to overreact, a smart investor can purchase stocks and other assets at bargain prices.

Right now, the stocks are in the midst of a six-year-long bull market following the great recession. Those who didn’t panic saw their portfolio values not only recover, but extend their gains, while those who chose to or were forced to sell, and waited until the bull market was in full swing to re-enter, are still licking their wounds.

Stock markets aren’t the only way to invest in a crisis. The great recession also saw a collapse in home prices as the housing market bubble burst. People who could no longer afford their mortgages foreclosed and many homes were underwater, the mortgage amount owed to the bank exceeding the equity value of the property. Homebuyers and those investing in real estate were able to pick up valuable real assets at below normal prices, and as a result have been able to enjoy handsome returns as the housing market has stabilized and recovered. Similarly, so-called vulture investors have also been able to profit from taking over good companies that have been battered by a recession but have otherwise good fundamentals.

Betting on a Crisis to Happen

Another way to make money on a crisis is to bet that one will happen. Short selling stocks or short equity index futures is one way to profit from a bear market. A short seller borrows shares that they don’t already own in order to sell them and, hopefully, buy them back at a lower price. Another way to monetize a down market is to use options strategies, such as buying puts which gain in value as the market falls, or by selling call options which will expire to a price of zero if they expire out of the money. Similar strategies can be employed in bond and commodity markets.

Many investors, however, are restricted from short selling or do not have access to derivatives markets. Even if they do, they may have an emotional or cognitive bias against selling short. Furthermore, short-sellers may be forced to cover their positions for a loss if markets rise instead of fall and margin calls are issued. Today, there are ETFs that give longs (holders of the ETF shares) short exposure to the market. So-called inverse ETFs may aim to return +1% for every negative 1% return the underlying index returns. Some inverse ETFs may also employ gearing, or leverage, returning +2% or even +3% for every 1% loss in the underlying.

For those individuals seeking simply to protect themselves from a crisis and not necessarily bet on such an event occurring, owning a well-diversified portfolio, including positions in asset classes with low correlations, can help cushion the blow. Those with access to derivatives markets can also employ hedging strategies, such as a protective put or covered call to lessen the severity of potential losses.

The Bottom Line

Economic crises happen from time to time. Recessions and depressions occur. In the 20th century alone there were around twenty identifiable crises – not including geopolitical events such as wars or terrorist attacks, which also caused markets to suddenly drop. Behavioral finance tells us that people are prone to panic in such events, and will not act rationally the way traditional financial theory predicts. As a result, those with cool heads, discipline, and an understanding that, historically, markets have always rebounded from such events can purchase assets at bargain prices and earn excess returns.

Those with the foresight that a crisis is impending may implement short strategies to profit from a falling market. Of course, timing is everything, and buying too early or late, or holding on to a short position for too long, can serve to compound losses and take away from potential gains.