PSYCHOLOGY OF STOCK MARKET AFTERSHOCKS

The greed that leads to market tops and crashes can account for the arguably more painful aftershocks too. And there's more psychology at work.

MASSIVE LOSSES

In 2007 the DJIA topped on 29 Sept at 14, 164.53. Then plunged 777.68 on 9 October. But the bottom did not hit until 6 March 2009 at 6,443.27 - more than a 54% loss!

The US markets famously crashed 18 October 1929 (almost 90%) BUT the market did not hit bottom until 8 July 1932. The "bargain scoop-up rally" did not last.

Some may recall 19 October, 1987, the market crashed again losing 23% in one day (DJIA).

A PSYCHOLOGICAL PERSPECTIVE

Markets are not things. Investments may be analyzed, but markets are about human behavior--people trying to be smart when buying and selling. Some try to get ahead of the herd. Some get greedy when markets fall and try to jump on a bargain only to find out it's cheap for a reason-- no one wants what they bought.

Stocks, bonds, and houses are not worth anything unless someone else is willing to buy what you are selling. Unless of course, you derive income from what you own that outweighs any drop in value below what you would have if you just held cash. That takes some calculation.

Like many things in life, the psychological principle of sunk costs applies. When an investment goes south, people often throw good money have bad rather than cut their losses. This situation is worse for individual stocks, bonds, and houses compared to people who hold an index fund. Any particular investment can go to zero! But large index funds like the S&P500 are probably too big to fail even when they drop 50%.

A market that sells off 7-10% seems bad to an average investor. Some hang on and endure losses of 20-50%. Others cut their losses and move to cash or find something better. A person's tolerance for risk is evident in their behavior. Most stay put or add more money until finally shaken out during the aftershock -- the date when everyone who wants out got out. The recovery can be a matter of years or decades.

Young people with a long work history ahead can afford to remain investors for the long hual. Wealthy people with diverse holdings can afford to remain in the markets as their wealth passes to the next generation via assets that will surely improve at some distant date.

But people near retirement who are heavily invested may not live long enough to enjoy a recovery if they lose double-digit percentages.

So, we must know our tolerance for risk. Recognize the trap of sunk cost psychology. Learn when to cut losses. Manage greed and fear (you may have more to fear than fear itself if you lose lots of money).

And consult a financial advisor when unsure. They might make you feel better even if they don't have a clue about the future. Really, who can predict the future? But they may help you think more clearly about your situation.

AND MORE

By the way, the principle of sunk costs applies to personal investments in relationships, education and career paths as well as commitments in politics and religion.

Of course I'm not giving financial advice. I am not a financial advisor - just a psychologist.