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Understanding Panic Selling: Causes, Effects, and Strategies

stock market
27 Jun 20246 mins readBy MOFSL

You may have seen documentaries on television about animal behaviour. Many of them move in herds to create a sense of security. It is a survival tactic. However, when signs of a predator are nearby, panic sets in. Each one is left to defend their own. 

Something similar plays out in the world of stock market investing. 

When a selloff is triggered, there is panic selling across the board. It is often observed when a sudden spike in the inflation rate occurs. There have been instances when financial markets worldwide fell sharply after the Asian currency crisis in the 90s or the global financial crisis in 2008. Fears of a sudden end to the US government bond purchases by the US central bank that were famously called 'taper tantrums' triggered a global selloff in 2013. It affected stock markets in emerging economies like India, where local currencies were under pressure. Similarly, during the COVID-19 pandemic, panic selling from risky assets led to a global meltdown in stock markets. 

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David Kahneman is a Nobel Laureate known for his work in behavioural economics. In his book Thinking Fast and Slow, he writes about our reactions to situations due to our brain's ability to think fast and slow. Our impulse reactions are a part of the fast-thinking mode. If you step back and take action after evaluating a situation, your brain is utilizing a slow-thinking mode. Kahneman argued in the book that 60% of our reactions are in a fast-thinking mode. As a result, whenever there is a negative' news flow' in the stock market, the instant reaction is to sell. This reaction is called panic selling. 

An impulse reaction to an event could trigger a selloff. For example, in the general elections in India, exit polls predicted a clear victory for the ruling party. The stock market reacted with a strong rally. However, the result was a bit unexpected. That triggered a selloff. It happened in 2004 and then again in 2024. 

There is a difference between equity trading and equity investing. 

Equity trading is mainly based on technical factors. Traders could quickly change positions from buying to selling or vice versa based on technical analysis, the latest news developments, or mere demand and supply of shares. The arbitrage activity during the day, where traders buy low and sell high or vice versa, also influences share prices. Then, there is an arbitrage across segments. People hedge their positions in the cash market using derivatives. They also take positions in the cash and derivative market by borrowing money. When sellers are more in the market than buyers, and the fall in share prices is sharper, those trading based on loans must either reduce their exposure or bring in more cash. That applies to the derivatives segment, too. That leads to sharp volatility in the stock market, which creates panic. All of that happened in the sudden episodes of panic selling that stock markets witnessed over the years. Most traders are in a fast-thinking mode. 

Equity investing, on the other hand, is based on a company's long-term fundamentals. You hold fundamentally strong companies to benefit from the capital appreciation for wealth creation. When your investments are aligned with your long-term financial goals, current developments have little impact on your actions. You want to benefit from the wealth that businesses create by riding through market cycles. If an economy grows steadily, companies that ride on that economy for growth show steady profit growth. Short-term trends do not impact the long-term returns in the market. However, your actions in the short term can affect your long-term wealth. If you sell in panic and do not invest regularly, you may not be able to achieve your financial goals. Most long-term investors follow a slow-thinking mode. 

Legendary American investor Warren Buffett has articulated several times that when others are fearful, you should be greedy, and when others are greedy, you should be fearful. His investment philosophy of buying and holding on to quality investments has created wealth for him and his company's shareholders over the years. However, fast-thinking people do not appreciate getting rich slowly. 

Conclusion

Panic selling is a function of impulse. Several factors trigger a selloff. A sudden spike in inflation and interest rates could trigger arbitrage activity in different market segments. The long-term direction of equity markets is linked to the underlying economic growth and corporate profits. Panic selling affects short-term traders and investors. It does not have a significant impact on long-term wealth.

 

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Disclaimer: The stocks, companies, or financial instruments mentioned in this blog are for informational purposes only and should not be considered as investment recommendations. It is advised to consult with your financial advisor before making any investment decisions. Investment in securities markets are subject to market risks, read all the related documents carefully before investing. Investors are strongly encouraged to carefully read the risk disclosure documents prior to participating in market-related investments or trading activities. Due to the volatile nature of financial markets, no guarantees can be made regarding investment returns. Motilal Oswal Financial Services Ltd. does not offer any assured returns on market-linked securities. Please note that past performance of stocks or indices is not indicative of future results.
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