The world is now experiencing the most severe financial panic since the Great Depression of the 1930s. In finance, panic is defined as widespread financial or commercial apprehension provoking hasty action.
The key to understanding panic is to appreciate that panic states cause an almost irresistible impulse to act. This differentiates panic from fear in which individuals while frightened can think their way through a crisis. Not so in panic, where the emotional state is so dystonic, so painful that the only solution is action.
The key to understanding panic is to appreciate that panic states cause an almost irresistible impulse to act.
The pathway for fear starts in the hippocampus which then radiates to the amygdala which in turn radiates to the frontal cortex. While this is very esoteric information for all except neurologists and neuroanatomists, it is crucial in understanding panic because such a pathway is primarily unconscious. The hippocampus and amygdala are parts of the limbic system, the part of the brain involved in emotions and memory. The limbic system operates primarily on an unconscious level while the final stop on the fear pathway, the frontal cortex is part of the conscious mind. The cortex is the gray matter of the brain, the thinking/reasoning part. What occurs in panic is that the activation of the hippocampus and amygdala is so great that the radiations stay primarily within the limbic system where they remain at an unconscious level thereby depriving the cortex the opportunity to do its work.
Another way to look at it is that the affect (the feelings) generated in the unconscious is so strong that action must be taken immediately to give relief. This impulse is so powerful that it never reaches the conscious level to be moderated by the cortex. For many years this idea was a theory of psychoanalysis, but now research with f-MRI machines has verified it. The end result of this is that in a financial panic judgment goes out the window. Inevitably this sends values well below “fair value” as more and more investors sell at any price.
Combating panic is the single most difficult problem for investors. Here is a simple outline of steps to combat panic, but the reader is reminded that hard work must go into this plan.
Develop a written plan. Do this now. If you need help, call your financial planner and/or financial representative. Having this in writing is crucial because if panic sets in it is highly likely you will react and not remember a plan that is only in your head.
Make sure your plan has an asset allocation appropriate to your age. The older you are the higher percentage of fixed income you should have. Your asset allocation should take into account geography, i.e., percentages allotted to the U.S., Europe, Asia, and developing markets, and allocation by market capitalization, i.e., large caps, mid-caps, and small caps. Doing this will give you a portfolio with non-correlated assets preventing the current situation in which a whole portfolio may be crashing. Be sure to re-adjust your assets annually on your birthday.
Practice fighting panic in your mind. This is based on the psychological principle of deconditioning. If you regularly imagine handling a problem, you will be better able to cope if and when that problem presents itself. It is this part of the plan that requires regular practice. If this kind of exercise is foreign to your experience, work with it and appreciate that it takes time to master. Get help with this from a friend or advisor who is sophisticated about psychology.
Talk to friends who have similar investment plans and needs. Be sure this is someone who is of your approximate financial standing. If you have $100,000, it isn't helpful to talk to someone with $10 million.
Utilize your financial team. Consult your financial planner frequently especially in developing your written plan. Also consult other experts who are available to you. Don't hesitate in doing this. The advisory team may welcome this as much as you do. Remember we are all in the same boat. Support during a panic is essential to financial survival.
Reprinted with permission from The Schott Letter, January 2009
John W. Schott, M.D., is a member of the Boston Psychoanalytic Society. He is director and portfolio manager at Steinberg Global Asset Management in Boston and Boca Raton, Florida. He also publishes a monthly newsletter on investment psychology, The Schott Letter.