Lesson 8: Three methods to profit from panic

Hello, Tigers!

In the previous lesson, I introduced you to a new term: "anomaly," and explained to you the investment opportunities presented by two types of financial report anomalies. In today's lesson, we will continue to discuss a common term: "panic," and I will teach you three methods to profit from panic.

1.How panic arises

How does panic occur during trading? Based on what we've discussed in previous lessons, we can roughly summarize it into four reasons:

(1) Herd Mentality

Investors are often influenced by other investors, leading to a herd effect. When sudden events or significant price fluctuations occur in the market, they may join the majority out of fear of missing out or fear of loss, resulting in excessive buying or selling, which can trigger market panic.

(2) Loss Aversion

People are more sensitive to losses than gains, a phenomenon known as loss aversion. In the stock market, when investors perceive losses, they may panic and overreact, eager to minimize losses, resulting in massive sell-offs.

(3) Overconfidence

Investors often overestimate their judgment and analytical abilities, leading to an overreliance on their own views. When uncertainty or negative news arises in the market, investors may overly trust their views, ignoring other possible factors, thereby causing excessive panic in the market.

(4) Mental Accounting Effect

Investors often divide their investments into different "accounts," such as retirement accounts or children's education accounts. When one account incurs losses, investors may feel anxious and panic, leading them to engage in excessive behavior in other accounts to compensate for the losses.

In summary, investors may exhibit irrational and emotion-driven behaviors in stock trading, which in specific contexts may lead to market panic.

2.Establishing your investment portfolio

So how can you overcome the fear of panic and prevent trading from distorting? Remember these three methods:

First method: Learn to rationally diversify your investment portfolio.

As rational investors, we should be very clear about our risk preferences, and risk preferences are not easily changed.

So, how should rational diversification of investments be done?

In fact, rational diversification of investments or optimal capital allocation ratios can be accurately measured. Each person's optimal capital allocation should maximize their utility, and utility depends on three variables: asset returns, asset risks, and one's risk preferences.

In other words, faced with the same assets, the optimal capital allocation ratio for each person depends on their risk preferences, and we need to calculate the most suitable allocation ratio based on our own risk preferences.

For example:

Investor A is more averse to risk, so A's optimal capital allocation may be calculated as 60% of funds invested in bonds and 40% invested in stocks; while Investor B is less averse to risk, so B's optimal capital allocation may be calculated as 40% of funds invested in bonds and 60% invested in stocks.

Because A and B have different risk preferences, their capital allocations are also different. Everyone has a definite risk preference, so the optimal capital allocation is determined for each person.

3.Addressing selling behavior bias

Second method: overcoming incorrect selling behavior bias.

We've discussed in previous lessons that in the selling process, it's easy to generate selling behavior bias due to panic, with the most common behavior being the "disposition effect."

This was proposed by behavioral economists Hersh Shefrin and his collaborator Meir Statman in 1985, referring to investors' reluctance to sell assets at prices lower than their purchase costs, meaning investors tend to "sell winners and hold losers."

So, as rational investors, how should we deal with this situation?

First, you should understand that the disposition effect is a decision-making error. The disposition effect is essentially caused by decision reference points. Because there are reference points, people tend to make decisions unconsciously in the perceived areas of gains and losses. And people have different risk preferences in the areas of gains and losses, which leads to the "sell winners and hold losers" selling decision.

Since selling winners and holding losers is incorrect, is it okay to choose to sell losing stocks next time?

If your answer is yes, then you're wrong again.

In fact, selling winners and selling losers are both incorrect. Investment should "look forward," not "look back." The correct selling behavior does not look back; selling behavior should be unrelated to cost reference points and corresponding gains or losses, but should look toward the future.

The correct approach is: choose to sell the stock with the lowest expected future return.

4.How to Obtain Rational Opportunities Based on Panic Index

Third method: learn to utilize the VIX panic index for contrarian trading.

The VIX panic index, whose full name is the Volatility Index, was created by the Chicago Board Options Exchange (CBOE) in 1993. The VIX panic index measures market participants' expectations of volatility for the S&P 500 Index.

In simple terms:

The higher the value of the VIX index, the greater the expected volatility of market participants, indicating higher market risk; the lower the value of the VIX index, the lower the expected volatility of market participants, indicating relatively calm markets.

Therefore, generally speaking, when the level of the VIX index is low, it represents a relatively stable market, and we can consider buying stocks on dips. When the level of the VIX index is high, it may represent market instability, and conservative strategies, reducing positions, or holding safe-haven assets can be considered.

So, those are the three methods to profit from panic. Have you learned them?

In the next lesson, I will tell you how to avoid three common traps in behavioral finance and win in long-term returns!