Fire drills help everyone be aware of steps to be taken in the event of a fire. Preparation for extreme events is best done when one is able to calmly consider various options and figure out the next steps. Unforeseen events happen, but planning for extreme events will help one think through various scenarios and will leave one better prepared to deal with new scenarios as well.
When extreme events occur some people either choke or panic. Let’s look at behavioural science to get a better insight into these –
- Choking is when one overthinks the situation instead of following their normally well-tuned instincts. For instance a player who is on the verge of victory suddenly feels the enormity of the situation and starts playing almost like an amateur. The player may be thinking about his technique than allow his well trained instincts to respond.
- Panic is when one is following instinct rather than using their thought process. For instance, when one encounters a deer in a fast moving car – ones instincts lead one to swerve, but one is better of driving straight than swerving. Statistics show that hitting another car by swerving is a cause of more accidents. This situation needs one to follow ones thought process rather than follow the insticnts.
- Choking is thinking too much when one should be following ones instincts and panic is thinking too little and following ones instinct. Art of failure is an interesting article by Malcom Gladwell – has insights on choking and panic.
Panic is the cause of many poor financial decisions made during extreme events. One can avoid this by having a fire drill. A fire drill for your portfolio is to figure out your next steps when extreme events occur. Key steps for the portfolio fire drill conducted in “peace time” are
- Ranking various stocks in the portfolio in the order of their quality and performance.
- Identification of the stocks that one would like to liquidate. Almost all portfolios will have some stocks that one may not want to hold for various reasons – e.g., the prospects have changed from the time of purchase, purchase was a poor decision etc.
- Identification of list of stocks that one would like to buy if their prices were lower (we call our list the “bucket list”)
Let’s consider 2 extreme scenarios a crash and a steep rally and a well thought out responses in those scenarios.
- Crash: When there is a market crash many stocks will be available at much lower prices than the recent past. This is the best time to look to purchase the stocks on the “bucket list” if their prices are attractive.
- If one doesn’t have the necessary cash at this moment to make the purchases, one should consider selling the relatively poor performers in the portfolio or index funds in the portfolio. One should be open to booking a loss in some stocks or index funds to be able to buy into the “bucket list”.
- Steep rally: When there is a steep rally it creates an opportunity to sell some of the poor performers at better prices.
- Though one can reasonably expect a correction after a steep rally, it may not be a great idea to sell good stocks in a rally as opportunities to purchase them at better prices may not arise. One should be open for a correction after a steep rally, in the long run these fluctuations don’t matter for good stocks.