Investing in Crisis: A High-Risk, High-Reward Strategy

The financial crisis of 2008 and the Great Recession that followed are still fresh in many investors' memories. People saw their portfolios lose 30% or more of their values, and older workers saw their 401(k) plans and IRAs drop to levels that threatened their retirement plans. Instead of acting rationally during severe bear markets, many people tend to overreact and make matters worse. However, while many people panicked or were forced to sell their assets at low prices, a small group of patient, methodical investors saw the stock market collapse as an opportunity.

Investing in a crisis is no doubt risky, for the timeline and scope of a recovery is uncertain at best. Double-dip recessions are a real possibility, and attempting to pick a bottom is largely a matter of luck. Still, those investors who can invest in a crisis without succumbing to irrational fear and anxiety may reap outsized returns during a recovery.

How Crises Affect Investors

Investors generally do not behave as predicted by traditional financial theory, in which each individual acts rationally to maximize utility. Instead, people often behave irrationally and let emotions get in the way, especially when the economy is experiencing some chaos. The emerging field of behavioral finance attempts to describe how people actually behave vs. how financial theory predicts they should.

Behavioral finance shows that people, rather than being merely risk-averse, are actually more loss-averse. This means that people feel the emotional pain of a loss much more than the pleasure gained from an equal-sized profit. Additionally, loss-aversion describes peoples' tendency to sell winners too early and to hold on to losses for too long.

These emotional biases may persist even after a recovery has begun. Investors may be leery of placing capital into the market. For example, in 2022, following the short Covid-19-induced recession, BlackRock polled 1,000 investors and found that 45% of the millennials interviewed added more equity exposure over the year, with 49% expecting to add more within six months of the survey.

Taking Advantage of a Crisis

While most investors are panicking as asset prices plummet, those with a cool head can see the resulting low prices as a buying opportunity. Buying assets from those restless individuals driven by fear is like buying them on sale. Often, fear drives asset prices well below their fundamental or intrinsic values, rewarding patient investors who allow prices to revert to their expected levels. Profiting from investing in a crisis requires discipline, patience, and, of course, enough wealth in liquid assets available to make opportunistic purchases.

When calamity strikes, investors fear the worst, and stocks are punished accordingly. But historically, when the dust clears, optimism returns and prices bounce back to where they were. Markets responded once more to fundamental signals rather than to perceived turmoil. By recognizing the fact that markets tend to overreact, a smart investor can purchase stocks and other assets at bargain prices.

Stock markets aren't the only way to invest in a crisis. The Great Recession also saw a collapse in home prices as the housing market bubble burst. People who could no longer afford their mortgages foreclosed, and many homes were underwater (where the mortgage amount owed to the bank exceeds the property's equity value). Homebuyers and those investing in real estate could pick up valuable real assets at below-normal prices. As a result, they enjoyed handsome returns as the housing market stabilized and recovered.

Betting a Crisis Will Happen

Another way to make money on a crisis is to bet that one will happen. Short-selling stocks or short equity index futures is one way to profit from a bear market. A short seller borrows shares they don't already own to sell them and, hopefully, repurchase them at a lower price. Another way to monetize a down market is to use options strategies, such as buying puts, which gain in value as the market falls. Some investors sell call options, which will expire to a price of zero if they expire out of the money. Similar strategies can be employed in bond and commodity markets.

Many investors, however, are restricted from short selling or do not have access to derivatives markets. Even if they do, they may have an emotional or cognitive bias against selling short. Furthermore, short-sellers may be forced to cover their positions for a loss if markets rise instead of fall and margin calls are issued. Today, there are ETFs that give longs (holders of the ETF shares) short exposure to the market. So-called inverse ETFs may aim to return +1% for every negative 1% return the underlying index returns. Some inverse ETFs may also employ gearing, or leverage, returning +2% or even +3% for every 1% loss in the underlying.

For individuals seeking to protect themselves from a crisis and not necessarily bet on such an event, owning a well-diversified portfolio, including positions in asset classes with low correlations, can help cushion the blow. Those with access to derivatives markets can also employ hedging strategies, such as a protective put or covered call, to lessen the severity of potential losses.

The Bottom Line

Economic crises happen from time to time, as do recessions and depressions. In the 20th century alone, there were about twenty identifiable crises—not including geopolitical events such as wars or terrorist attacks, which also caused markets to drop suddenly. Behavioral finance tells us that people are prone to panic in such events and will not act rationally the way traditional financial theory predicts. As a result, those with cool heads, discipline, and an understanding that historically, markets have always rebounded from such events can purchase assets at bargain prices and earn excess returns.

Those with the foresight that a crisis is impending may implement short strategies to profit from a falling market. Of course, timing is everything—buying too early or late or holding on to a short position for too long can serve to compound losses and take away from potential gains.