Fear is one of the primal elements in our psychological make-up and primary drivers of our behavior. Fear is perhaps most apparent in moments of heightened threat and turmoil such as in the wake of a terrorist attack. When terror strikes, our “fight or flight” impulses kick in.
Since financial markets are a microcosm of human behavior, it is not surprising that we see this same fear-driven phenomenon play out on global exchanges in the wake of terrorist attacks. Markets, like humans, tend to react emotionally and therefore improperly to acts of terrorism.
The Toll Of Terror On Markets
The events of September 11, 2001, are a case in point. The Dow Jones Industrial Average dropped by over 14% in the ten days after the attacks on New York’s World Trade Centers, while the FTSE 100 decreased by nearly 12% and the Nikkei 225 fell by more than 6%. Conversely, gold—traditionally viewed as a “safety” — rose by more than 6.6% over that same period as many investors made a “flight to safety.” Even if the attack itself does not directly impact us, our survival instincts take over when terrorism occurs. The effects of terrorism can ripple far beyond the site of the attack, unleashing a wave of emotion in the collective global psyche.
Other terrorist attacks have seen a more “rational” reaction from markets. For example, in the wake of the Paris attacks in November 2013, major global indices initially fell, but rallied to finish the month in positive territory. Interestingly, gold prices slipped steadily, ending the month of the attacks down by nearly 3%.
Each terrorist attack has triggered a different reaction from global markets, and perhaps the only overarching trend we can extract is that the financial world — driven by human emotion — is random and uncertain at best. Sometimes investors overlook acts of terror. But if not, being unprepared can leave you and your portfolio feeling deep financial reverberations while bewildered searching for how to recover.
So, how can we protect our portfolios against the potentially negative impact of this turbulence and unpredictability?
Keep Calm And Carry On (With Your Investment Process)
Of course, we cannot control the behavior of global financial markets — this would be akin to attempting to take command of other humans’ brains. But importantly we can work to control our own actions and thereby mitigate any damage that is done to our own portfolios. It is in this way, by looking within ourselves, that we find steps we can take to combat a tendency to overreact and therefore better protect our investments against the impact of terrorism.
There is one well-known rule in any crisis: Do not panic. This is especially the case in the aftermath of a terrorist attack. When fear rears its ugly head, our survival mechanism takes effect, and we — as human beings and investors — feel the urge to run for cover. In these moments, we must strive to control our fear and not let fear control us. We must remember the wise words of Franklin D. Roosevelt: “The only thing we have to fear is fear itself.”
As the contagion of fear proliferates and uncertainty rocks financial markets, we must resist the impulse to succumb to panic and make snap decisions about our investments. We must — to put a twist on the famous British slogan — keep calm and carry on with our investment process. Remaining composed and committed to our investment approach and asset allocation will enable us, over the long haul, to ride out economic storms precipitated by terrorist acts.
Be Psychologically Prepared
The above advice sounds easy, but in reality, when terror strikes and chaos reigns, it is tough to stay calm and stay true to our investment process. Preparing psychologically for the likelihood of an attack can enable us to conquer (or at least mitigate) our fear and overcome the innate impulse to react and stray from our investment approach. And doing so often means maintaining at least a basic understanding of what is happening inside our heads when the panic occurs.
On a physiological level, the limbic system is the part of our brain that handles fear, and it is powerful. And to that, what it likes least is the feeling of being out of control; since the beginning of logical thought many thousands of years ago, the limbic system (i.e. the fear inside our heads) has worked non-stop to contest the reality of a world where we have so little actual control. Today, each terrorist attack is an unsettling reminder of how little control we have over our world, and so in the wake of these attacks we instinctively reach for something that seems more solid and stable. As humans, we reach for (the illusion of) solid ground by screaming for greater defense spending or even stationing armed police in schools. And as investors, we may overly gravitate towards more “safe” assets such as gold and the U.S. dollar, thereby losing our diversification and ultimately (and ironically) making our portfolios more vulnerable.
To insulate our investments, we should make changes to our portfolios before terror strikes, when our heads are clear and not clouded by emotion.
Bolster And Balance Your Portfolio
Although each investor’s approach and asset allocation is unique, there are a few salient points on investing that may help insulate a portfolio against the impact of a terrorist attack.
Investors should look for greater diversification and structure their portfolio to better withstand the effects of unexpected, external shocks. This objective can be accomplished by incorporating assets — such as gold and the U.S. dollar — that are typically negatively correlated with stocks. These assets can serve as buffers against short-term volatility caused by terrorist attacks. But investors must be mindful to resist the impulse — when overall market volatility is low and these type of hedges out of favor — to opt for more exciting, better-performing assets.
As humans, we deeply desire to review our investments and see all assets going up. But, such portfolio performance is the antithesis of diversification. If you look at your portfolio, and everything is up, this is just as bad as when everything is down. And though making lots of money may momentarily make you feel good, your investment selection is being illogically driven by your limbic system, and therein you are asking for tremendous trouble when terror strikes. By contrast, true portfolio diversification means some of your investments should be up and some down, at all times.
The Bottom Line
We must adapt to the new reality of terrorism in our day and age; attacks can happen at any time and place — it is no longer a matter of if, but when. Faced with this seeming inevitability of cataclysmic events and the potential for ensuing upheaval, we can prepare ourselves psychologically and our portfolios structurally to withstand the impact.
As investors, our chief enemy is not the terrorists, but the fear inside our own heads. Such fear may run rampant in the outside world, including our financial markets, but individually we cannot let it infiltrate.