There is a saying in financial circles that stock markets are driven by two emotions – fear and greed. Whilst this might be an over simplification, these are two of the biggest psychological effects of investing and both of them become very apparent during volatile markets.
Most of us want to make as much money as possible in the shortest period of time. Research has shown that the best way to acquire wealth is by having exposure to the share market. When the market starts to climb steadily the emotion of greed starts to take over.
As the good news and rising markets continue, investors become over confident and often assume that the good times will continue unabated. In their minds this signals an opportunity to invest more and this drives the markets even higher whilst the investor reaps the rewards that they have come to expect.
This irrational exuberance will result in over inflated markets and stock bubbles which will burst at some stage.
A perfect example of this is the dotcom boom of the 1990s where any share that was internet based became a buying opportunity driven primarily by greed. As soon as the dotcom bubble burst investors flocked out of technology stocks in a flight from risk and moved into less risky asset classes such as cash to protect what was left of their original investment.
In doing so the investors locked in their losses, they were now invested in cash earning a low rate of interest with no hope of making a capital gain. In their panic they had forgotten a few of the fundamental rules of investing in shares.
- Buy into stocks that you believe in for long-term growth
- Think long term and
- Do not focus on the short term noise.
Just as a market can become overwhelmed by greed the same can happen with fear. When markets suffer large losses for a sustained period of time, the overall market can become fearful of making further losses.
But being too fearful can be just as costly as being too greedy – in some cases investors become paralysed by their fear and tend to move out of their stocks at the bottom of the market into more secure, low risk, low return investments such as cash.
After locking in a loss, the investor then becomes nervous of entering back into the market for fear of making further losses. In many instances the investor moves back into the market once he has seen the share values increase and he will often buy into the share when it is at a high.
The mass exodus out of stocks shows a complete disregard for a long-term investment plan based on fundamentals. Investors threw their plans out of the window because they were scared, overrun by a fear of sustaining further losses.
What is the answer to emotional investing?
Fear and greed will always drive the stock market and will have an influence on the way that people react to market volatility.
The “get rich” mentality is a very enticing proposition to envisage but it is important to follow sound fundamental investment principle such as the following:
- Know how much money you can afford to lose by being exposed to the share market.
- Understand the risks associated with being invested in shares.
- Take a long term view on shares.
- If you lose money on the market, can you afford to sit it out and wait for it to recover.
- Avoid getting caught up in the dominant market sentiment of the day which is often driven by fear and greed.
- Stick to the basic fundamentals of investing.
- Select an appropriate asset allocation mix taking your personal tolerance for risk into account.
It is important to understand the effect that our emotions have on our investment decisions and it is equally important to employ the services of an accredited Certified Financial Planner to look at your investment plan holistically and to guide you through the investment principles and decisions that would be suitable for you.