When Fear and Greed Take Control of the Financial Markets
On Wall Street, there is an old saying that the market is driven by only two emotions: fear and greed. This is true to some extent. Despite the fact that this is an oversimplification, it can often be applied. Succumbing to these emotions, on the other hand, can have serious consequences for investor portfolios, the stability of the stock market, and even the health of the economy as a whole.
Market psychology is the subject of a large body of academic literature known as behavioral finance, which is devoted to the study of market psychology.
Fear and greed are discussed in detail below, as well as what happens when these two emotions become the driving force behind investment decisions.
The Most Important Takeaways
Allowing your emotions to dictate your investment behavior frequently results in irrational decision-making that can be extremely costly.
It’s usually best to ignore the current trend, whether it’s bullish or bearish, and stick to a long-term strategy based on sound fundamentals rather than following it.
Understanding your level of risk aversion and adjusting your asset allocations in response to market volatility is also critical when fear and greed grip the market.
Greed Has a Significant Impact
The majority of people want to become wealthy as quickly as possible, and bull markets encourage us to do so. The Internet boom of the late 1990s is an excellent illustration of this. At the time, it appeared that all an adviser needed to do was pitch any investment with the word “dotcom” at the end of the name, and investors would jump at the chance.
The accumulation of internet-related stocks, many of which were still in the early stages of development, reached a fever pitch. Investors became excessively greedy, causing prices for buying and bidding to rise at an alarming rate, eventually reaching exorbitant levels. It eventually burst, as have many other asset bubbles throughout history, causing stock prices to plummet from 2000 to 2002. 1
When it comes to investing, greed is a good thing, as fictional investor Gordon Gekko famously stated in the film Wall Street. It is, on the other hand, difficult to maintain a disciplined, long-term investment strategy in an environment marked by what former Federal Reserve Chair Alan Greenspan dubbed “irrational exuberance,” as he put it.
It is during times like these that it is critical to maintain a level head and adhere to the fundamentals of investing, which include maintaining a long-term horizon, dollar-cost averaging, and ignoring the herd, regardless of whether the herd is buying or selling stocks.
The “Oracle of Omaha” Taught Us Something Important
One of the best examples of long-term investing is Warren Buffett, who largely ignored the dotcom bubble and ended up having the last laugh on those who thought he was mistaken in his predictions. Buffett stuck to his tried-and-true value investing strategy, which has worked for him for decades. This entails purchasing companies that the market appears to have underpriced, which necessitates ignoring speculative fads in order to do so.
Fear Has a Significant Impact
In the same way that the market can become overwhelmed by greed, it can also become overwhelmed by fear. When stocks suffer significant losses over a prolonged period of time, investors may become collectively fearful of further losses and begin to sell their holdings.
It goes without saying that this has the self-fulfilling effect of ensuring that prices continue to fall. Herd behavior is the term economists use to describe what happens when investors buy or sell because everyone else is doing so: it is a phenomenon known as herd behavior.
Similarly to how greed rules the market during a boom, fear rules the market following a bust. In order to limit their losses, investors sell their stocks and invest in safer assets such as money market securities, stable-value funds, and principal-protected funds, which are all low-risk but low-return investments.
When it comes to investing, following the herd versus investing on fundamentals is the difference.
This massive exodus from stocks demonstrates a total disregard for long-term investing based on fundamentals. Granted, losing a significant portion of your equity portfolio is a difficult pill to swallow, but failing to take advantage of the inevitable recovery only serves to compound the damage.
In the long run, low-risk investments impose an opportunity cost on investors in the form of forfeited earnings and compounded growth, which eventually outweighs the losses incurred during a market correction.
Just as abandoning your investment plan in favor of the latest get-rich-quick craze can cause a significant hole in your portfolio, fleeing the market with the rest of the herd, which usually exits the market at the worst possible time, can cause a significant hole in your portfolio. In situations where the herd is fleeing, you should be buying, unless you have already invested all of your money. You should simply hold on tight in that case.
The Importance of Having a High Level of Comfort
All of this talk about fear and greed has to do with the volatility that exists in the stock market today. As a result of losses or market instability, investors find themselves forced out of their comfort zones, making them more vulnerable to their emotions, which can lead to costly mistakes.
Continue to focus on the fundamentals and avoid getting caught up in the dominant market sentiment of the day, which can be driven by irrational fear or greed. Select an appropriate asset allocation strategy.
Those who are extremely risk averse are more vulnerable than those who have a high tolerance for risk, and as a result, their exposure to equities should be smaller than those who have a high tolerance for risk.
Buffett once said, “Unless you have the ability to watch your stock holding decline by 50% without becoming panicked, you should not be in the stock market.”
This isn’t as straightforward as it appears. You have to walk a fine line between controlling your emotions and just being stubborn out of defiance. Keep in mind that you should re-evaluate your strategy from time to time as well. Flexibility is important, but only to a point. You should maintain your rationale when making decisions to alter your course of action.
Frequently Asked Questions are listed below.
Why are fear and greed so important in the psychology of the stock market?
Many investors are emotional and reactionary, and fear and greed are major players in this arena. Fear and greed are particularly powerful in this arena.
According to some researchers, greed and fear have the ability to influence our brains in such a way that we are compelled to disregard common sense and self-control, resulting in the instigator of change. When it comes to humans and money, the emotions of fear and greed can be extremely powerful.
What is the impact of fear and greed on the stock market?
It is possible for overreactions to occur in a market when people are overcome by the power of greed or fear that has become widespread. These overreactions can cause price distortions. Taking the side of greed, asset bubbles can inflate far beyond their intrinsic value. Sales may be prolonged and prices may fall far below where they should be depending on the size of the fear.
How can traders profit from the fear and greed that exists in the market?
Overreactions are caused by fear and greed, and as a result, savvy traders can profit by purchasing oversold assets and selling overbought assets. Following a contrarian strategy, in which you buy when others are panicking – picking up assets while they are “on sale,” and sell when euphoria leads to bubbles, can be an excellent strategy.
The fact is that it is human nature to want to be a part of a group, and it can be difficult to resist the temptation to deviate from your original plan at the end of the day.
What is the best way to determine the level of fear or greed in the stock market?
One can examine several market sentiment indicators, but two stand out for their ability to probe for the emotions of fear and greed in particular. As an example, the CBOE’s VIX index, which measures changes in volatility in the S&P 500, measures the implicit level of fear or greed in the market and is released every day.
Another useful tool is the CNNMoney Fear & Greed Index, which measures changes in fear and greed on a daily, weekly, monthly, and yearly basis, as well as in the stock market. In order to determine how much fear and greed exist in the market, it is used as a contrarian indicator that examines seven different factors and scores investor sentiment on the basis of a scale ranging from 0 to 100.
What’s the bottom line?
If you make the final decision about your portfolio, you will be held accountable for any gains or losses resulting from your investments. Keeping to sound investment decisions while controlling your emotions (whether they are greed- or fear-based) and not blindly following market sentiment is critical to achieving financial success and maintaining your long-term investment strategy.