There is an old saying on Wall Street that the market is driven by just two emotions: fear and greed. Although this is an oversimplification, it can often ring true. Succumbing to these emotions, however, can also profoundly harm investor portfolios, the stock market's stability, and even the economy on the whole. There is a vast academic literature, known as behavioral finance, which is devoted to the topic of understanding market psychology.
Below, we focus on fear and greed and describe what happens when these two emotions come to drive investment decisions.
- Letting emotions govern investment behavior often leads to irrational decision-making that can cost you dearly.
- It's usually best to ignore the trend at the moment—whether bullish or bearish—and stick to a long-term plan based on sound fundamentals.
- It's also critical to understand how risk-sensitive you are and to set your asset allocations accordingly when fear and greed grip the market.
The Influence of Greed
Most people want to get rich as quickly as possible, and bull markets invite us to try it. The internet boom of the late 1990s is a perfect example. At the time, it seemed all an adviser had to do was pitch any investment with "dotcom" at the end of it, and investors leaped at the opportunity. Accumulation of internet-related stocks, many of them barely startups, reached a fever pitch. Investors got exceedingly greedy, fueling ever more buying and bidding prices up to excessive levels. Like many other asset bubbles in history, it eventually burst, depressing stock prices from 2000 to 2002.
As fictional investor Gordon Gekko famously said in the movie Wall Street, "greed is good." However, this get-rich-quick thinking makes it hard to maintain a disciplined, long-term investment plan, especially amid what Federal Reserve Chair Alan Greenspan famously called "irrational exuberance." It's times like these when it's crucial to maintain an even keel and stick to the fundamentals of investing, such as maintaining a long-term horizon, dollar-cost averaging, and ignoring the herd, whether the herd is buying or selling.
A Lesson From the "Oracle of Omaha"
An exemplar of clear-eyed, long-term investing is Warren Buffett, who largely ignored the dotcom bubble and had the last laugh on those who called him mistaken. Buffett stuck with his time-tested approach, known as value investing. This involves buying companies the market appears to have underpriced, which necessarily means ignoring speculative fads.
The Influence of Fear
Just as the market can become overwhelmed with greed, it can also succumb to fear. When stocks suffer large losses for a sustained period, investors can collectively become fearful of further losses, so they start to sell. This, of course, has the self-fulfilling effect of ensuring that prices fall further. Economists have a name for what happens when investors buy or sell just because everyone else is doing it: herd behavior.
Just as greed dominates the market during a boom, fear prevails following its bust. To stem losses, investors quickly sell stocks and buy safer assets, like money-market securities, stable-value funds, and principal-protected funds—all low-risk but low-return securities.
Following the Herd vs. Investing Based on Fundamentals
This mass exodus from stocks shows a complete disregard for long-term investing based on fundamentals. Granted, losing a large portion of your equity portfolio is a tough pill to swallow, but you only compound the damage by missing out on the inevitable recovery. In the long run, low-risk investments saddle investors an opportunity cost of forfeited earnings and compounded growth that eventually dwarf the losses incurred in the market downturn.
Just as scrapping your investment plan for the latest get-rich-quick fad can tear a large hole in your portfolio, so too can fleeing the market along with the rest of the herd, which usually exits the market at exactly the wrong time. When the herd is fleeing, you should be buying, unless you're already fully invested. In that case, just hold on tight.
The Importance of Comfort Level
All this talk of fear and greed relates to the volatility inherent in the stock market. When investors find themselves outside of their comfort zones due to losses or market instability, they become vulnerable to these emotions, often resulting in very costly mistakes.
Avoid getting swept up in the dominant market sentiment of the day, which can be driven by irrational fear or greed, and stick to the fundamentals. Choose a suitable asset allocation. If you are extremely risk-averse, you are likely to be more susceptible to fear, therefore your exposure to equities should be smaller than that of people with a high tolerance for risk.
Buffett once said: "Unless you can watch your stock holding decline by 50% without becoming panic-stricken, you should not be in the stock market."
This isn't as easy as it sounds. There's a fine line between controlling your emotions and being just plain stubborn. Remember also to re-evaluate your strategy from time to time. Be flexible—to a point—and remain rational when making decisions to change your plan of action.
Frequently Asked Questions
Why are fear and greed so important to market psychology?
Many investors are emotional and reactionary, and fear and greed are heavy hitters in that arena. According to some researchers, greed and fear have the power to affect our brains in a way that coerces us to put aside common sense and self-control and thus provoke change. When it comes to humans and money, fear and greed can be powerful motives.
How do fear and greed affect markets?
When people are overtaken by the power of greed or fear that becomes rampant in a market, overreactions can take place that distorts prices. On the side of greed, asset bubbles can inflate well beyond fundamentals. On the fear size, sell-offs can become protracted and depress prices well below where they should be.
How can traders take advantage of fear and greed in the market?
Fear and greed create overreactions, which means that savvy traders can buy oversold assets and sell overbought ones. Adopting a contrarian strategy can be a good idea, whereby you buy when others are panicking - picking up assets while they are "on sale", and selling when euphoria leads to bubbles. At the end of the day, however, it is human nature to be part of a crowd and so it can be difficult to resist the urge to deviate from your plan.
How can one measure the level of fear or greed in the stock market?
There are several market sentiment indicators one can look at, but two specifically interrogate the emotions of fear or greed. The Cboe's VIX Index, for instance, measures the implicit level of fear or greed in the market by looking at changes in volatility in the S&P 500. The CNN Business Fear & Greed Index is another good tool that measures daily, weekly, monthly, and yearly changes in fear and greed. It is used as a contrarian indicator that examines seven different factors to establish how much fear and greed there is in the market, scoring investor sentiment on a scale of 0 to 100.
The Bottom Line
You are the final decision-maker for your portfolio, and thus responsible for any gains or losses in your investments. Sticking to sound investment decisions while controlling your emotions—whether they be greed-based or fear-based—and not blindly following market sentiment is crucial to successful investing and maintaining your long-term strategy.