Mastering Fear and Greed

 

The target of objectivity or mental balance lies approximately in the middle between the two destructive mental forces of fear and greed. Fear is a complex emotion taking many forms such as worry, fright, alarm, and panic. When fear is given free rein, it typically combines with other negative emotions such as hatred, hostility, anger, and revenge, thereby attaining even greater destructive power.

Aspects of Fear

In the final analysis, fear among investors shows itself in two forms: fear of losing and fear of missing out. In his book How I Helped More Than 10,000 Investors to Profit in Stocks, George Schaefer, the great Dow theorist, describes several aspects of fear and the varying effects they have on the psyche of investors: A Threat to National Security Triggers Fear. Any threat of war, declared or rumored, dampens stock prices. The outbreak of war is usually treated as an excuse for a rally, hence the expression: "Buy on the sound of cannon, sell on the sound of trumpets." This maxim is derived from the fact that the outbreak of war can usually be anticipated. Consequently, the possibility is quickly discounted by the stock market, and, therefore, the market, with a sigh of relief, begins to rally when hostilities begin. As it becomes more and more obvious that victory is assured, the event is factored into the price structure and is fully discounted by the time victory is finally achieved. "The sound of trumpets" becomes, therefore, a signal to sell. Only if the war goes badly are prices pushed lower as more fear grips investors.

All People Fear Losing Money. This form of fear affects rich and poor alike. The more you have the more you can lose, and therefore the greater the potential for fear in any given individual. Worrisome News Stimulates Fear. Any news that threatens our economic well-being will bring on fear. The more serious the situation, the more pronounced is the potential for a selling panic.

A Fearful Mass Psychology Is Contagious. Fear breeds more fear. The more people around us who are selling in response to bad news, the more believable the story becomes, and the more realistic the situation appears. As a result, it becomes very difficult to distance ourselves from the beliefs and fears of the crowd, so we also are motivated to sell. By contrast, if the same breaking news story received less prominence, we would not be drawn into this mass psychological trap and would be less likely to make the wrong decision.

Fear of a Never-Ending Bear Market Is a Persistent Myth. Once a sizable downtrend has gotten underway, the dread that it will never end becomes deeply entrenched in the minds of investors. Almost all equity bull markets are preceded by declining interest rates and an easy-money policy that sow the seeds for the next recovery. This trend would be obvious to any rational person who is able to think independently. However, the sight of sharply declining prices in the face of such an improving background reinforces the fear that "this time it will be different" and that the decline will never end.

Individuals Retain All Their Past Fears. Once you have had a bad experience in the market, you will always fear a similar recurrence, whether consciously or subconsciously, or both. If you have made an investment that resulted in devastating losses, you will be much more nervous the next time you venture into the market. As a result, your judgment will be adversely affected by even the slightest, often imagined, hint of trouble. That intimation will encourage you to sell so that you can avoid the psychological pain of losing yet again.

This phenomenon also affects the investment community as a whole. Prior to 1929, the collective psyche lived in dread of another "Black Friday." In 1869, a group of speculators tried to corner the gold market. When the gold price plummeted, they were forced to liquidate. This resulted in margin calls, the effect of which also spilled over into the stock market causing a terrible crash. Even though few of today's investors experienced the "Black Thursday" crash of 1929, this event still casts a shadow over the minds of most investors. As a consequence, even the mere hint of such a recurrence is enough to send investors scurrying.

The Fear of Losing Out. This was not one of Schaefer's classifications of fear, but it is a very powerful one, nonetheless. This phenomenon often occurs after a sharp price rise. Portfolio managers are often measured on a relative basis either against the market itself or against a universe of their peers. If they are underinvested as a sharp rally begins, the perception of missing out on a price move and of subsequent underperformance is so great that the fear of missing the boat forces them to get in. This form of fear can also affect individuals. Often, an investor will judge, quite correctly, that a major bull market in a specific financial asset is about to get underway. Then when the big move develops, he does not participate for some reason. It might be because he was waiting for lower prices, or more likely because he had already got in but had then been psyched out due to some unexpected bad news. Regardless of the reason, such "sold out bulls" suddenly feel left out and feel compelled to get back into the market. Ironically, this usually occurs somewhere close to the top. Consequently, the strong belief in the bull market case coupled with the contagion of seeing prices explode results in the feeling of being left out.

I have found personally that this fear of missing the boat is frequently coupled with anger, which may be triggered by a minor mishap that compounds my frustration. These mistakes typically take the form of an unfortunate execution, a bad fill, a lost order, and so on. Inevitably, I have found this burst of emotion to be associated with a major, often dramatic turning point in the market. This experience tells me two things. First, I have obviously lost my sense of objectivity as the need to participate at all costs overrides every other emotion. My decision is therefore likely to be wrong. Second, the very nature of the situation-a lengthy period of rising prices culminating in total frustrationsymbolizes an overextended market. It is reasonable to expect that others are also affected by the same sense of frustration, which implies that all the buying potential has already been realized.

When you find yourself in this kind of situation it is almost always wise to stand aside. A client once said to me, "There is always another train." By this, he meant that even if you do miss the current opportunity, however wonderful it may appear, patience and discipline will always reward you with another. If you ever find yourself in this predicament, overcome the fear of missing out and look for the next "train."

Fear, in effect, causes us to act in a vacuum. It is such an overpowering emotion that we forget about the alternatives, temporarily losing the perception that we do have other choices. Fear of losing can also take other forms. For instance, occasionally we play mental games by refusing to acknowledge the existence of ominous developments. This could take the form of concentrating on the good news, because we want the market to rally, and downplaying the bad news, although the latter may be more significant. Needless to say, this kind of denial can lead to some devastating losses.

Alternately, an investor may get into the market in the belief that prices are headed significantly higher, say by 30%, over the course of the next year. After a couple of weeks, the stock may have already advanced 15%. It then undergoes a minor correction that has absolutely no relevance so far as the long-term potential is concerned. Nevertheless, the investor's fear of losing comes to the surface as he mentally relives experiences of previous setbacks.

The reasoning may be, "Why don't I get out now? The short-term correction that is likely to take place may well push the price below my entry point and I will be forced to take another loss. Far better if I liquidate and get back in when it goes lower." He has diverted his focus from what the market can give

him to what it can take away. Getting out would be quite in order if his assessment of conditions had changed, but if the appraisal is based purely on a change in perceptions unaccompanied by an alteration in the external environment, liquidation would not make sense. One way of solving this dilemma would be to take profits on part of the position. This would relieve some of the pressure but would also leave him free to participate in the next stage of the rally.

A more permanent and viable solution is first to recognize that you have a problem in this area. Next, establish a plan that sets realistic goals ahead of time and also permits the taking of partial profits under certain predetermined conditions. This approach would stand a far greater chance of being successful than knee-jerk trading or investment decisions caused by character weakness. If this type of planning went into every trading or investment decision it would eventually become a habit. The fear of losing would then be replaced by a far more healthy fear of not following the plan.

* From Investment Psychology Explained