Why Investors Often Buy Euphoria And Sell Fear: Getting Past The Psychology
Investing isn't primarily a mathematician's game. It's a psychologist's game. Investors often make decisions based on their feelings, not on algebraic functions. When you understand why investors behave the way they do, you are that much closer to making money in the market.
Most investors who let their emotions get involved operate off one of two emotions — fear or greed. Sometimes, they run on both. Warren Buffet, the famous Oracle of Omaha who made his fortune in stocks, once advised investors: "Be fearful when others are greedy, and greedy when others are fearful."
What Is The Fear And Greed Index?
The fear and greed index is a CNN Business metric that shows investors' market sentiment (positive or negative) toward the stock market and certain investment vehicles such as mutual funds or ETFs.
It reveals whether investors are greedy and making risky investments to try to make money or if they are fearful of risky investments and investing in safer vehicles like U.S. Treasury notes to ensure their money is safe in case the risky investments don’t pan out.
The fear and greed index is a measure of market sentiment that essentially captures the emotions and mental patterns that determine investor behavior. When the index is high, it means that investors feel greedy and are more likely to take on risks. When the index is low, it means that investors feel fearful and are more likely to sell off their assets.
According to CNN marketing, investors might pay attention to this measure because it can give them an idea of what type of investments you should be making. For example, if you see the fear and greed index go down, as it has recently with crypto investments, then you know that other investors are operating in fear and may be willing to sell at lower rates. On the other hand, if you see the fear and greed index go up, it’s possible that investors are feeling euphoric and are about to go on a buying spree, meaning potentially higher selling rates.
The Fear And Greed Index And Investor Behavior
CNNMoney initially created the fear and greed index to measure the level of fear or greed in the stock market. The index is based on seven factors: stock price, volatility, put/call ratio, junk bond demand, emerging markets, credit spread, and market breadth.
CNN isn’t the only one to measure investor sentiment. For the active and seasoned investor sentiment measures, often when combined, may act as a guide of when to buy or sell. In this case, the index may be helpful to draw awareness to one's own emotions and biases.
How do emotions play a role in investor behavior?
It’s no secret, human beings tend to act on their emotions. Dr. Terrance Odean, a professor of business at the University of California Berkeley, is an expert on behavioral finance. In his seminal study on the subject, Odean says that investors should always buy fear and sell euphoria — the opposite of what feels natural — because he believes people tend to make irrational decisions based on their emotions. In other words, they will often buy stocks when they're too expensive only to sell them later at a loss.
In another study, Odean also notes that many of these decisions can be attributed to groupthink, which is where a group conforms to majority opinion and comes up with conclusions without challenging them independently. For example, Odeon found that the portfolio results or investment clubs lag behind the S&P 500's average by 3.7% per year. Those clubs operated on groupthink rather than independent assessment. Some might say a recent example of this - last year's Gamestop saga.
How To Use Fear & Greed To Manage Risk
The fear and greed index can be a helpful tool for investors to measure how much risk is in the market. By looking at the ratio of emotion to emotion, you can get a sense of whether investors are feeling more bullish or bearish.
A high ratio means there is more fear in the market, while a low ratio indicates more greed. You can use this information to help you make decisions about when to buy or sell stocks.
How To Trade Fear & Greed
The index fluctuates between 0 and 100 with zero indicating extreme fear, 100 showing extreme greed, and 50 being considered neutral.
The metric doesn't only show extremes, though. A value reading slightly below 50 indicates mild fear while a value hovering a little above 50 indicates some greed. For example, an F&G reading of about 45 would indicate that people are feeling a touch fearful these days.
As of July 2022, the index stood at 42, having just bounced out of the 20s.
How Does Psychology Affect Investment Returns?
Fear and euphoria (greed on the index) are emotions that affect behavior, including investor behavior.
Both behavioral psychology and common sense tell us that the typical person seeks short-term gains and tries to avoid losses. This behavioral bias leads to a strong preference for the status quo.
When it comes to investing, these biases can have a profound impact on returns, and short-term market movement. For example, investors tend to buy when stock prices are rising (euphoria) and sell when they fall (fear). This often results in buying high and selling low, the exact opposite of what should be done.
To illustrate this point, let’s consider the example of a recent IPO stock offering.
It is typical for investors to buy shares of a company when they first come public and then sell them off as soon as they start going down in value. In this way, an investor can quickly lose money if the stock falls below its initial price.
This behavior is referred to as buying euphoria and selling fear. It is typical for new stocks that don’t have much history behind them or companies whose financial performance is unknown or has declined recently.
Emotions play a key role in the short-term volatility of the market. Recent research shows that investors share their enthusiasm in real time on social media during trading hours. Consequently, both fear and happiness tend to create actual changes in market value — at least for the span of a few days. Investor emotions have little effect on the market's long-term performance.
As a result, many advisors recommend dollar cost averaging into investments over time. If you invest $5,000 every month into an index fund, then you systematically end up buying more shares when prices are down and fewer shares when prices are up — never paying more or less than $5,000 a month and lowering your average cost per share (over time). That way you don't get caught up in the market's euphoria or fear.
Why People Make Big Decisions During Emotional Turmoil (and why you shouldn't)
People tend to make bad decisions when they're emotional — whether that's happy or sad, greedy or fearful. They get caught up in the moment and don't think things through rationally.
Harvard Business Review tells us why. Our brains help us make decisions through two primary processes. The first is called pattern recognition, and the second is emotional tagging.
Pattern recognition helps us cope with new experiences by linking them to similar past experiences. This process can cause us to think we understand a situation even when we don't. Emotional tagging refers to the brain's habit of tagging past memories with emotions.
Most of the time, pattern recognition and emotional tagging actually help us reach good decisions. However, false patterns and distorted emotional tags work against us. These usually crop up when we are facing a situation with biased self-interest, misleading memories, or strong personal attachments. All of these factors can influence our financial choices.
This is why investors often buy during euphoria (when everyone is feeling good and optimistic) and sell during fear (when everyone is panicking). If you can get past the psychology, you can make better decisions with your money.
Whether it's the temptation to believe it is possible to get rich quick or to only remember the bad times or that story a friend told you when they guessed it right - fear and greed often lead to poor investment decisions. Or to put it in the words of Jesus: “Watch out! Be on your guard against all kinds of greed; life does not consist in an abundance of possessions.” Luke 12:15
7 Tips to Avoid Emotional Investing
Buy and hold. In Odean's studies on investor behaviors, he found that active traders usually underperform the market. Often, they wind up selling their winnings and holding their losses. By contrast, the highest performers don't trade very often. They keep what they have.
Don't just vow to do better. If we could change our behavior through sheer willpower, we would. To help you make better investment choices, surround yourself with a team of level-headed experts.
Don’t make any rash decisions when you’re feeling any extreme emotion. Instead, use proven investment strategies to help protect your portfolio during a dip.
Diversify your portfolio. Having a broad-based collection of assets typically means that growth in some investments helps offset periods of losses in others.
Learn about financial markets. Lack of information often drives fear. The more you know, the more comfortable you may feel with the market's normal patterns. Read articles, work with a coach, or talk with your investment advisor about market conditions.
Trust the process. Dollar cost averaging is a set-it-and-forget-it strategy that works. Most people use it for their 401(k), and that's partly why there are more than 400,000 401(k) millionaires. Eight out of ten millionaires invest in their 401(k). It's not an original strategy, but it works!
Get comfortable with boredom. As a general rule, it may seem boring, but boring, with a long-term track record, is likely to pay off over time.. If you're looking for excitement, consider taking up extreme sports, and leave your investments alone so they will grow and be there for you when you need them.
Do you want to talk through your investment strategy with an objective third party? Contact Cooke Wealth Management. Our financial advisors rely on the principles of Biblical wealth management to assist our clients in making wise choices.