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When fear and greed take over stock market...

06 Jan 2013 - {{hitsCtrl.values.hits}}

There is an old saying that the market is driven by just two emotions: Fear and greed. Although this is an oversimplification, it can often be true. Succumbing to these emotions can have a profound and detrimental effect on investors’ portfolios and the stock market.

In the investing world, one often hears about the juxtaposition between value investing and growth investing and although understanding these two strategies is fundamental to building a personal investment strategy, it is important to understand the influence of fear and greed on the financial markets. There are countless books and various courses devoted to this topic. This article demonstrates what happens when an investor gets overwhelmed by one or both of these emotions.

Greed’s influence
So often, investors get caught up in greed (excessive desire). After all, most of us have a desire to acquire as much wealth as possible in the shortest amount of time.
This get-rich-quick mentality makes it hard to maintain gains and keep to a strict investment plan over the long term, especially amid such a frenzy or as the former American Federal Reserve Chairman, Alan Greenspan, put it, the “irrational exuberance” of the overall market. It’s times like these when it is crucial to maintain an even keel and stick to the basic fundamentals of investing, such as maintaining a long-term horizon and avoiding getting swept up in the latest craze.

Lesson from Warren Buffett
We would be remiss if we discussed the topic of not getting caught up in the latest craze without mentioning a very successful investor who stuck to his strategy and profited greatly. Buffett stuck with his comfort zone: His long-term plan. By avoiding the dominant market emotion of the time - greed - he was able to avoid losses.

Fear’s influence
Just as the market can become overwhelmed with greed, the same can happen with fear (‘an unpleasant, often strong emotion, of anticipation or awareness of danger’). When stocks suffer large losses for a sustained period, the overall market can become more fearful of sustaining further losses. But being too fearful can be just as costly as being too greedy.
This was clearly evident in our stock market in the early part of 2012. When the stock market went down due to different reasons, some domestic investors moved out from the market with the fear of further losses but foreign investors moved in. In 2012, the total net foreign inflow was Rs.38.6 billion, the highest ever net foreign investment recorded in the Colombo Stock Exchange (CSE).

In a bid to stem their losses, investors quickly move out of the equity (stock) markets in search of less risky buys. This mass exodus out of the stock market shows a complete disregard for a long-term investing plan based on fundamentals. At times, investors throw their plans out the window because they are scared, overrun by a fear of sustaining further losses. Granted, losing a large portion of your equity portfolio’s worth is a tough pill to swallow, but even harder to digest is the thought that the new instruments that initially received the inflows have very little chance of ever rebuilding that wealth.

The behaviour of Sri Lankan domestic investors in our stock market prompted Senior Minister of International Monetary Co-operation and Deputy Minister of Finance and Planning, Dr. Sarath Amunugama to state, “The Colombo stock market has always given good returns to the investors in the long run far exceeding the returns of conventional savings methods. Also, the prices of most of stocks are currently quite attractive with overall forward P/E ratio of the market being less than 15 times. This is one reason why in 2012 we saw the highest ever net foreign inflow of Rs.38 billion.”

“These foreign investors have seen the potential of the market and have entered at the right time. We urge the domestic funds and investors to study and understand the behaviour of the foreign investors and exploit the opportunity without waiting further.” (From the speech of Dr. Sarath Amunugama, Senior Minister of International Monetary Co-operation and Deputy Minister of Finance and Planning at the Capital Market Education and Training Awards Ceremony held in December 2012).
Just as scrapping your investment plan to hop on the latest, get-rich-quick investment can tear a large hole in your portfolio, so too can get swept up in the prevailing fear of the overall market by switching to low-risk, low-return investments.

Importance of comfort level
All of this talk of fear and greed relates to the volatility inherent in the stock market. When investors lose their comfort level 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 a mentality of fear and/or greed and stick to the basic fundamentals of investing. It is also important to choose a suitable asset allocation mix. For example, if you are an extremely risk averse person, you are likely to be more susceptible to being overrun by the fear dominating the market and therefore, your exposure to equity securities should not be as great as those who can tolerate more risk. Buffett was once quoted as saying, “Unless you can watch your stock holding decline by 50 percent without becoming panic-stricken, you should not be in the stock market.”

Easier said than done
Keep in mind 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 investment strategy and allow yourself to be flexible to a point and remain rational when making decisions to change your plan of action.

Conclusion
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 it is greed or fear and not blindly following market sentiment is crucial to successful investing and maintaining your long-term strategy. But beware: Never wavering from an investment strategy during times of high emotions in the market can also spell disaster. It’s a balancing act that requires you to keep your wits about you.

(Source: Investopedia)

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When fear and greed take over stock market...

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