In this blog post series, we review how the typical investors emotions change over the course of the cycle and how these changes impact on returns.
In the beginning –
In the most basic sense, there are two basic, negative, emotional states for any investors. Loss aversion and FOMO.
Most investors have loss aversion. Loss aversion describes the fact that for many investors, losses represent a bigger risk than gains. Put another way, the pain of losing 10% of our portfolio is greater than the joy of gaining 10% of our portfolio.
However, on the other side, we experience a fear of missing out (FOMO) which is particularly acute as markets or prices are rising and we hear stories of others making returns which we have missed out on.
It is these two emotions that are always battling it out in our investment decisions.
Lets run through the cycles in the chart above
Up the hill: FOMO
As prices rise, the battle between FOMO and Loss Aversion is typically won by FOMO. Investor successes in the press, ADVFN blog posts on soaring penny stocks and tweets from rampers all speak of getting in at the bottom and enjoying mega gains as prices rise. These all work to blur our perceptions of the true gains and risks. The psychologically urge underlying FOMO is easily understood here – it is the fear of pain or the actual pain of missing out on returns that others have – similar to the fear of pain of suffering absolute losses (like loss aversion) but because of the stimuli around us, we ignore loss aversion and get caught up in FOMO.
At this stage in the cycle, our poor investment decisions are likely to be buying too high and taking on too much risk.
Back down the hill: heads in the sand
Whatever price we purchase at, that is the price at which we anchor to and judge our returns and the market against. Unfortunately, if we purchase at a high relative price because of FOMO, we are likely to be in for some painful losses.
As we know, we are averse to losses, however, this will manifest as us often refusing to realise those losses. The means, 1) collectively, markets may stay higher for longer as the broader investor base refuses to sell as prices grind lower; 2) individually we may avoid engaging with objective information at all and start shielding ourselves from it.
At the bottom: emotional liquidity
As investments lose value, the pain of selling at a loss increases. However, like many perceptions, it has a diminishing impact on us – at a diminishing rate. Losing 10% is painful, but the second 10% is less painful than the first. However, of course in the end, we often do sell. So why? Two reasons 1) financial liquidity – particularly if we use leverage, and 2) emotional liquidity – we lose the resilience to hold on any longer.
The issue is, if we sell at the bottom, we are paying a very high price to get this emotional liquidity back. As we know, entering the market requires us to overcome our loss aversion, which often requires us to see markets rise before we enter. So to sell at the bottom, will often mean we can’t re-enter until the market has already made (often) very material gains, and we have paid the price in lost capital.
Buy when there is fearful blood in the streets
Many investors (famously/notoriously Rothschild and Buffet, for example) believe the best time to buy is when everyone is emotionally at their most fearful. They use this proxy of emotion as a signal for market pricing. It all makes sense in hindsight, but as we have seen from above, it requires us to overcome our most base emotions, which is really tough.