Financial Markets are driven by emotions: Fear and Greed
Master your investing emotions, or they will master you
The stock and bond markets are driven by four primary motivations. These four motivations are based on only 2 emotions, fear and greed. Investing is scary if you don’t know what you are doing. It is even scarier if you fully understand the risks through your own experience. Fear is a primal and instinctual emotion. Fear has kept our species from getting eaten by sabertooth tigers and jumping off cliffs trying to fly like a bird.
However when it comes to investing, that same primal instinct clouds the judgment of an otherwise rational educated person and causes him or her to make silly mistakes. In order to be successful as an investor, that fear has to be understood and harnessed in a productive way. I find fear to be the trickier of the two emotions because most people don’t understand how it applies to their own psychology.
Fear: The two fears of investing
The emotion of fear when investing can be broken down into 2 subcategories: Fear of losing money, and fear of under-performing the market (or more commonly known as, the fear of under-performing your friends).
Everyone is familiar with the fear of losing money. Whether it is money which was lost by falling out of your pocket, lost at the poker table, or lost by investing in a bad investment, unless you have an endless supply of money, everyone understands this fear.
The second part of fear is often overlooked. I see it every day in people I meet. The second part of fear is the fear of under-performing, or not doing as well as your peers. While this should be rather irrelevant to a rational person, the drive to compete or “fit in” with one’s peers, often over-powers a person’s better judgment. This feeling could also be described as “keeping up with the Joneses.”
While the fear of losing money is natural and important to retain, this second part of fear is extremely hard to overcome. It takes years and persistent hard work to master this fear. While it is hard work, it can be done. It is a worthy goal.
Greed: Greed is good… sometimes
Greed is a much more understandable emotion. It is what drives us as a species to do better, and achieve great things by wanting more. Greed is not quite as strong an emotion as fear, but it can also make people act in ways which they rationally shouldn’t do.
Greed can also be broken into 2 sub-categories: greed to make more money, and greed to keep it.
The emotion of greed to make more money is a driving force in the lives of people, however it can also cause people to do silly things… Like investing in tech stocks with no business plan, no earnings, a large number of employees, expensive office space in 1999, while knowing it would eventually end badly. Most people knew it was a bubble and that it would eventually burst causing large losses, however most people ignored their better judgment because it was easy to make money as the stock market rose.
The other side of greed, which is the greed to keep your money, is closely related to the fear of losing money. This typically happens to investors when they make 10% in a stock and then sell it even though they think a stock should rise 30%. Most people don’t understand this part of greed. It can be very detrimental to long term returns. There is a well-known saying, one which will be one of my future wall street wisdom posts, “cut your losers quick and let your winners run”.
Unfortunately, what frequently happens to investors, due to this part of greed, is that they cut their winners short and let their loser run. This is a recipe for poor performance. The table below should exemplify this point.
Fear and greed can affect your performance
You are not alone. There are solutions.
Mastering one’s emotions while investing is a hearty challenge, but all top investors have done this. Some have done it through introspection, others have done it through a computer trading system, which is primarily used to remove emotions from decision making, and still others have done it by hiring an investment advisor to make those decisions in order to remove the emotional component. In order to invest successfully, one needs to master these emotions in a way which is suitable for that person.
There is no singular way to accomplish this goal of mastering one’s emotions. Every person is different, and only that person would know which method works best for them to manage their own emotions pertaining to investing. Unless you are one of those uniquely gifted people who can detach their investing from their emotions without years of mastery, the best course of action is to either find an investing/trading system that works for your suitability, or find a financial advisor to help you remove emotion from your investing.