While modern psychology is founded on the assumption that humans tend to think and behave rationally, this assumption is not always true when it comes to investor behaviour. While behavioural economics explores the social, cognitive and emotional factors that affect economic decisions, the relatively new field of neuroeconomics goes a step further by trying to bridge the disciplines of neuroscience, psychology, and economics to understand what happens inside our brains when we make financial decisions.
Plummeting oil prices coupled with an official declaration by WHO that Covid-19 is a pandemic means that markets are currently being driven by fear and greed. Whether it’s dumping shares, stocking-piling toilet paper or bleach, greed and fear can drive seemingly rational people to make irrational decisions, especially in times of crisis.
As a species, we are hard-wired with a set of in-built emotions designed to ensure our ongoing survival, although when it comes to investing emotions such as greed and fear can serve to work against these primal instincts. At the top end of the investment markets, greed can drive investors to purchase large quantities of overpriced stocks, while at the bottom of the market irrational fear can cause panicked investors to dump stocks. Although years of research has shown that investors are notoriously bad at timing the markets, many investors still succumb to greed and fear by trying to time the markets – most often to the detriment of their financial futures.
Greed in the context of investing is defined as an excessive desire to create as much wealth as possible over the shortest possible time – and it’s this ‘get rich quick’ mentality that makes it difficult for affected investors to maintain their gains and stick to their investment strategy. If you’re invested for the long-term, your financial planner has likely advised you to remain focused on your game plan and to ignore the market volatility we are currently experiencing. This is because staying focused on your retirement goals will help you stay calm and invested while we ride out this storm.
Fear is an intense feeling of awareness of danger or loss and can wreak havoc in the stock markets as investors bid to stem their losses by moving out of equity markets into lower-risk investments. Fear, coupled with fake news and ignorance, can give rise to herding which can take the form of panic buying or selling on the basis that ‘everyone is doing it’. Also referred to as the ‘bandwagon effect’, herding can cause investors to ignore their judgement in favour of what the crowd is doing while erroneously believing that ‘everyone can’t be wrong’.
To exacerbate the problem, fear can be further fuelled by what is known as loss aversion – the fear of losing something that one already owns. Psychologists believe that our fear of losing something is greatly outweighed by our desire to gain more. Into the fray is thrown the fear of regret, which is the fear that investors feel when they think they’re missing out on a once-off investment opportunity, a get-rich-quick tip-off or a sure-fire investment.
After more than thirty years of research, behavioural economists now understand considerably more about investor behaviour than ever before, although there is still much to be learnt. In the emerging field of neuro-economics, recent studies reveal that investors are not only influenced by their emotions but by the time of day, the weather, what they are wearing and how hungry they are. It’s been found that a woman’s hormonal cycle can influence her tolerance for risk, whilst men with higher testosterone levels have a greater propensity for risk than those with lower testosterone levels.
When taking investment decisions with their fellow investors, people tend to make riskier decisions than when on their own, and people who’ve just made a lot of money will be less cautious when it comes to risk-taking in general.
Investment markets are, by their very nature, riddled with the volatility of peaks and troughs, the unpredictability of pandemics and oil price slumps, and the inexplicable reality of market highs and lows caused by factors beyond our control. Accepting that the investment graph will rise and fall many times over your long-term investment horizon is the first step towards adhering to your long-term investment strategy.
As difficult as it may be, now is the time to de-sensitise yourself to the inevitability of market fluctuations and ensure that you remain invested to achieve your retirement goals. These peaks and troughs, as frightening as they may appear, create peripheral investment noise which should not impact on your investment strategy in the long term.
Successful investing towards sustainable wealth creation depends on your retaining composure and staying vigilant against the destructive potential of fear and greed.