Fear And Greed - The Ongoing Battle For the Trader!

Let’s imagine a simply game, where participants are enticed to play it due to the potential rewards on offer. The players are not required to make anything useful, or provide any needed service, nevertheless a few of the participants, maybe less than 5 per cent of them consistently win at it reaping huge rewards.  Perhaps you are wandering how this could be; bearing in mind that in this hypothetical games no tangible products or services are being created. It occurs because the winners' profits are generated from the losers’ losses.  This type of game is known as a zero sum game, in which the winners, a small minority of the participants, enjoy huge profits from playing it, which incidentally equates to the losses of the other 95 percent of the participants. Put simply, Bob’s win is Jill’s loss.

Naturally, for this game to continue functioning it would need to draw in a constant stream of new participants, since many of the players would either give up, believing that they can’t make money out of playing it. Sadly, for a few they may even be expulsed by the game, playing it to the bitter end, kidding themselves that a big win was around the corner, but in realty finish up, penniless, hopeless and in the poor house.  

Now assuming the game has been deliberately designed to tap into the two most powerful human emotion; fear and greed. Then, new participants could be drawn into playing, enticed by the perception of huge wins.   So greed would ensure a steady stream of new suckers to the game.  Moreover, both emotions could be extremely useful in bamboozling players to make the wrong decisions, to hand over their hard earned money in the form of losses to the fortunate winners of the game. To spice things up a bit a few entertainers, such as clowns, magicians, charlatans and glamour beauties could be hired to further seduce the players, make them even more bewildered, but keep them eager and playing.

This game isn’t fiction, it actually exists and probably if it were masterminded by America’s best known gangster, Al Capone, he would have been arrested by the authorities and charged for running a racket.  But that is not going to happen because this game is played by those respectable, eloquent, suited and booted men and rubber stamped by our own political masters.

So the stock market, like in the game mentioned above, is driven by similar emotions, fear and greed. Emotional investing/trading is akin to holding a match to a stick of gelignite. The results can be equally damaging to you and your wealth. 

So those who invest using their logical analytical side of their brain, rather than their emotions tend to perform better than their rivals. These types of alpha investors are different to the rest, in a sense that they tend to have a well thought-out plan by their side, ready to implement should things go pare shaped.  By doing this, somehow they have managed to suppress the primitive side of their brain, which controls the emotion of fear.  

Somehow, and perhaps this is due to the forces of natural evolution, way back when homosapians lived in caves and carried clubs they had to react fast, for survival reasons, to the sounds of a roaring lion. So modern humans are hardwired to respond to negative event, which tend to spark off stronger emotional behavior and a cognitive response, than positive event. Perhaps this explains why sharp falls on the market are often steeper, rapid and more violent, than rises. Indeed, that shear blind panic, as people are desperate to avoid losses can be devastating, resulting in a stock market crash.  

Nevertheless, if investors over react to bad events and oversell the market due to their irrational fear this could also offer a buying opportunity for cool headed bargain hunters.  Again another strong emotion, greed would draw the bulls in.  

Keep an eye on the FTSE big losers of the day and track their share price the following day, notice how the big losers yesterday sometimes are the big winners the following day.

But over optimism can equally be detrimental to investors’ decision making, as can excessive pessimism.  Are we now witnessing over optimistic investment in parts of the technology sector today with some companies exhibiting colossal PE ratios with titanic market capitalizations.  Have you heard the expression a “suckers rally?”  Fair enough, keep dancing while the music plays, nobody likes a party-pooper but make sure you’re near the exit door when the bulls make a dash for it.

On the other hand, investors with well thought-out investment plans, which clearly outlines what they should do if the financial markets move against them. Who offset potential losses that they may occur from other investments in their portfolio, an investment strategy known as hedging; tend not to panic in a market crash because they have already factored in their tolerance to risk. Moreover, by not acting on their emotions they tend to make better investment decisions and outperform their competitors. They are able to see buying opportunities in an oversold market and profit from the fear of others. They are also able to avoid buying bubbles. Indeed, these alpha investors profit from the erratic mood swings of the market.   

So the cost of emotional investing to an investor is huge, moreover it fuels the profits of the others who act with their head rather than their emotions. By having a plan in place you won’t be like a startled, rabbit staring frozen at the headlights when the market moves against your investments.