Investment
The Power of Fear and Greed
In Homer's ancient Greek myth the Odyssey, the hero Ulysses must pass through the Straits of Messina between Italy and Sicily to continue his long journey home. But guarding the straits are two perils: on one side Scylla, a female sea monster with the heads of dogs growing from her waist; on the other side Charybdis, a gigantic whirlpool. To make matters worse, a group of beautiful sirens uses their irresistible singing to lure mariners passing through the straits to one side or the other, ensuring their ship will be lost.
As many investors have learned from recent experience, today's stock markets appear no less treacherous than the straits that Ulysses faced. And like Ulysses, investors face two great monsters on journeys toward their long-term objectives. Less colorful, but no less dangerous, are the investment perils of Fear and Greed. And to help ensure that investors accept the temptation to veer toward one peril or the other, there are the helpful sirens of the media, in the form of nightly television broadcasts, monthly magazines, or various investment newsletters touting some improved investment strategy.
Ulysses survived the Straits of Messina by putting wax in his ears to avoid listening to the sirens and in this way stayed on course toward his home. Investors, too, can avoid the perils of Fear and Greed – first, by understanding what it means to be a rational investor, and second, by recognizing the role that fear and greed play in irrational investment decisions.
Rational Pricing
Stock prices are largely determined by all current and past news through the decisions of active investors (primarily the managers of mutual funds and pension funds). Upon release of a news item each active investor adjusts an assessment of the fair value of each stock that the investor already owns or is considering for purchase.
If the news bodes well for a company, investors generally raise their fair values for the company's stock and are then willing to hold existing shares or buy additional shares at a higher price than previously.
If the news is perceived to be negative, fair values decline and investors want to hold or buy only at a lower price. Decisions to sell the stock are made by investors whose assessments of fair value are lower than the current price.
Collective Fear and Greed
That rational process for determining stock prices is not the whole story, though. Groups of investors sometimes act on the basis of irrational fear or greed.
The technology-stock bubble of the late 1990's was an extreme example of collective greed. Investors bid up the values of money-losing, start-up companies to levels that exceeded the values of long-established companies that pay regular dividends. Investors focused on rapidly rising prices and bought over-valued assets because those purchases seemed like a certain course to financial success.
Stock-market history has many other examples of manias that ended in spectacular collapses. Each mania was supported by actions that were clearly irrational, but collective greed led many investors not to fortune but to ruin.
Stock prices reach high points when collective greed peaks. Lows occur when fear is rampant. The swing between a high and a low often exceeds 20%. For example, between March 2000 and October 2002 broad stock-market averages declined over 40%. Collectively, investors have great power to move stock prices up and down.
Individual Fear and Greed
For an individual investor, fear and greed also have great power, and the investor can use that power either to succeed or fail in efforts to grow and preserve wealth.
Many investors get caught up in stock-market hype when collective greed is strong and feel deep despair when everyone seems fearful. An investor who acts on those emotions is likely to buy over-valued stocks and then sell them after they have declined by 20% or more.
Some investors restrain themselves from making large changes during periods of extreme greed and fear. Those investors earn returns over time that are similar to long-term historical averages.
Many successful investors are "contrarians." They recognize that periods of collective fear are times when stocks are available at bargain prices and that periods of collective greed are good times to move money from over-valued assets to those that are out of favor.
Pleasanton Financial Advisors helps clients recognize collective fear and greed, counsels them on avoiding the problems associated with those collective emotions, and applies disciplined strategies to allow those emotions to work for the client.