“You want to be greedy when others are fearful. You want to be fearful when others are greedy”,
-Warren Buffett
Greed and fear are the two most powerful psychological features that activate the investors to buy and sell stocks which sometimes create irrational decisions by investors.
So often, investors caught up in greed as most of us have a desire to acquire as much wealth as possible in the shortest period of time. Most of the times, unknowingly, we make decision by emotions which creates cycle of greed and fear.
When the market is up, greed is stuck in investor and we tend to neglect all the bad things happening in the market and tend to buy overpriced stocks. The psychological aspect of human is that we find safety in numbers, so when we see others buying, we also tend to buy the same thing irrespective of the price or its fundamentals. Just as the market can become overwhelmed with greed, the same can happen with fear. When stocks suffer large losses for a sustained period, the overall market can become more fearful of sustaining further losses. But being too fearful can be just as costly as being too greedy.
However, it is very easier to say-Be greedy when others are fearful and be fearful when others are greedy because of the human biases which are ingrained in the investing world.
In this article, we will try to learn about some of these biases and learn about the greed and fear cycle and help investor to extend the knowledge. Some of these human biases can be as follows.
1. Anchoring Bias
The concept of anchoring draws on the tendency to attach or "anchor" our thoughts to a reference point - even though it may have no logical relevance to the decision at hand.
The above figure is the example of the anchoring bias from the book predictably irrational which shows the anchoring bias as the tendency to attach or "anchor". In this case social security number has impact on the cost of the wine bottle which has no logical relevance whatsoever.
Anchoring can also be a source of frustration in the financial world as investors base their decisions on irrelevant figures and statistics. For example, some investors invest in the stocks of companies that have fallen considerably in a very short amount of time. In such case, the investor is anchoring on a recent "high" that the stock has achieved and consequently believes that the drop in price provides an opportunity to buy the stock at a discount.
While, it is true that the puzzles of the overall market can cause some stocks to drop in value, allowing investors to take advantage of this short- term volatility. However, stocks quite often also decline in value due to changes in their underlying fundamentals.
Also, the technical analyst use this bias to find the support and resistance, as people are anchored to the low and high and the point there can be change in pattern.
- Mental Accounting:
We tend to treat money differently by the way we earn it. There is tendency for the people to put money in separate account using different subjective criteria such as source of the money. For example, if we get money from gambling we are more likely to spend or bet it in more risky stuff than the hard money that we have earned from salary.
According to the theory, individuals assign different functions to each asset group, which has an often irrational and detrimental effect on their consumption decisions and other behaviors.
Another aspect of mental accounting is that people also treat money differently depending on its source. For example, people tend to spend a lot more “free or found” money, such as winning lottery, windfall gains and bonus, compared to a similar amount of money that is normally expected, such as from their salaries. This treating money differently can violate the logic as money is same irrespective from where we get it.
In investing world we tend to take more risk when we have windfall gains by taking more risk which may make us end up losing all the money. Logically speaking, money should be interchangeable, regardless of its origin. Treating money differently because it comes from a different source shows that we are irrational.
3. Confirmation and Hindsight Biases
Confirmation Bias
In this bias, people try to conform to the things that support their opinions while ignoring or rationalizing the rest. While investing, investors are more likely to look for information that supports his investment ideas whereas ignoring the other which doesn’t support. This can result in cause faulty decision making skew to his initial ideas which live with incomplete picture of the situation.
Consider, for example, an investor hears about a bank’s stock about potential returns in 4th quarter. Hence, to conform that is right; investor might choose to research the stock in order to "prove" its potential is real.
Hindsight Bias
It is a bias that occurs in situation where a person feels that past event was predictable and completely obvious whereas it was hard to be predicted.
Many events seem obvious in hindsight this is mostly because people tend to create order by making us believe that the events were predictable. For example, many people now claim that signs of the crash of Nepal Stock Exhange (NEPSE) in 2008 were obvious. This is a clear example of hindsight bias: If the formation of a bubble had been obvious at the time, it probably wouldn't have escalated and eventually burst.
- Gambler's Fallacy
It is all about probability and when it comes to probability we tend to take wrong assumption about onset of events. In the gambler's fallacy, an individual erroneously believes that onset of a certain random event is less likely to happen following an event or a series of events. This line of thinking is incorrect because past events do not change the probability that certain events will occur in the future.
It is very easy for trader or investor to fall in this trap. A trader or investor may not liquidate the position when it has gone up in series of subsequent trading position because people may feel that it is likely to continue to go up. Just because the stock has gone up on six consecutive trading sessions does not mean that it is likely to go up during next sessions too.
- Herd Behavior
People believe to be a hardwired human attribute: herd behavior, which is the tendency for individuals to mimic the actions (rational or irrational) of a larger group. Individually, however, most people would not necessarily make the same choice. When one is running forward, other running opposite seems crazy. Natural desire to be accepted by a group, people follow what other are doing. Another reason is that rationalizing of people that large group is unlikely to be wrong which is especially prevalent in the situation where they have very little experience.
In Nepal herd behavior is very prevalent as some people simply trade looking at the volume and price people feel that if everybody is buying there must something and hence they buy the same stock.
Even the financial professionals can be trapped in this herd mentality. For example, a wealthy client may have heard about an investment gimmick that's gaining notoriety and inquires about whether the money manager employs a similar "strategy". Another herd behaviour example can be strategy of talking with broker for information since everybody does it why don’t we do it.
Just because everyone is jumping on a certain investment herd strategy doesn't necessarily mean the strategy is correct. The best thing to do is to do your own work before following the trend. We should not forget that particular investments strategy favored by the herd can easily become overvalued because the investment's high values are usually based on optimism and not on the underlying fundamentals.
6.
Overconfidence
Overconfidence is overestimating one’s ability to successfully perform a particular task. Investor being overconfident in their stock picking ability can be harmful in the long run. In a good time when all traders are earning money, overconfident investors generally conduct more trades and believe that they are better than others at choosing the best stocks. Unfortunately this overconfidence can lead investor to take a huge leveraged bet and also can lose significant amount if he does not realize that he might be wrong.
- Overreaction and Availability
Market overreaction is everyday seen phenomena in the stock market .Participants in the stock market predictably overreact to new information, creating more than appropriate effect on a stock price. Bias Availability can also be seen in stock investment or about the company bias people act at news which is recently available around. Also in this bias, people tend to heavily weight their decisions toward more recent information, making any new opinion biased toward that latest news. For example, when there is recent news of the huge bonus and right share people tend to overreact and tend to buy stock on the available information which might make the stock overvalued. Similarly, when there is political change people tend to overreact on availability of the news.
8.Prospect Theory
In 1979, Kahneman and Tversky presented an idea called prospect theory, which contends that people value gains and losses differently, and, as such, will base decisions on perceived gains rather than perceived losses. Thus, if a person were given two equal choices, one expressed in terms of possible gains and the other in possible losses, people would choose the former - even when they achieve the same economic result. Hence, in economic and decision theory, pain of loss is three times greater than the pleasure of equal amount of the gain. This shows the human are more risk adverse. For example, if you buy a stock at Rs 300 and the stock price goes to Rs 400 there is gain in Rs 100 and, if the same person buys another stock at Rs 300 and the price goes to Rs 200 there is a loss of Rs 100 although they are same amount of gain or loss the person will feel pain of loss 3 times more when there is loss than pleasure when gaining same amount.
Greed and fear Cycle
Fig: Greed and Fear Cycle Adapted and modified from “Why Investors Fail”, by Barry Ritholtz
As we came to know about the different biases surrounding investing world we also should know about greed and fear cycle .Knowing some of the symptoms of when we are too greedy and when we are too fearful can help investors to be greedy when others are fearful and fearful when others are greedy.
Symptoms of greed
- Holding onto gains for too long. Investors tend to look at hot-performing stocks like superstar athletes: They expect them to continue to repeat their excellent performance over and over. The problem is, once the market recognizes an outstanding company, the upside becomes more limited and the risk increases.
- Chasing a rising market: Generally investors go for stocks which had increased rapidly and has become overpriced. For same reason, investments seem different from most other things people buy -- people are more attracted to them the higher their prices get. Greed and emotion is the culprit here. Investors who chase the market typically make investment choices based on emotion rather than careful consideration of market trends using statistics and financial data. When market seems to be providing easy money, everybody wants to ride the bus. That's why so many people tend to be in a market when it finally collapses.
- Falling for scams. While stock market is unreliable and savings account interest is very low, it's natural to look for alternatives. However, it's greed that gets people to put their trust in something they should know is too good to be true. These scams are surprisingly common.
Symptoms of fear
- Panic selling. When you buy a stock, you need to have conviction in what you are buying, and why. Understand that the price will fluctuate up and down. As long as the fundamentals of the underlying company haven't changed, don't let a change in market price alter your perception of that company's potential value.
- Pulling out of a down market. Just as greed leads people to jump on a bandwagon when prices are high, fear pushes them off it when prices fall. Buy low and sell high seem like incredibly simple principles, but it is amazing how emotions like fear and greed can interfere with them.
- Not getting started. Often time when fear is struck in we do not think about investing in stock market. Even mutual fund will not issue any new fund because there is fear in the market and it very hard to get people to invest in the market.
Hence, market is about balance of greed, fear, and psychological bias around the investment. There is constant tug of war between greed and fear. For those who have knowledge and courage to enter when nobody is willing to enter will surely gain from the market. So, you should be greedy when others are fearful and fearful when others are greedy.
Source:
Behavioral Finance: Key Concepts
Investopedia,(2010). The Financial Markets: When Fear And Greed Take Over.
Thinking Fast and Slow by Daniel Kahneman
Predictably Irrational, the Hidden Forces That Shape Our Decisions by Dan Ariely
Akhilesh Bikram Sthapit
Senior Research Analysts
Sanima Capital Limited
bik.akhilesh@gmail.com
