How do we make investment decisions? The standard response is that we gather information and facts, and after due consideration carefully invest our money. If we are too busy or feel we lack experience and knowledge we outsource the job to a fund manager either via portfolio management or perhaps in an investment vehicle such as a mutual fund or investment trust.
All of this is often the case, but there is also a very large emotional element in the way that we invest (or make any decision for that matter). The key decision bias in investment looks to be emotional excitement. Despite all the best intentions of addressing financial markets in a sober and considered manner we have a tendency to get wrapped up in the perceived excitement of it all.
Financial intermediaries know this well and have carefully crafted marketing messages to exploit our foibles. The two favourite approaches run along these lines. For the cautious nervy types, they push the line that they will reduce the risk in investment decisions (but not the market risk of course!) and for the more susceptible and in fact excitable, they stress how it’s important to act fast and not to miss out on whatever opportunity that is tantalisingly within our grasp – provided we act now.
This desire for excitement underpins what really drives market cycles and the ever-present bubbles and crashes. Conventional wisdom states markets are driven by greed and fear – but I disagree. In fact they are driven by fear (on the way up) and hope (on the way down). The excitement element is the rocket fuel that drives the fear.
Well let’s firstly consider a strong bull market in stocks; as the trend strengthens more and more investors pile in; previously cautious types get involved as they fear missing out. After all if everyone is making money why not me? Egged on by brokers et al – the fear of missing out on future spectacular gains and its accompanying excitement is just too much. Then curiously when there is no fear left in the market – prices can only go up from here – we are usually at the very top. Having climbed the wall of fear there is only one way to go – down.
When markets are on the slide its Hope that is the dominant factor – all those small losses start to snowball and investors, instead of cutting their positions, start hoping, perhaps even praying, that things will turn around. This is the slippery slope leading to losing positions and in some extreme cases spectacular rogue trader fiascos. Only when all hope is extinguished and all the towels have been thrown in can markets make a bottom and the trend change.
So when the next time you are gripped by worries of missing a big investment opportunity that has been described as really exciting – just lie down until the feeling goes away!
Gerald Ashley is a consultant, broadcaster and writer on Risk, Uncertainty, and Decision Making. He is currently working on a new e-book called Serious Money.