While fear and greed are not the only emotions that prevail among traders in the financial markets, they certainly can have the most costly impact on a trader’s portfolio and the stock market as a whole.
A well-known parallel in the investing world is the juxtaposition between growth investing and value investing. These are fundamentals that traders should thoroughly understand in order to build a personal investment strategy. However, it is the influence of fear and greed on the markets that traders really need to understand. This article discusses the results of when a trader succumbs to either of these emotions in the trading arena.
The destructive influence of greed
A central component in investing is the accumulation of wealth in the shortest amount of time. This is the desire of most people in the trading world. The influx of Internet-related businesses in the 1990s is an example of this concept. If the investment involved a dot-com organization, investors leaped at the opportunity. The growth of the dot-com industry was huge and moved fast. Investors got greedy which led to securities being overpriced and the creation of a bubble. That bubble burst during the middle of 2000 and weighed heavily on the leading indexes throughout 2001.
The lure of fast and easy income was strong among investors. Many ignored the rules and guidelines as well as the basic fundamentals of investing that they established in their investment plans. Referring to the overall market, former Federal Reserve chairman, Alan Greenspan coined the term “irrational exuberance.” When the markets experience a fast-paced growth like in the 1990s, it’s easy to get caught up in the latest craze and try to ride that wave of high returns for as long as possible. However, this is the most important time to stick with your plan and maintain your long-term vision and dollar-cost averages.
What you can learn from the “Oracle of Omaha”
One example of an investor who adhered to his plan during the dot-com surge is Warren Buffett. Critics often chided him for refusing to invest in high-flying tech stocks. Still, he refrained from getting caught up in the greed that drove the market into a bubble by remaining in his comfort zone and sticking to his long-term plan. Naturally, when the tech-stock bubble burst, his critics were silenced. Buffett successfully avoided losses by ignoring the dominant market emotion — greed.
The influence of fear
It is clear that greed can negatively impact the market. At the same time, fear can also have a negative influence over the market. Fear is defined as an unpleasant emotion elicited by the awareness of danger. When stocks experience losses for an extended period, it can cause traders to become more fearful of sustaining large losses. Therefore, fear can be just as costly as greed.
Following the dot-com bubble burst in early 2001 and global financial crisis of late 2007, a wave of fear permeated the market. In order to curb their losses, investors turned away from equity markets and sought out markets that were less risky. Some of these markets included money market securities, principle-protected funds, and stable value funds. All of these fall into the category of low-risk/low-return securities.
Here again, just as with the tech-stock market boom, investors abandoned their long-term plans and fundamental approach to investing in favor of more secure, low-yielding investments. This was all based on the fear of sustaining more losses in the markets. Losing large sums of equity in your portfolio is discouraging. However, it is equally discouraging to face the prospect of never rebuilding wealth due to fear-based investing practices. This can be just as detrimental to your portfolio as charging into get-rich-quick investments.
The importance of maintaining your comfort level
Any trader will acknowledge that the stock market is volatile. However, it is when investors step out of their trading comfort zone that they start making costly mistakes.
Both greed and fear can be detrimental in the financial market. Whichever emotion is prevalent in the current market, you must stick to the basic fundamentals of investing in order to survive. It is vital that you establish a suitable asset allocation mix that is devoid of emotion. If you are opposed to high-risk investing, you might be more susceptible to a fear-dominated market. Therefore, your participation in equity securities should be lower than investors who are more tolerant of risk.
“Unless you can watch your stock holding decline by 50% without becoming panic-stricken, you should not be in the stock market.” – Warren Buffett
Controlling your emotions is easier said than done
The line between controlling your emotions and simply being stubborn is often blurry. In the financial markets, it’s important to develop and follow a trading plan. It is also necessary to regularly revisit your plan and investment strategy and be both rational and flexible when you make changes to your plan.
The bottom line is that you are in charge of your portfolio. You are responsible for the decisions you make as well as the gains and losses you experience. Sticking to a concrete investment strategy involves maintaining your emotions, not blindly following current market sentiment, and staying within your investing comfort zone. This is a balancing act, but you can do it if you keep your emotions in check.
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