WARREN Buffett once said, "The first rule of an investment is don't lose [money]. And the second rule of an investment is don't forget the first rule. And that's all the rules there are."
As long as you do not lose money, there is no pain. But individual stocks in a portfolio will lose money. The idea is for the portfolio, as a whole, to not lose money.
As markets are roiling downwards, many investors will be gripped by the fear factor. Fear is the other side of greed – the twin propellers that drive market emotion.
Fear is an emotional response to perceived threats, danger, or stress. It had helped our forefathers stay out of danger from marauding dinosaurs and other catastrophes. The emotional response to fear works - we are proof of that.
In the context of the stock market, fear can be driven by various factors, including economic instability, geopolitical events, company-specific news, and broader market trends.
Understanding how fear affects stock market investing involves exploring the psychological aspects of fear, its impact on investor behaviour, and the subsequent effects on market performance.
The Psychology of Fear in Investing
Fear in the stock market often manifests as a response to uncertainty and the potential for financial loss. It is rooted in the human brain's evolutionarily developed mechanisms for survival, which prioritise avoiding threats over seeking rewards.
This predisposition can lead investors to act irrationally in the face of market volatility.
When investors experience fear, it can trigger a fight-or-flight response, causing them to either sell off their investments hastily (flight) or refrain from making new investments (freeze).
This response is often exacerbated by cognitive biases such as loss aversion, where the pain of losing money is felt more acutely than the pleasure of gaining an equivalent amount.
Behavioural Effects of Fear on Investors
When fear grips the market, investors may engage in panic selling, liquidating their holdings en masse to avoid further losses. This can create a snowball effect, driving prices down sharply and increasing market volatility. Panic selling is often seen during market corrections or crashes, where the rapid decline in stock prices feeds back into investors' fears, perpetuating the cycle.
Fear can lead to herd behaviour, where investors follow the actions of others rather than relying on their own analysis. This collective movement can exacerbate market trends, both upward and downward.
For example, during a market downturn, seeing others sell their stocks might prompt an individual to do the same, irrespective of the underlying value of their investments.
In fearful market conditions, investors tend to become more risk-averse. They might shift their portfolios towards safer assets such as bonds, gold, or cash, abandoning stocks perceived as higher risk. This shift can depress stock prices and reduce liquidity in the market, making it harder for companies to raise capital.
Fear often drives a short-term focus among investors, prioritizing immediate market movements over long-term fundamentals. This myopic view can lead to poor investment decisions, such as selling quality stocks during temporary downturns or missing out on potential long-term gains.
Impact on Market Performance
Fear-induced trading increases market volatility. High volatility can deter long-term investors and disrupt normal market functioning. Companies might find it more challenging to plan and
invest for the future amid such uncertainty.
Extended periods of fear can lead to significant market corrections or crashes. These events can wipe out substantial amounts of wealth, undermine investor confidence, and take years for markets to recover.
Fear can cause price inefficiencies, where stock prices deviate significantly from their intrinsic value. Overreaction to negative news can undervalue stocks. Savvy investors might exploit these inefficiencies.
The broader economy can suffer as fear-induced market declines reduce consumer and business confidence. This reduction in confidence can lead to lower spending and investment, slowing economic growth and potentially leading to recessions.
Managing Fear in Investing
Investors and financial professionals employ several strategies to manage fear and mitigate its impact on investment decisions.
By spreading investments across various asset classes, sectors, and geographies, investors can reduce the impact of any single market event on their overall portfolio. Diversification helps manage risk and reduce the emotional impact of market fluctuations.
Maintaining a long-term investment horizon can help investors look beyond short-term market volatility. Historically, stock markets have trended upwards over the long term, so staying invested during downturns can lead to eventual recovery and growth.
Staying informed about market fundamentals, economic indicators, and company performance can help investors make more rational decisions. Understanding the underlying causes of market movements can mitigate irrational fear.
Recognising cognitive biases and emotional triggers can help investors avoid common pitfalls. Techniques such as setting predefined rules for buying and selling, or using automated investment tools, can help maintain discipline.
Financial advisors can provide objective guidance and help investors navigate turbulent markets. Their experience and expertise can be invaluable in making informed decisions and avoiding emotional reactions.
Conclusion
Fear is a powerful emotion that significantly affects stock market investing. It can lead to irrational behaviour, increased volatility, and market inefficiencies. However, by understanding the psychological roots of fear and employing strategies to manage it, investors can make more informed decisions, maintain a long-term perspective, and ultimately achieve their financial goals.
Recognising and mitigating the impact of fear is crucial for maintaining a healthy and stable investment environment.
*The writer is a former chief executive officer of Minority Shareholders Watch Group and has over two decades of experience in the Malaysian capital market.