The Money Managers | In the News

We are all feeling pretty lousy about investments at the moment. That is actually a cause for some optimism. Recent media reports have been full of predictions of a gloomy future; many have likened this downturn to the great depression of the early 1930’s. History shows that there have been many periods when markets have declined and then recovered, and likely there will be many more. The one thing that is similar about every downturn is the effect it has on our emotions.

Market movements are largely unpredictable but their effects on our emotions are quite predictable. In falling (bear) markets investors are increasingly pessimistic; conversely in rising (bull) markets investors are notoriously optimistic. This emotional roller coaster ride has been termed the cycle of investor emotions.

The cycle usually starts with optimism. The investor has selected an investment because of a belief in its potential to rise in value. The investment can often be promoted in glossy brochures with reference to recent past performance. This prior performance is often mistakenly used as a guide to possible future returns. If the investment initially continues to rise in value any skepticism gives way to euphoria and a desire to add even more money to the investment. The investor becomes excited about the idea of making more money than expected.

Positive experiences lead investors to put more money at risk. Sometimes they can be encouraged to even borrow to leverage their potential outcome. Continual rises in a market can lead investors to a discounting of any possibility of the risk of the investment. If the market continues upwards the positive experience reinforces the euphoria. This is a dangerous time in the emotional cycle, unrealistic expectations begin to influence the investor and blindness to potential risk often takes hold.

All markets inevitably go through periods of decline. For the investor the emotional cycle takes a turn when markets are down. When the investment starts to have a fall in value, investors suffer some anxiety. Nerves start to play up as markets stop giving positive feedback. The anxiety stage has investors wondering if they have made the right decision. If the downward trend continues, investors go into denial about the fact that they possibly made the wrong decision and wait for the price to recover. They refuse to believe they have lost money on their previous investment valuation, especially if they had unrealistic expectations in the first place.

Assuming markets continue to fall beyond this stage, fear begins to set in. The uncertainty in this stage of the investor emotional cycle becomes unbearable. If markets continue to fall, the investor may panic and start to act out of character. The likelihood is that by this stage emotions have started to take over and there is no room for rational decision making. The media coverage of a market downturn feeds on the uncertainty and the situation becomes too much to cope with and investing doesn’t feel like a good idea at all.

It is at this point that sound independent advice should be sought if you haven’t already got a strategy to deal with difficult markets. The alternative is that many people sell out at the worst possible time and miss out on any potential recovery. Capitulation in markets occurs soon after most investors panic. At this stage investors feel the investment they are investing in is void - or not at all suitable for them. Inevitably, the market does recover and the investor emotional cycle starts all over again.

This is the experience of thousands of investors. The common theme in their psychology is that they each go through the stages of the investor emotional cycle, from optimism through to euphoria in bull markets, and anxiety through to capitulation in the bear markets. Over many years investors step through the various stages and eventually they become educated on the matter. Having an understanding of the process has helped many people become less emotional and more disciplined investors. These are people who know the risks, understand what’s happening and focus on their goals to see past the short term noise.

In The Intelligent Investor, Benjamin Graham, said ‘Investors’ chief problem – and even his worst enemy - is likely to be himself’. Investor education and advice can help any of us to weather the storms. It is obvious that making investment decisions emotionally most often leads to hardship. Discipline and a sound intellectual framework is the only way to prevent the investor emotional cycle destroying us.

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