What is meant by Greed and Fear?
Greed and Fear are two opposing emotional states of investors that are thought to be the factors causing the unpredictability and volatility of the stock market, resulting in irrational market behavior that contradicts the efficient market hypothesis.
According to the efficient market hypothesis (EMH), share prices reflect all available information, and stocks trade on exchanges at their fair market value, making it impossible for investors to buy undervalued stocks or sell overvalued stocks. According to this theory, investors always act rationally based on accurate information readily available to them.
However, in reality, investors are not always rational. They have limits to their self-control and are influenced by their own emotional biases. Investors make cognitive errors that often lead them to make the wrong decisions. Thus, the price movements in the stock market are also not always rational. Rather, emotion has a significant influence on the decision-making process of investors. Fear and greed are the most common emotions that can affect the pricing of stocks and other securities. When greed dominates the market, investors are concerned with maximizing their portfolio returns. On the contrary, when fear dominates the market, investors are concerned with avoiding or minimizing the losses in their portfolios. Hence, in both of these situations, stocks and other securities are more likely to be traded at irrational price levels.
How do emotions affect the stock market?
Traditionally, human beings are most often influenced by their emotions, which hampers the rationality of the human mind, thus preventing them from taking proper and timely decisions. “Greed” and “Fear” are the two extreme emotions of people that often hinder them from acting rationally, thereby preventing them from making sound investment decisions.
Stock market prices are the reflections of the collective investment behavior of all the investors in the market. Investors are prone to greed since almost all of us want to acquire as much wealth as possible in the shortest period. When the stock prices are rising, more and more investors become interested in buying the stocks. The psychological aspect of being human is that we find safety in numbers, so when we see others buying, we are more likely to buy it as well, regardless of the price or fundamentals. High prices encourage investors to make more profits, and increasing profits encourages even more greed. As a result of the increased demand, prices and profits continue to rise. Investors become involved in the pursuit of short-term profits. As a result, bubbles form at very high prices, and because the intrinsic value of stocks is significantly lower than the market price, the bubble eventually bursts, and prices tumble.
Similar to how greed may overwhelm the market, fear can do so as well. A downward trend in prices is witnessed when the stock market undergoes a process of correction due to overpricing in stocks. Investors get into a panic selling mode in a declining market because they believe the market will continue to fall, resulting in a sharp fall in the share prices. Investors who purchase stocks at extremely high prices following the bullish market’s aggressive price growth suffer huge losses due to the crash in the bearish market.
When the markets are rising, everyone wants to become rich by booking profits and getting involved in buying overpriced stocks. In a falling market, everyone starts selling to minimize their losses, fearing that the market will continue to decline. Thus the contagious disease of “Greed and Fear” becomes a massive impediment to wealth creation in the long run.
For example, Mr. X buys 100 shares of a stock at BDT 30. After the purchase, the stock price eventually continued to rise consistently for a few days. Based on the company and market fundamentals, the intrinsic value of the stock is around BDT 35. Due to the continual rise in price, more and more investors create buy pressure for that particular stock, and thus the current share price becomes BDT 38, which is above the intrinsic value of the stock. However, Mr. X gets influenced by greed and expects the price to rise even more in the future. Thus, he buys 250 more shares of this particular stock at this inflated price, bringing his average purchase price to BDT 35.71. Eventually, after some period, the price continues to decline as the investors start selling the shares to minimize the losses or realize the minimal return they have achieved before it’s too late. As a result, the price now settles at around BDT 28. Due to a fear that the stock price may decline further, Mr. X finally sells off all the shares of this particular stock to avoid further losses. However, that exit price was at the lowest level, and hence it starts to rise again after Mr. X realized the loss due to a lack of proper judgment and analysis.
Figure: Recent movements of DSEX
When looking at the price chart of nearly any stock market index, you’ll find that volatility is highest during major highs and lows. The above graph depicts the recent movements of the DSEX index, which also depicts the same phenomenon. These highs and lows often do not correspond to major changes in the economy or company profits. This increasing volatility is clear evidence that traders’ decision-making is influenced by emotion, particularly greed and fear.
The Greed and Fear Cycle
To make timely and effective decisions, a trader or investor must be aware of the various stages of the collective psychology of traders and investors. These market cycles can occur over many years, although smaller episodes occur regularly. Most of the time, we subconsciously make decisions based on our emotions, which creates the cycle of greed and fear.
Figure: Greed and Fear Cycle
The first phase of the market cycle is marked by optimism. This occurs when the market has been on an uptrend for several months. In this environment, the prospect of earnings and the economy appear to be on a rising trend. Traders are confident in their buying because they believe there is no risk in investing in the stock market. As the market rises, optimism turns to enthusiasm or excitement as early buyers begin to realize substantial returns, and every slight decrease is viewed as a new buying opportunity.
The exuberance phase begins as the market cycle continues to accelerate to the upside, with profits soaring and investor confidence at a peak. And then there is the euphoria phase when profits are so easy to come by that so many traders and investors feel tempted to use leverage and ignore basic risk management principles. Although it seems like nothing can go wrong on the surface, the reality is that this is the point in the cycle in which the most risk exists, but everyone is too blinded by greed to realize this. This is the stage when institutional investors get a lot of liquidity by offloading millions of shares of stock because there are so many interested buyers.
The market begins to roll over as the new pool of buyers begins to decline. At first glance, it appears to be a typical decline; until the market fails to break above the prior high watermark and the prior lows are breached. The anxiety phase of the cycle starts when earning profits begins to be not so easy anymore. Furthermore, some of the initial gains start to fade over time.
The denial phase begins when investors begin to rationalize their decisions to hold on to losing trades, considering those as good long-term opportunities. As the market continues to fall and losses keep rising, denial gives way to fear, which depresses the traders and investors and leads them to do nothing due to a lack of confidence in their actions.
The phase of despair begins as the willingness of traders and investors to hold on to their positions for the long term begins to shatter as the persistent selling pressure in the market creates a sense of frustration. It doesn’t take much for panic to set in at this stage, as the terrible reality of the losses is too much for them to bear. This is the most emotional phase of the market cycle.
Investors reach their breaking point as the selling pressure intensifies. This is known as the capitulation or give-up phase, in which investors are forced to sell in order to escape the severe distress they’re in. This is the point in the market cycle where institutions can make huge profits by buying stocks in anticipation of the probable recovery that is most likely to begin soon.
After people have given up, the market almost always recovers. As the recovery begins, investors get depressed as they realize they have made a terrible mistake in selling near the lows. People become confused about whether they should be trading or not during this phase of the market cycle, which is known as dismay.
Finally, when the market continues to recover, investors feel more hopeful and begin to dip their toes back into the water. This definitely occurs only after a sustained rally has progressed. Eventually, the cycle begins again from the optimism phase as the uptrend continues.
Symptoms of Greed and Fear
It is very much essential for traders and investors to know some of the symptoms of when we are too greedy and when we are too fearful, as this can help them to make the most suitable investment decisions. So let’s talk about some notable symptoms of greed and fear in the stock market.
Some common symptoms of greed:
- Holding onto gains for too long
Investors tend to look at the top-performing stocks, much like people look at superstar athletes. They expect that the stocks will continue to deliver good performances in the future as well. As a result, many investors hold on to their gaining stocks, while others try to enter positions in the hope of making larger profits in the short run. But the reality is that once the market recognizes an outstanding company for so long, the upside trend of the stocks gradually begins to decline and the risk increases.
- Chasing a rising or bullish market
Often, investors seek stocks that have rapidly increased in price and have been overpriced. For this reason, investing appears to be different from most other items people buy; when the prices rise, people become more interested in buying them. The emotion of greed is a state of the human mind that is responsible for this phenomenon. Investors who chase the market are more likely to make decisions based on emotion than on careful analysis of market patterns using statistical and financial data. Everyone wants to ride the bus when the market appears to be delivering quick profits. That’s why, when a market finally falls, a large number of people are affected.
- Falling for fraud and scams
When the market is in a rising trend, many instances of fraud and scams start happening in the market. Many junk shares are pumped and dumped to general investors, resulting in massive profits for a specific group of people and eventually a state of financial distress for the general investor. However, it’s the emotion of greed that gets people to put their trust in something that they should rather not. When the market is up, greed is stuck in investors’ minds, and they tend to neglect all the bad things happening in the market and buy the overpriced stocks. Besides, some people misuse this greed by misleading a group of investors into buying stocks at inappropriate price levels, who are unaware of the fundamental information about the company. These scams are very common in the stock markets.
Some common symptoms of fear:
- Panic selling
Fear may also dominate the market in the same way that greed does. When stocks experience substantial losses over a long period, the overall market may become fearful of more losses. As a result, to avoid further losses, the majority of traders and investors sell stocks out of panic and fear.
- Pulling out of a down market
Fear pushes people off a gravy train when prices fall, just as greed pushes them on when prices rise. When the market falls for several days in a row, investors are psychologically influenced by the fear of incurring losses that may exceed their tolerance capacity. To avoid further losses in their portfolio, most investors attempt to liquidate their holdings in the market.
- Rising of Unanticipated Inflation
Consumers, stocks, and the economy may all suffer as a result of an unexpected rise in inflation. Higher inflation is usually viewed as a negative for stocks since it increases financing costs and input expenses for companies, as well as increases the cost of living for most people. With the anticipation of higher inflation in the coming days, many investors will liquidate their equity positions in the stock in order to use the cash for any unanticipated future contingencies. Thus, the fear of inflating prices of commodities negatively impacts the stock market index and creates a downtrend in the market. However, if the unexpected rise in inflation persists for a temporary period and the investors are unable to recognize it properly, the actions performed out of fear may be considered irrational.
Notable instances of Greed and Fear in the stock market
The Dot-Com Bubble in the US:
The dot-com bubble of the 1990s is one of the most common instances of situations when greed has taken over people’s actions. The Dot-com bubble, also known as the Internet bubble, was a speculative investment bubble centered around the new internet startup companies between the years 1995 and 2000. Excessive prices for new tech-based companies at that time attracted investors to invest in companies with a “dot com” domain in their business plans. Investors became greedy, which fueled more greed, resulting in securities that were significantly overpriced, eventually resulting in a bubble.
The Internet bubble is not just a perfect example of investors’ greed, but the period following the bubble can also be used to represent fear-induced markets. Fearful investors decided to quickly exit the stock markets to find a solution to minimize their losses following the Internet bubble crash. They were focusing their attention on less risky investment opportunities such as stable value funds or money market securities, which are both low-risk and low-yield.
Figure: Impact of the Dot-Com Bubble on the NASDAQ Composite Index
Between 1995 and its peak in March 2000, the NASDAQ Composite stock market index rose 400%, only to fall 78 percent by October 2002, wiping out all of the gains made during the bubble.
Bangladesh share market scam (2010-11):
The 2010-11 Bangladesh stock market scam was a period of stock market instability in Bangladesh from 2009 to 2011, with the turmoil centered on the two Bangladeshi stock exchanges, the DSE and CSE. The market index rose by 62 percent in 2009 and 83 percent in 2010, but then fell by 10 percent in January 2011 and another 30 percent in February 2011.
Throughout much of 2009, the stock market was in turmoil, with the long-term bullish trend beginning to fade. The prices surged initially as some worthless stocks created a lot of noise, thus attracting a large number of investors. Some stocks with poor fundamentals had become surprisingly “valuable.” It was commonly perceived that Bangladesh’s capital markets were extremely overvalued and overheated by the end of 2010.
Figure: Daily DGEN index between October 2010 to February 2011
In order to cool the market and control inflation, the central bank has taken steps to curb excess liquidity in the market. The capital market was negatively affected by the conservative monetary policies, with the market losing 285 points on December 13th, or about 3% of the DGEN Index, which was around 8,500 points. On December 19, the stock market took another hit, with the index dropping 551 points or approximately 7%. This 7 percent drop in the Dhaka Stock Exchange’s index in a single day was the largest in the 55-year history of the exchange, exceeding the market crash of 1996. Analysts thought the market was overvalued, so this drop was deemed “natural.”
Strategies to tackle Greed and Fear
Market sentiments are beyond our control, but we can control our actions. So investors should study the fundamentals behind their investment strategy and avoid making quick judgments based on the market’s overall upward or downward trend. They should always respond to the market with logic and reason and make judgments based on those principles.
Investors should research the fundamentals and track records of stock for good returns rather than only getting enticed by quick gains. When purchasing a stock, investors must be certain of what they are purchasing and why. They should understand that the prices in the market will fluctuate over time. Investors should not let a change in market price affect their perception of a company’s potential value if the fundamentals of the underlying company haven’t changed. Rather than being concerned about losing money in the short run, we should concentrate on long-term gains based on the company’s fundamentals and economic conditions. Rather than being guided by greed and fear, investors should rationalize their decisions based on available information.
Warren Buffett is a well-known personality in the investment industry who is considered to be one of the most successful investors in the world. From his various famous quotes regarding investing, one such interesting quote is –
“Be fearful when others are greedy and
Be greedy when others are fearful”
The stock market is based on a dynamic equilibrium of greed, fear, and psychological bias. There has always been a constant tug of war between greed and fear. These are the two basic emotions that drive our investment decisions, yet they are extremely harmful to our financial interests. It’s difficult to maintain calm in highly volatile markets. However, if we don’t let greed and fear influence our investment decisions, we’ll be in a lot better position to achieve our financial goals in the long run. Those who have the knowledge and courage to enter the market at the appropriate time when nobody is willing to enter will surely gain from the market. So, we should be greedy when others are fearful and fearful when others are greedy, obviously with a comprehensive study of the fundamentals of the market and the investment securities.
Courtesy to Mr. Rayhan Ahmed, Research Intern, Royal Capital Ltd.