How Fear And Greed Can Lead to Wrong Investment Decisions

May 20, 2023 Mutual Fund

Individuals strive to invest their hard-earned money in a variety of lucrative investment options in order to fulfil their short-term and long-term financial objectives. As a result, the investment decisions you make have a tremendous impact on the investing process. It is critical to make sound financial decisions that are not influenced by a variety of variables, including behavioural or emotional biases.

Last week, I met my uncle Viren who has been working as an investment broker in the capital markets for over 25 years now. He has experienced various market phases and how market fluctuations drive investor sentiment. While we were discussing the current market trends, he said, “Mitali, emotions, biases, and other macroeconomic factors frequently impact human behaviour, which can lead to inefficient investment decisions. Understanding behavioural finance as an investor can help you overcome these limitations. Behavioural finance combines traditional finance with psychology to understand how the emotions of an individual may influence their investment decisions.”

He further added, “For instance, do you base your investment decisions solely on logic: Facts and figures?” Or do your emotions impact your financial decisions? This is where behavioural finance comes into play.”

This conversation got me thinking about how an investor’s behavioural traits can affect their investment decision-making. I replied to him, “I do understand how external factors like macroeconomic uncertainty, rising inflation, hike in interest rates, and recessionary risks can influence the investment decision of any individual investor. But how do you define these emotions or behavioural biases that can create an impact on the investment decisions?” I questioned.

He responded, “You know, there is an old saying on Wall Street that the market is driven predominantly by two emotions: Fear and Greed. And in my experience, I have seen investors in despair and terror following a tumultuous market phase, whereas the same faces expressed excitement and delight during an upswing or bull market phase. This represents the two magnetic forces that may have an impact on and affect one’s investing decision: Greed and Fear. As a result, using a balanced and objective approach will enable you to make informed investment decisions and accomplish your long-term financial objectives.”

In this article, I will help you understand how these emotions, i.e., greed and fear, can create an imbalance in deciding your investment strategy. While there are various behavioural biases, they invariably emerge in one of two ways: Excessive risk aversion (fear) or acquisitiveness (greed).

[Read: How to Overcome Behavioural Biases that Impact Your Investment Decisions]

Influence of Greed

Greed motivates investors to maximise their money as rapidly as possible, and bullish market patterns reinforce this attitude. It may also tempt you to borrow money for investment purposes without fully knowing (or ignoring) the hazards involved. Your emotion of greed may also drive you to invest after the markets have risen (at the peak possibility of downtrend in the market).

Many investors are drawn in by the bullishness and begin purchasing touted schemes or stocks in the market based on the company’s market value. However, investors’ get-rich-quick mentality makes it difficult to stick to a disciplined, long-term investment strategy, especially during volatile market stages. When markets are performing well, the feeling of greed may lead you to make poor financial judgements. For example, one may invest in a mutual fund scheme or stock that has produced high returns in the recent past. However, after a while, an economic downturn may cause you to lose all of your money because the investment you made in the bullish market was due to the economy’s upswing. It would have been wise if you invested in a scheme or stock which is fundamentally strong, has a high growth potential and provides significant returns in the long term.

Influence of Fear

When you witness negative patterns, market swings, or extreme volatility in the market, fear enters your thoughts. Fear causes investors to sell fundamentally strong schemes or stocks that have the potential to perform well in the long run. Panic in the market may increase your fear and lead to dubious financial decisions. Just like the investor sentiment can become overwhelmed with greed, it can also succumb to fear. Similarly, as greed dominates the market during a boom, fear prevails during a market downturn. To mitigate losses, investors may exit current schemes on the spur of the moment and invest in comparably safer assets.

Fear may also drive an investor who could stomach risk to remain invested in low-return generating investments for goals that are years or decades away just because you prefer the comfort of linear, non-negative returns over volatile, inflation-beating ones. It also forces you to sell your investments after they have fallen in value (ironically, at the peak of financial potential). When assets experience losses over an extended length of time, investors may become fearful of further losses and begin to sell.

How investors can avoid falling prey to their emotional biases

You see, emotional biases and other external influences can have a substantial impact on investment decisions and lead to deviations from traditional investing principles. For example, emotions such as fear and greed frequently push people to make impulsive decisions, while overconfidence bias causes investors to overestimate their ability to develop investment predictions. These deviations from traditional principles can have a significant impact on investment outcomes and result in lower returns or increased risk in your portfolio.

Regardless of how strong any emotion is, fear or greed, you need to emphasise on making rational financial judgements. The most effective strategy to combat these behavioural characteristics is through goal-based investment rather than focusing on returns (high/low). As a result, it is essential for investors to evaluate current holdings or invest in new ones based on qualitative and quantitative parameters while avoiding any behavioural or emotional biases. Before investing your hard-earned money, you should thoroughly study or consult a financial professional who can give product or market information backed up by a stringent research process.

This article first appeared on PersonalFN here