Importance of investor behaviour in Market Swings
A popular mantra of the stock market is “buy low, sell high”. However, when push comes to shove, this strategy is hard to follow. Investors in general are irrational and are driven by their emotions and biases.
Due to the uncertainty in the markets, there is a general belief that markets will keep plummeting and vice versa when markets are rising, reflecting the market psychology. This generally happens when investors fall victim to their own emotions.
There’s an evergreen saying “Financial markets are driven by two powerful emotions, greed and fear.” These emotions are so strong that they can cause harm to not only your personal life but can affect your financial health and wealth building process too. It is these emotions along with biases and rumours that cause bubbles in the market and eventual market corrections. In technical terms, this is called the fear and greed cycle. Investors who can behave rationally and control their emotions when the entire market behaves irrationally, have the potential to build the most wealth. Let’s see how these emotions affect investor decisions.
The Influence of Greed
In today’s materialistic world, everyone wants to get rich, and everyone wants to get rich faster. When markets are bullish people are driven by their greed. Looking at the rising prices denoting higher returns, investors get greedy to earn as much as possible quickly. As the profits grow, more and more people invest causing the prices to inflate to exorbitant levels. After reaching these extreme high levels, bubbles get created in the market, indicating high market values as compared to fundamental values. Eventually the bubble bursts, causing losses to investors.
For instance, before the great financial depression of 2008-09, there was a housing bubble in the US, meaning that the prices of houses had reached exorbitant levels, while the actual value of the houses was much lower. Consequently, the bubble burst, bringing in recession and causing many people to lose their homes.
During such times, to avoid losses immense control is required on emotions such as ‘herd behaviour’ and ‘fear of missing out’ and greed. The true fundamentals of investing is something any investor who wants to behave rationally should practise. These include keeping a long-term horizon and resetting the desired asset allocation based on the advice of a qualified mutual fund distributor.
The Influence of Fear
It can be said that greed and fear are 2 sides of the same coin. Similar to how greed can take the market over, fear can have a monumental effect on the market too. Fear in the market is visible when the markets fall steeply. When the markets start falling, a general panic is created in the market. This panic drives the investors to sell their investments in order to limit their losses. However, what they don’t realise is that the loss is not realised until the investment is sold.
For instance, you purchased 10 units of a mutual fund at NAV of Rs 100. Due to over-optimism and greed in the market, the value drove up to Rs 120. At this point, the investor’s greed kicks in and results in an attempt to buy more units. However, in the following few months, the unit price plummets to Rs 90. Such a loss is called notional loss and converts to an actual loss only when the decision to sell has been made. In a bid to not lose any more money, the investor books a loss. After a few months the prices start falling back to normal rates, and an element of regret due to booking a loss kicks in.
Similar to how greed rules the markets in their bull phase, fear prevails after the markets go bust. Investors, in order to protect themselves from losses, sell their mutual funds due to their irrational fears and turn to safer traditional investment avenues like fixed deposits which have low risk and low returns.
Riding the Fear and Greed Cycle
“Individuals who cannot master their emotions are ill-suited to profit from the investment process” - Benjamin Graham. The entire concept of greed and fear, denotes the volatility of the stock market. These cycles of market instability and notional losses are outside the comfort zone of investors. This leads them to give into these emotions and consequently make tremendous losses.
Some things are out of our control. Just like you can’t control the actions of others, you can’t control the market. However, what you can control is your actions. You can control whether or not your emotions have power over you and your actions. Furthermore, your actions will decide whether you make profits or losses in the market. Giving into the dominant market sentiment will do you more harm than good. Moreover, it will signify your irrationality.
Controlling your emotions is one of the most difficult things to do. Making decisions that are different from everyone else is much easier said than done.
Here are a few tips that can help you refrain from the influence of the dominant market sentiment and make wise decisions.
- Create a Plan
Defining an investment strategy is important before starting any type of investment. It includes deep analysis of your financial needs, risk capacity and risk appetite. Once the strategy is created, it's essential to stick to the strategy and not let emotions take over. Regardless of the market sentiment, deviating from the predefined plan can cause adverse consequences on your portfolio resulting in poor returns. Without such plans in hand, impulsive decision making takes place where emotions of greed and fear come in power. Doing nothing despite the rise and fall in your investments, except for rebalancing the asset allocation based on the advice of the mutual fund distributor will be the most efficient way to make the most of your investment.
- Invest in the Long Run
While mutual funds are a great way to maximise wealth, it can only be done in the long run. Living under the assumption that you will get rich quickly through investing in the markets is a hazardous misconception and one shouldn’t fall into such false traps. If you are willing to multiply your wealth, you need to be patiently invested in the long run rather than making rash decisions influenced by emotions. Seeking for ‘stock market tips’ to get rich quick or predicting the next ‘multibagger stock’ is a grave mistake and can wash away all your hard earned money parked into the market. Assuming extra risk, to try and bag profits through risky investment avenues like futures and options or through trading can be very harmful. Hence, it is wise to stay invested in the long run.
- Check Your Portfolio
As an informed investor, it is of utmost importance to keep a track of your investment portfolio. Periodic reviews of your portfolio are necessary to analyse the performance of the investments in accordance with your needs. While checking your portfolio daily is not required, it is advisable to view it in regular periods, say quarterly or at times of extreme market movements. This gives you the opportunity to analyse the alignment of your portfolio with your risk profile. Furthermore, one can also make analytical decisions such as whether to rebalance the portfolio while not being influenced by emotions.
- Enhancing Knowledge
Learning is a never ending process. Having some knowledge of investment avenues, like mutual funds, can go a long way. Since it may be difficult to always keep updated with the investment avenues, one can seek help from a mutual fund distributor. Learning the technical jargon can help you understand the latest economic developments more efficiently. Learning from the experiences of the best like Warren Buffet and learning from the mistakes of others, like the dotcom bubble or the great financial depression of 2008-09 can go a long way. Brushing up your knowledge can also help you identify rumours in the market and help you refrain from making rash decisions based on them. Most importantly, as you progress in your financial path, keep in mind the lessons you've learned from your personal experiences.
To conclude, emotions like greed and fear may have a major impact on investment, if you give them the power to drive you into making rash decisions. This eventually puts you at the risk of making mistakes. When making investment decisions, it can be difficult to suppress these emotions. However, you can gradually begin shaping yourself into the wise investor you want to be with information, experience, conviction, and a solid investing strategy.