The Fearful, The Hopeful and The Greedy in You!
Breaking News: “You cannot work forever. You have to retire sometime”. As you plan for retirement and decide to become an active participant in financial markets, you are can be full of hope. Hope to accumulate enough wealth and be able to maintain your current lifestyle during retirement. You can also be full of fear; fear of losing all your investment. So which one are you? The hopeful? The fearful? Or is there a middle ground?
Finance professionals see fear as an emotion consistent with the observation and expectation of continuous poor performance of an investment. While this emotion is not unusual in financial markets, our response to fear can have important implications for our investments value. The common of us would expect that with anticipated negative performance, any investor would immediately sell off the asset for which the value is expected to decrease. This intuition however, has historically proven not to apply to the average investor. We tend to hold onto losing assets too long, demonstrating a clear preference for paper loss rather than realized loss. It is not until we realize the loss that it “hurts” and we are willing to delay this pain for as long as we can. Yet, this attitude unsurprisingly leads to further negative returns.
So why do we wait so long? The answer is hope. As fearful as we are, we are also very much hopeful. When facing uncertainty and experiencing negative returns, it is hope that gets us to ride our losses even further. Perhaps more interesting, is the average investor’s attitude when experiencing positive returns. You would think the common of us would hold, for as long as possible, onto an asset for which the value has increased over time. Well, historically, investors have gotten rid of – sold off – those assets too soon, demonstrating in this case a preference for realized gains rather than paper gains. This time, it is the fear of a potential reversal that drives our decision to sell. We would rather cash in what we can and as soon as we can; even if that is far from the best we can achieve.
The average investor behavior described above is known among finance professionals as the Disposition effect. It somewhat characterizes our risk loving behavior with respect to losses, and our risk averse attitude vis-à-vis of gains. What this suggests is the importance of understanding how hopeful we are when experiencing losses, and how fearful we get when experiencing gains. It also tells us that we are neither consistently hopeful, nor are we consistently fearful.
Although we choose what we are depending on our most recent experience, we are also likely to overreact to recent positive returns – and be greedy – or underreact to negative returns and act as ostriches – putting our heads in the sand. Greed in financial markets can be disguised as hope. So, perhaps there exist a middle ground that financial market participants ought to identify. Warren Buffet famously said: “Be fearful when others are greedy and greedy when others are fearful”. It is nonetheless important to remember to be attentive at all times. Which one are you?