There is an old saying or theory on Wall Street that investors are driven by two emotions: fear and greed. While that may be an oversimplification, in my 19 years as an advisor, those are the two I deal with regularly. There have been many books and articles written on how emotions affect your investment decisions. Allowing either of these two powerful emotions to influence your decisions can have negative consequences.
Think back on your last investment decision.
Did you listen to your financial advisor when he advised you to invest more during a stock market decline? Or, did you let fear be your decision maker?
S o it is important to understand both of these powerful emotions and how they can persuade us. I’ll show you what can happen when an investor gets overwhelmed by one or both of these emotions.
Gordon Gekko’s famous quote from the movie Wall Street, “Greed is good,” may not absolutely be correct. One could argue that greed has been good overall for the United States and its economy.
However, when you choose to get rich quick, it rarely works out. The dot come bubble is a perfect example of how greed can drive our decision. I saw investors put 80% of their portfolio in technology, and taking out second mortgages to invest in the next internet phenomenon. Only to see the markets pull back dramatically, and in some cases wiping out all the short term wealth that was created.
Oil and gold have been the most recent greed plays by investors. In 2011 almost every conversation I had with clients included whether they should buy gold at an all-time high. It’s times like these that taking a diversified approach to your investments will eventually pay off. You must maintain a long-term perspective and not give in to what Alan Greenspan called “irrational exuberance.”
Just as an investor can become overwhelmed by greed, the same can happen with fear, and often does. Fear is a very powerful emotion. In 2008 when the S&P declined 37%, many people thought it would continue and liquidated their portfolios. This mass exodus from out of stocks shows a complete disregard for a long-term investment plan. Investors didn’t follow their plans because of the fear of further losses.
Granted, losing a large portion of your equity portfolio is a tough pill to swallow, but jumping from a declining portfolio into a low-risk, low-return portfolio ensures that the loss is permanent. If you stay put, and not let fear be your motivator, you at least have a chance to get back some, or all of the losses.
Fear and greed relate to the volatility that exists in the stock market. When investors get over confident, or lose their comfort level due to losses, they become susceptible to these powerful emotions, often making costly mistakes.
I advise my clients to cope with both of these emotions the same way. Follow my four fundamentals of a good investment plan, including asset allocation, controlling expenses, knowing what you own and keeping a long-term perspective. Sticking to a sound investment strategy while controlling your emotions, whether it be fear or greed, and not blindly following the herd, is crucial to successful investing. If you need help with your portfolio, feel free to write me at firstname.lastname@example.org, or call me at (859) 225-2596.