Chapter 35

Blinded by fear

The emotional response to danger, known as fear, is vital to our survival. Those who are totally without fear are in great danger of self-destructing in numerous ways. Fear is also important in the stock market, but while it can protect us, it can also lead us into grievous error.

Loretta is a young woman walking home late at night. She takes a shortcut down a side street. No sooner is she in the side street than she catches sight of a group of youths coming toward her. She instantly recognises them as fitting the stereotype she has recently seen in the media as involved in attacks on young women.

Instantly Loretta’s entire body and mind are thrown into panic. She imagines being attacked by the group approaching her. Adrenaline pulses through her system, her heart thumps in her chest and every muscle is taut. Thinking only of escape, she turns and runs blindly away from the group and out onto a busy road. Cars that Loretta did not even see coming swerve to avoid her.

The next day, Mark comes back to his office after an all-morning meeting. He fires up the internet to check his investments. Most of his savings are invested in a mining exploration company that has fallen 10 per cent this morning. This is on top of a 20 per cent decline over the past month. He is gripped by an overwhelming fear of losing his savings.

In his mind, Mark sees the rest of his savings disappearing down a black hole. He imagines his money burning before his eyes. He nervously calculates how much of his savings are left. He pounds the desk with his fist and flings the newsletter in which he saw the stock tipped across the room. Fear of losing the rest of his money is so strong that his hands are shaking and his stomach is in a knot. Unable to stand the stress, he logs on to his broker and sells his stock holding at the low price for the day. The following week the company announces an important discovery and the price skyrockets.

Loretta and Mark have reacted instinctively to perception of impending physical danger and severe financial loss respectively. When we think we are in danger, fear takes over our mind. We imagine only the worst that can happen; Loretta can only envisage being physically attacked and Mark can only envisage losing his savings. Because of our total focus on the potential danger, we filter out all other information. We are in ‘fight-or-flight’ mode, and we have no sense of perspective.

In their situation, both Loretta and Mark do what is most natural for everyone, they flee rather than fight.

For Loretta, this is clearly the prudent course, notwithstanding that her fear may turn out to be unfounded. However, it has also blinded her to another risk — the cars into whose path she has run.

On the other hand, Mark’s reaction is inappropriate. While for Loretta to hesitate would be a mistake, Mark’s best reaction is to take time to think calmly about what is happening and what his alternatives are. He should seek information from his broker and maybe telephone the company to find out whether there is a reason for the fall and what its future plans and outlook are. Has anything changed since the newsletter was written? Is the market down far more heavily than his stock, suggesting that the selling may be irrational crowd behaviour?

Loretta has reacted rationally to a real risk that she is in physical danger. Her fear is acting to protect her. Mark is reacting to a kind of emotional danger: regret over the loss of his savings and potential embarrassment if others find out about his loss. His body reacted automatically, just as Loretta’s did, but it led him to make a poor financial decision.

Mark has made a fundamental mistake I have often observed among investors: to react blindly to what is happening in the market right now. Even if Mark’s correct course, after doing the necessary checks and thinking, is to sell, it is silly to sell into a panic. He may be better to hold on and sell into the next rally. All markets overreact, because others are panicking and being swept up in crowd behaviour.

What Mark should be doing is looking back to his investment plan. He should be examining whether the company is still on track. If it is, should he hold on? If it is not, he should calmly plot the most sensible way to sell out. Of course, readers may recognise a typical bull market speculator in Mark, who does not have any investment plan. He has jumped in on a tip without working out if it fits his financial situation or plans. He reacts blindly because he has no frame of reference to make a decision.

The first thing that will help those who have found themselves in Mark’s position is to stop what they are doing in the stock market and develop a sound plan for what they are trying to achieve. However, this is only the start, there is a more general and important problem that is to do with the way we think about markets. All my experience suggests that the difference between successful, skilled investors and unsuccessful beginners lies not in their analysis, but in whether the way they understand the markets is in tune with reality or divergent from it.

Most beginners cannot understand why a stock goes down on good news and goes up on bad news. Nor can they understand why bear markets start when the economy is booming along and bull markets start when all around them is doom and gloom. However, the reason is simple: people do not invest on the basis of what has happened or is happening. They invest on what they expect will happen in the future.

Economists have known this for generations and use the stock market as a leading indicator of the real economy. It is generally agreed that the stock market moves a good six to twelve months ahead of the real economy. Back in the late nineteenth century Charles Dow created the market average, the predecessor of today’s stock market index, not to trade the stock market itself, but as a barometer of the business cycle.

The problem is that Mark and his fellow investors are reacting to their emotional responses to current events, rather than looking to put them in perspective. To avoid this cognitive bias, once he has a sound investment plan, the two attributes that Mark needs are patience and discipline — patience to let his plan work for him in the time frame that his plan envisaged and discipline to stick to his plan while everything is still on the course he plotted.

It is most important to maintain perspective. This means we have to stand apart from the crowd. It also means understanding that markets swing between extremes of panic and euphoria. Cutting your throat in the face of imagined ruin in a bear market is just as bad as following the lemmings running toward the cliff in a bull market.

Summary

The interplay of fear, regret and ego can lead to inappropriate decisions. The stock market is a leading indicator because people invest on expectations. Have a sound plan. Practise discipline and patience. Maintain perspective.