“If you spend more than 14 minutes a year worrying about the market, you’ve wasted 12 minutes.”

Fear is uncomfortable, and it can drive investors to make rash, often poor, financial decisions. Fear can be so overwhelming that it over-poor, financial decisions. Fear can be so overwhelming that it overrides reason, patience, and good judgment. When less intense, fear is experienced as a gnawing sense of worry. In either form, fear has distinctive effects on financial decision making.

Among investors, intense fear often leads to panicked selling. Many novice investors first experience panic when the price of a stock they have overweighted in their portfolio begins a rapid and unexpected plunge. Watching one’s wealth evaporate like this is a terrifying experience. Surprisingly, it’s not only inexperienced investors who experience intense fear during the trading day.

Jim Cramer, former hedge fund manager, founder of TheStreet.com, and currently star of CNBC’s television show Mad Money, is intimately familiar with investing emotions. In one of the columns he wrote for financial web site TheStreet.com, he described the feeling of being caught in a rapidly losing position. In the following excerpt from that column, he is dramatizing the experience of being caught on the wrong side of a short squeeze in the fictional stock “National Gift.” Traders who are short shares of a rapidly climbing stock experience a pressured “squeezing” feeling as they quickly lose money, hence the phrase “short squeeze”:

Now the world is collapsing around you. Your breath, it isn’t happening, it is forced. Your forehead is flushed. You are sweating profusely and you are scared. You can’t even panic. You can’t even react. You can’t do a thing.

“Buy 200,000 National Gift at the market!” you shout out as the hammer that’s been slamming your head instantly goes away. “Just &*$&^#^#^@ buy the &*(%$&^$ thing.”. . .

It has to do with fear. Fear is the real driver of stocks.... Head traders like Todd Harrison can smell fear from symbols and prices. And you can never hide the smell of your own fear.¹

Jim Cramer’s lucid account of panicked selling highlights two of the chief emotional obstacles for investors—fear and panic. Yet fear doesn’t always sabotage investors; by summoning courage, it can be used to one’s advantage. Panic, however, is always a bad thing. While fear can crescendo into panic, they are quite disparate experiences. In this chapter I will primarily describe fear and its financial effects.

There are five principles essential to understanding fear and panic:

1. Fear leads to physiological changes in the body (forced breathing, sweating, head pressure). Thus, it can personally be identified.

2. Fear causes changes in how people think about and react to bad news (indecision, paralysis, building pressure, and panic). Thus, it often leads to bad decisions.

3. Fear is different from panic. Fear is an anticipatory emotional state. Fearful people see many risks. Panic is reactive, and it is characterized by an urgent pressure to act immediately.

4. It takes tremendous effort and fortitude to “keep one’s cool” when frightened.

5. Other investors’ fear can be detected in the markets, often via an experienced reading of price dynamics.

People’s natural reaction to perceived threats is to get away from them. Yet most experts can coolly stand back, take a deep breath, and analyze the dangerous situation logically. The courage required to push back against fear and the panic reflex is honed through experience, practice, and mental exercise. The inner strength needed to look at all sides of an investment objectively, including one’s own emotional reactions, is one of the key traits of successful investors.

While it isn’t difficult to be conscious of one’s anxiety, it is tremendously challenging to objectively question the merits of it when experiencing it. Anxiety orients one’s cognitive resources toward preparation for the perceived threat, making deviations from such a train of thought extremely uncomfortable and effortful. There is also a socially infectious element to fear. In the markets, part of the reason it’s hard to fade (trade against) fear relates to the collective changes in thinking and behavior that accompany it, which are often reflected in the media and among colleagues. If one can objectively observe investor anxiety, such as by using mental training exercises, learning the signs of fear in market prices, and employing sentiment indicators, then it can be used to improve investment returns.

CLIMBING A WALL OF WORRY

It’s an old adage that the stock market “climbs a wall of worry.” Often, stock prices seem to rise while investors and the business media are fretting about one or another potential danger. However paradoxical, worry actually provides opportunity. The following Wall Street Journal quote, from June 1997, illustrates: “Market watchers and investors alike expressed a measure of awe—and a dose of trepidation—as the market scaled what looked to them like a sheer cliff.”² While investors were nervous that the market rally would falter, a growing sense of confidence in the economy drove them to buy.

Intense fear is different from the worry that accompanies rallies. Strong anxiety cannot last long, though it feels interminable to shortsighted investors. Investors are biologically induced into short-term thinking by the stress hormones released during episodes of acute fear. Fear has the effect of inducing concrete short-term thinking with poor flexibility in judgment. Following a fearful event, as stress hormone release abates, and the intensity of the fear subsides, investors start seeing bargains where they previously saw only danger. In the short term, periods of high market fear usually present excellent buying opportunities (such as the fear that preceded the 2003 invasion of Iraq).

Figure 9.1 is a chart of the S&P 500 (the SPY index) from June 2001 to February 2002. Two sentiment indicators are superimposed on the index prices. The first indicator is the amount of fear expressed in the business news (the Nightly Business Report), while the second is the amount of joy expressed in that broadcast. Notice how the stock market appears to rise when the level of fear is greater than the level of joy. The market appears to fall when joy is more prevalent than fear.

This is a “cherry-picked” example of a period in history where joy and fear levels correlated with market price trends. Usually, such correlations, while significant in a statistical sense, do not provide for excess trading returns.

FIGURE 9.1 The levels of fear and joy in the Nightly Business Report around the September 1 1 , 2001, New York City terrorist attacks. The values are superimposed on the S&P 500 (SPY). Notice that when fear is dominant over joy, the market tends to rally, and when joy is more prevalent, the market declines. This technique works only in emotion-driven markets.

DREAD IN THE MRI

“The key to making money in stocks is not to get scared out of them.”

—Peter Lynch

It makes sense, evolutionarily, that anxiety is such a powerful driver of thinking and behavior. For our ancestors on the Serengetti, not heeding signs of danger could lead to sudden death by crocodile or lion. People without rapid panic reactions couldn’t last long. In fact, agoraphobia (fear of open spaces) runs in families. It is thought that this gene was preserved by those of our ancestors who experienced hair-trigger anxiety when walking across an open plain (where they could be targeted by predators or enemies). Because of their hypervigilance, they presumably would be the first to escape the danger zone and continue their genetic lineage.

Anxiety is such an uncomfortable feeling that people will often accept greater short-term pain just to end an anxious waiting period quickly. There is a psychic cost to anticipating a negative event, which is a result of the attention and energy our minds devote to “dread.”

Professor Gregory Berns at Emory University used functional magnetic resonance imaging (fMRI) to measure neural activity as subjects awaited electric shocks. Some individuals dreaded the shocks so much that, when given a choice, they preferred to receive more voltage sooner rather than waiting for a less painful shock later. These “high dreaders” showed greater activation in their brain’s pain circuits during anticipation of the shock. Even during an experimental condition in which they had no opportunity to hasten the delivery of the shock, the “high dreaders” continued to display greater neural pain system activation. Such neural pain circuit activation implies that the “high dreaders” were mentally replicating the anticipated “pain” of the shock as they were waiting for it.³ They accepted greater pain in the short term just to end their ongoing (mental) suffering. The anticipatory pain truly was “all in their heads,” but to them, the experience of it was real.

As an event approaches in time, anticipatory fear intensifies. Even when an event’s expected probability and severity remain constant, anticipatory dread escalates as it approaches in time.⁴ When research subjects are told that they will receive an electric shock at a specific point in time, their heart rate, galvanic skin response, and reported anxiety all increase as that time approaches.⁵

“Chickening out” is one result of increasing anticipatory anxiety. In one study, students were asked if they would perform mime routines in front of their class the following week for a payment of $5. Sixty-seven percent (six of nine) of the students who had agreed to mime chickened out when the designated time arrived. Yet the students reported the same probability and severity estimates of possible negative consequences in both weeks. Their objective observations of risk remained constant, but their decisions changed.

In a modified version of the above experiment, students who had recently watched a fear-inducing film clip were significantly less likely to initially volunteer to tell a joke in front of the class the following week than those who had not seen the movie clip.⁶ Experiencing fear from an extraneous source prevented risk-taking in other areas.

NATURE VERSUS NURTURE

Fear arises from several brain regions that together form the loss avoidance system. Long-term fear-based memories are recorded in the brain’s amygdala (fear processing) and hippocampus (memory center). During periods of high (but not extreme) stress, fearful memories are recorded in greater detail in these structures.

There are two fear-related pathways that travel through the amygdala. The fast pathway drives automatic, reflexive responses to threats—activation of this circuit occurs below conscious awareness and is not affected by prefrontal cortex inputs. Being exposed to passive threats, or witnessing fear in one’s colleagues, can be enough to activate unconscious fear.

Amygdala sensitivity is both related to past experiences and one’s genetics. The short form (polymorphism) of the promoter region of the serotonin transporter gene (5-HTT) has been associated with susceptibility to fear conditioning (after traumatic experiences) as well as increased anxiety and emotional illness. This gene may be associated with greater vulnerability to life stress, such that individuals with this gene are less resilient and more likely to develop anxiety disorders when exposed to intense threats.

Another way to measure the role of genetics versus environment in shaping emotional responsivity is to look at the prevalence of psychiatric disorders in relatives. Anxiety disorders, even in people with identical DNA (identical twins), have less than one in three odds of simultaneous occurrence. “Nurture” (life experience and environmental events) has the dominant role over “nature” (genes) in determining who ends up with anxiety disorders. This dominance of “nurture” over “nature” is true for most types of anxiety: panic disorder, generalized anxiety disorder, and social phobia, among others.

While anxiety does have genetic contributions, one’s life experiences and environmental events are most influential in determining whether someone will develop a full-blown anxiety disorder. For example, after a large stock loss, one may become afraid of the markets for a brief period. This type of fear is “conditioned.” After one has been conditioned to be afraid of an event or circumstance, without concerted intervention, it can take decades for that fear to be extinguished. For example, many adults learned to fear bank savings accounts during the Great Depression, and some Depression survivors put their money “in the mattress” for decades after the economy had recovered. Habits borne out of self-protection die hard. There is likely a lifelong interaction between biological factors (e.g., genetic) and environment in the establishment and remodeling of networks involving fear and fear memory.⁷ Regardless of one’s personal sensitivity to fear, we can all use similar techniques to learn to manage it.

IT’S ALL IN YOUR HEAD

Neuroimaging data shows that cognitive techniques help manage fear. In several fMRI studies, amygdala and limbic system activation are reduced after individuals are trained to use cognitive fear-reduction techniques. When they are confronted with feared items (such as spiders) or events (such as public speaking), their fear circuits are less active than prior to the training.

The placebo effect is a fascinating example of the prefrontal cortex’s power—demonstrating how beliefs and expectations alter how we experience the world. Most people’s level of anxiety is reduced by placebos,⁸ implying that there is a significant element of cognitive control that underlies fear. In one study, researchers placed a cream on the arms of experimental subjects before they received a series of painful electric shocks. In the first condition, participants were told that the cream was a highly effective new topical anesthetic that would reduce the pain of the impending shock. In another condition, subjects were told that the cream was electrode paste, intended to improve the conduction of the shock to their skin. In fact, the cream was inert and identical in both conditions.⁹

About one-third of subjects experienced decreased pain when given the alleged anesthetic. For subjects who expressed less pain when given the purported “anesthetic,” researchers noticed a significant reduction in activation of their brain’s insula (pain processing) and increased activation in their prefrontal cortex (cognitive attentuation of emotional intensity). Increased activation in the prefrontal cortex predicted pain relief. Furthermore, researchers found that prefrontal cortex activation reduced their insula activity in response to the shock (after it was delivered).

The researchers concluded that expectations of pain relief, working through the prefrontal cortex, could control “even the most primitive and conserved of evaluative mechanisms: the visceral response to pain.”¹⁰ These results demonstrate that how we think about danger, whether electric shocks or an impending bankruptcy, significantly alters one’s emotional experience of it. It is possible to profoundly alter physical and emotional experience by altering one’s beliefs.

EMPATHY GAPS

Jim Cramer, the celebrity investor cited in the opening vignette, illustrates the challenge of managing intense feelings while losing money in an investment. Most investors have had experiences like Cramer describes, on some level, multiple times. If fear is so painful, why do investors leave themselves vulnerable to it by trading “too big,” and not using protective stops or price alerts?

There is a “projection bias” that unites how people feel today and how they expect to feel in the future. That is, they project their current feelings into the future and expect to feel the same then as they do now.

In one study of people working out at a campus gym, everyone entering and leaving the gym was asked to read a short vignette and answer a question in exchange for a bottle of water. The vignette described three hikers who had become lost in the dry Colorado mountains without food or water. One follow-up question asked whether hunger or thirst would be more unpleasant for the hikers. Another question asked whether, if the subject were in the hikers’ position, they would find hunger or thirst more unpleasant. Of people entering the gym, 61 percent thought the hikers (and themselves) would find thirst more unpleasant. Of those leaving the gym after their workout, 92 percent thought the hikers would find thirst more unpleasant. Those leaving the gym were projecting their own feelings of thirst onto others.¹¹ It is difficult to imagine a future outside one’s window of recent experience.

These findings suggest that if the markets are calm, investors will tend to project the tranquility into the future. Similar projections probably hold true for established bull markets, bear markets, and long periods of price volatility. Fearful investors often cannot take the pain, in part, because they project that it will continue indefinitely. They sell in order to escape the pressure of declining positions—pain for which they can see no end.

During calm markets most investors don’t prepare adequately for volatility. They cannot accurately forecast how they will feel and what they might do in such conditions. They project their current sense of security onto their future self. Some naïve investors take on excessive credit risk because they see no threats on the horizon and they project an excellent borrowing climate into the foreseeable future. Investors caught with excessive risk exposure during a credit contraction are the origin of the Wall Street adage, “It’s only when the tide goes out that you learn who’s been swimming naked.” When credit dries up, those who took excessive risk, whatever their justifications, are exposed.

Many people intellectually understand that they will feel differently about risk in the future, but they still do not prepare adequately for those conditions because they cannot feel now how they will feel then. Recall the college students who intellectually estimated the social risks of performing a mime routine in front of their class. They then agreed to perform the routine. Yet when the time arrived to perform, two-thirds of the students anxiously backed out even though their intellectual risk assessments remained constant. There are several techniques that can be used to reduce the projection bias.