Finance, in general, has been based on rational and logical theories, and for most part, tends to be somewhat ‘predictable.’ Early financial theories assumed that people behave rationally and predictably, and that outside factors and emotions do not influence people when it comes to making financial decisions. However, behavioral finance has proven people behave irrationally and differently in the real world. The human brain has difficulty assessing risk (fear) and possibility (greed), which causes our emotions to affect our decision-making process. Investors make irrational decisions when it comes to their own investments. Investors react stronger (it’s painful) to financial loss, than to gain. This is what has the most impact on our portfolio aside from investment performance. Fear and greed are such powerful emotions that there is now a Fear & Greed Index that tracks what is driving the stock market today!
In thinking about yourself, do you react to televised market commentary or to ‘Herd Instinct’ causing you invest in something because everyone else is? When the market declines are you fearful of loss and sell or invest or hold onto an investment in a down market? Fear and greed can be beneficial to your portfolio or have the opposite effect.
As Warren Buffet said, “Be fearful when others are greedy and greedy when others are fearful.”
Discussing your fears and financial dreams can give both the investor and financial advisor a better understanding of what may cause bad decisions leading to errors that you may not recover from.
Hearing the term ‘greed’ isn’t bad unless it leads to thoughts of confusion, questioning decisions, or changes in behavior similar to ‘gambling’ on an investment. As an investor, you can have a ‘financial crisis’ by not fully thinking about what you want and how you will react to changes in the markets. You need to know yourself before you can determine your goals and start to invest.
How much market fluctuation can you tolerate? Are you comfortable with separating money into different investment options to help fund each goal you have? Are you comfortable with investment advice and the monitoring of your portfolio? The best way to harness fear and greed to your benefit is by understanding your investor profile:
Personal or social traits such as gender, age, income, family, even tax situation
Part of the emotions and beliefs of the investor.
Balancing Risk vs. Reward
Tolerating more risk in order to have the higher reward or less risk and contentment with a reasonable return.
Area of Focus
Types of investments (ex. Stocks, bonds) and sectors of investments (ex. Technology).
Helps to shape the investor profile by the type of investing the investor uses (ex. ethical, growth, indexes)
Helps to develop the investor profile through the valuation method (ex. Fundamental analysis, technical analysis, quantitative analysis).