The Greed and Fear Cycle

There is an old saying in Wall Street, “Financial markets are driven by two powerful emotions – Greed and Fear”. Legendary investor, Warren Buffet in his 1986 letter to Berkshire Hathaway shareholders wrote that, “Occasional outbreaks of those two super-contagious diseases, Fear and Greed, will forever occur in the investment community”. Investor behaviour driven primarily by Greed and Fear is responsible for the dizzying highs in bull markets and subsequent crash in bear markets.

Jeff Bezos, the CEO of Amazon once asked Warren Buffet, “Your investment thesis is so simple. Why doesn’t everyone just copy you?” Buffet responded to Bezos by saying, “Because no one wants to get rich slow”. What Warren Buffet said to Jeff Bezos is the essence of Greed in investment behaviour. Investors want to make profits quickly and bull markets provide a great opportunity to make profits in a short period of time. When price keeps rising, more and more people invest more and more money in stocks. Stock prices follow the law of demand and supply. With higher demand (more money), prices keep rising further and profits grow. Growing profits fuel more greed and more money get invested raising prices to excessive levels. At very high prices, asset bubbles are created i.e. prices are much more than intrinsic or fundamental value of assets. Like all bubbles, asset bubbles eventually burst and prices crash. Investors who had bought stocks at very high prices face big losses when market corrects.

Bear markets (falling markets) can be triggered by a number of factors but the most common factor is slowing or sluggish economy. It has generally been seen that a stock price fall faster than it rises. Just like a ski slope. When prices fall sharply, investors fear that it will fall more and sell in panic. In a bear market, supply of stocks is high since most investors want to sell in panic. Panic selling causes stock prices to fall sharply. Ultimately, prices fall to such low levels that stock valuations become attractive (cheap) and the markets eventually bottoms out.

You cannot control the market but you have control over your actions. Your actions will determine whether you make a profit or loss in stocks or mutual funds.

By now you know that there are only three ways the markets could move – up, down or sideways. Nearly everything will depend on inflation, Federal Reserve’s policy pronouncements, Biden’s infrastructure implementation, Omicron’s impact and prospective GDP in the U.S. and other developed nations, including China.  That’s fundamental. But what is the Black Swan or Shiller’s Index (CAPE at 38) or Buffets’ Indicator (at 2.1 standard deviation or strongly over-valued) say? The latter two are pessimistic and suggest value stocks. The Black Swan is an event which we cannot foresee – so that may trigger a panic sale – and the best strategy to follow is to remain cautious in your continued investments.

Reference:

Importance of investor behaviour in market correction – Greed and Fear Cycle, Mirae Asset Mutual Fund (https://www.miraeassetmf.co.in)