Mindfully Investing

4.1 Greed and fear

Why do they always talk about greed and fear in the finance media?  You see and hear it constantly on the web, television, radio, and in books on finance and investing.  The greedy bulls are battling with the fearful bears and so on.  This shorthand jargon describes the highly emotional process of investing.  Greed is one aspect of our need to meet our investment goals.  Fear is one aspect of our need to avoid losses that can dash our investment hopes.  For me, watching my investments get crushed in 2008 involved a fair amount of sadness as well, and watching them come back over the next six years involved some mild and protracted excitement.  So, greed and fear don’t really capture the full spectrum of investing emotions, but they are the symbols of the emotional nature of investing.

Greed and fear also neatly represent the two sides of investment risk.  As we noted in Article 4, you need to accept a greater risk of losing some of your original investments to actually grow the money you need to retire.  Greed represents the willingness to take on more risk.  Likewise, you need to moderate your level of risk to preserve your savings and actually reach your end goal of retiring at all.  Fear represents the willingness to recognize the risks and appropriately manage them.

Obviously, we would all prefer to avoid the stress of constantly vacillating between greed and fear, but beyond that, a less emotional decision process clearly makes you a better investor.  The chart below shows the difference in investment performance between the S&P 500 index and a theoretical investor who is overcome by fear, resulting in “bouts of panic selling”.

Merrill Lynch’s Savita Subramanian developed this chart.  She defined panic selling, for the sake of the comparison, as an investor selling after a 2% down day in the stock market and then buying back 20 days later, provided that the market is flat or up at the end of that period.  Although selling after every 2% dip is an extremely fearful method, this assumption helps illustrate that succumbing to fear can severely damage your long-term returns.  And note that the chart vertical axis is on a logarithmic scale, so the panic selling approach here performs many times worse than the index over long periods.

Although the panic selling chart is a theoretical analysis, it is backed up by actual data from real investors.  Vanguard reviewed information from Morningstar estimating the difference between fund results and the results obtained by investors in those same funds.  They concluded that investor performance lags fund performance by about 1 to 2.5 percentage points depending on the particular comparison, as shown in this figure from Vanguard.

Although some investing decisions are presumably for simple reasons like someone needs the money to buy a car, the coincidence of cumulative market inflows and outflows with the larger market ups and downs as discussed in the Vanguard review strongly suggests that most decisions are an emotional reaction to market volatility.  No matter what time frame you look at, the data are pretty clear.  Making decisions driven by greed and fear, or emotions in general, is a poor investment approach.

The obvious advantage of mindfulness is that you avoid the greed and fear trap that imprisons most (perhaps 99%) other investors.  This trap is the source of the Warren Buffet adage that we should, “Be greedy when others are fearful and fearful when others are greedy.”  People are always looking for some advantage in investing, even doing illegal things like trading based on insider information.  If you like to think about investing in competitive terms, mindfulness provides us with a readily accessible advantage over the vast majority of our investing competitors.  Better controlling our emotions makes us smarter than other investors, at least in terms of “emotional intelligence”.  It allows us to recognize when others are avoiding risks irrationally or taking on risks recklessly.  We discuss this concept more in Article 5 on “beating the market”.   But first, read Article 4.2, which describes how to use mindfulness to better handle greed and fear.