Greed of gains and Fear of losses

There are three great forces in the world – greed, fear, and stupidity. This is what Sir Isaac Newton had said and what we observe it in the market, too, while looking at the investing pattern of most of the population. We all will agree that psychology plays an important role in investing, the way we think decides the trades we execute. The figure below shows the greed and fear cycle which generally prevails in the market. As you may see, when the prices start rising, an optimistic investor turns enthusiastic, starts showing exuberance, and finally goes into euphoria. It is at this point that greed takes over and an irrational investor decides to buy a particular stock.

However, over the short to medium term, the market goes through several phases and there are days of correction too. Now, when the market starts correcting, the same investor becomes anxious; at first s/he denies correction and later starts to panic. These then lead to selling the stock at a lower price, incurring losses.

And the cycle goes on.

This is why the Oracle of Omaha, Warren Buffett says, “be fearful when others are greedy and greedy when others are fearful”. Owing to the general human behaviour, people look to irrationally sell stock in a fearful market and buy in a greedy market.

How greed and fear affect prices

Stock prices are governed by the law of demand and supply, when demand increases, the price increases and vice versa. As more and more people become greedy, they are ready to buy a stock, even at a higher price, without looking at the intrinsic value of the stock. Thus, increasing its demand in the market. However, the institutional investor or a more rational investor would at this point realise that the stock is overpriced and would start to sell. The price bubble finally bursts with the exit of these investors, leaving the irrational investors in despair.

Now, with the decreasing prices, panic selling starts. The demand of the stock decreases, prices keep on falling giving the rational investors another opportunity to accumulate the stock at a lower price. 

For an irrational investor the cycle goes on, instead of buying at lows and selling at highs, s/he keeps on doing the opposite. Thus, losing money to greed and fear.

So, what’s next…

You might have noticed the usage of the words ‘irrational’ and ‘rational’ in the discussion above, rational investors might have seemed to be perfect investors or traders. Unfortunately, no one in the world is perfect and no one can time the market. A person who acted rationally in a particular investment idea may act irrationally in the other. What best one can do is to be cognizant of the intrinsic value of the stock and avoid the common behavioural biases, mainly, loss aversion bias, overconfidence bias, and the sunk cost fallacy.