subscribe: Posts | Comments

Investor emotions part 2: Fear


Fear. We’ve all felt it at some point. The ominous sound of footsteps padding along behind you as you walk back from the pub in a provincial town at 2am on a Saturday night. The realisation that your evil mother-in-law is coming to dinner and you’ve forgotten the steak (not to mention the garlic and holy water). The awareness, halfway through a trans-Atlantic flight, that you’ve left the gas on. The soft ‘click’ as you wake up from your sleep-walk and realize that you’re standing naked in the hotel corridor and the door to your room has just locked itself.

Fear. It’s that stomach-dropping, bowel-loosening moment when you realise that you’re about to suffer a deeply unpleasant experience that will probably scar you mentally (and perhaps physically) for years. The feeling that urges you to cut your losses and run, run while you can.

Fear. Investors get it too.

OK, so much for the dramatic, movie-style introduction. In the real world, fear is a perfectly rational emotion that has evolved to allow humans to run away from danger, such as when confronted by woolly mammoths, sabre-toothed tigers and estate agents. It allows people to escape from unpleasant situations without suffering further losses, helped by a dose of adrenaline that gets the body and mind working at a frantic rate. It is, therefore, not a good emotion to have when you’re investing.

Unfortunately, fear isn’t something you can easily switch off, and while you’re not likely to suffer physical injury through your investments, the anguish of losing money is mentally scarring enough for fear to be a very real factor in many people’s financial decisions.

Consider the following example. You decide that you’d like to invest some money in a particular listed company. For the sake of argument we’ll call it Acme Widget Holdings Plc, purveyors of fine-tooth spigots and grease nipple adjusters to the flange-buffing industry. This is an established family firm that’s been around for decades and has seen a steady growth in its share price. It also pays a decent yearly dividend. You’ve studied its business model and market carefully and you’re happy that this is a well-run company with a good future.

Acme Widget Holding Plc’s shares are currently priced at 145p. You decide to buy in, aware that there might be some short-term price fluctuations, but confident that the long-term trend is upwards. Just in case things go badly wrong, you decide to set a stop-loss (a price point at which your shares will be sold by your broker to avoid further losses) at 100p. So far, so good. You’ve invested a reasonable sum, you’ve set a stop-loss that you’re comfortable with and you have reasonable expectations of where the share price will go, along with the cherry on the cake of a decent dividend payment each year. What could possibly go wrong?

Well, lots of things. But for this example, let’s say that China suddenly announces that it is building a new flange-manufacturing plant, capable of producing flanges 20 percent cheaper than domestic manufacturers. Stock market investors panic, dumping everything that’s even vaguely flange-related. Even though Acme Widget Holdings Plc doesn’t actually make flanges itself, and so shouldn’t be adversely affected by the new factory, its stock is hit by the fear sweeping through the flange sector and its shares take a dive of 25p in one day; they’re now down to 120p.

That’s the first effect of fear; contamination. Investors tend to tar all sorts of companies with the same brush, selling anything that might have even the remotest connection with a piece of bad news. For example, Nintendo’s shares dropped during the early stages of the credit crunch on the mere rumuor that the company’s significant cash pile might have some exposure to sub-prime mortgage-backed securities. “If in doubt, get out” seems to be the mantra of many investors.

So, other people’s fear has put you in the situation where your investment is down by almost one-fifth in the space of a day. Being human, at this point you start to fret, extrapolating the effects of the day’s drop. “If it’s gone down by 25p in one day, then in another five days’ time it could be worth zero!”, you think to yourself, while chewing your nails. Now uncomfortable with your 100p stop-loss point, you move it up to 115p, determined not to lose all your stake and willing to take the chance of losing less money should the worst happen.

Sure enough, the markets open the next day and Acme Widget Holdings Plc stock drops down further, to 110p. Your stop losses are hit, your shares are sold and you’re out, nursing a significant loss. Still, lucky escape, eh?

Perhaps not. A few days later, once the markets have properly digested and understood the flange situation, investors realize that if anything there will be a greater demand for flange-buffing equipment now that more people will be able to afford flanges. The share price recovers, and continues to do so, stabilising at around 150p a few weeks later. So, in fact, you lost out.

What did you do wrong? Simply put, you got scared; you let fear get the better of you. When you opened your trade you thought that a stop-loss of 100p was the right thing to do. As it turned out, you were right. But once the price had dropped so dramatically, your nerve failed and fear led you to change your strategy. That change of strategy, although it appeared to save you from further losses, actually cost you a significant amount of money.

This is probably the most common effect of fear; changing a strategy that seemed sensible but now looks vulnerable. There are times when a change of strategy makes sense, but if you’ve analysed the company in which you’ve invested and thought carefully about the long-term effects of a piece of supposedly bad news, you should be able to make a rational decision about whether to stay in or cut your losses. But if you’re feeling scared, you’re probably going to make the wrong decision.

Comments are closed.