Fighting the fear - why investors need to overcome their emotions

By Tom Stevenson, 17 July 2008

In his latest column, Tom Stevenson explores how fear can affect investing and how to overcome it. Having watched the FTSE 100 fall by 20% in less than two months⁽¹⁾, investors are experiencing a range of emotions. Possibly anger and frustration, probably regret too, but top of the list is certainly fear.

Understanding, and controlling fear, is key to success in investment and not always in obvious ways. It might seem that an ice-cool, emotionless personality with a killer instinct would be the model investor, but the reality is more complex than this James Bond image. If investors can’t live with their emotions, they certainly can’t live without them. 

James Montier, an investment strategist at Societe Generale and an authority on behavioural finance, examines the investment implications of fear in his excellent book Behavioural Investing⁽²⁾.He refers to two experiments that show how fear can both help and hinder investors.

In the first study, different groups play an investment game. Players are given $20 and then play a series of 20 rounds in each of which they have to decide whether to invest $1 or not to invest. If they choose to invest, a coin is tossed with two possible outcomes. A head results in the player losing their dollar while a tail means they win $2.50.

The first group is “normal”, the second group suffers from damage to the neural circuitry associated with fear (they can no longer feel fear), the third group has other brain damage but to areas unassociated with fear.

If you think logically about the game it is obvious that players should choose to invest in each round because the possible gains outweigh the possible losses and the chance of a head or a tail is 50:50.

However, the results do not reflect this. The experiment found that players with damage to their fear circuitry invested in 83.7% of rounds, while the normals invested in 62.7% and the other patients in 60.7% of rounds. In other words, fearless patients had a greater appetite for risk.

What is more interesting is what happens in rounds following a loss in the previous round. In these cases, normal players invested in only 46.9% of rounds while the players with damaged fear circuits invested 85.2% of the time. Fear made the normal group act irrationally.

It is perhaps intuitively obvious that fear should impair our judgement. But the second experiment in Montier’s book shows that lack of fear can also be detrimental.

In this study, two groups take part in another gambling game. The first group consists of players with damage to the emotional centres of their brains while the second comprises “normal”, undamaged players.

Each player is given $2,000 and told that the point of the game is to avoid losing the loan and to make as much extra money as possible – the classic investment situation. They sit in front of four packs of cards and learn that drawing cards will result in either a financial gain or a loss.

Drawing from packs A and B results in either a $100 gain or a loss. Packs C and D result in either a $50 gain or a loss. Crucially, the packs are loaded so that drawing consistently from A and B results in a loss while drawing from C and D results in an overall gain.

Performance is assessed at various points in the game so that as the players draw more cards it becomes clear to them that A and B are riskier draws than C and D.

The two groups behave differently through the game. The normal group quite quickly picks up on the difference between the packs and well before it is able to articulate that A and B are riskier it is already favouring the “good” packs.

The emotionally damaged group, however, continues to draw more cards from the “bad” packs even when they “understand” the difference. Their inability to feel the emotional pain of loss hampers their performance and a higher proportion of this group runs out of money than in the normal group.

So a certain amount of fearlessness is necessary to be a successful investor (cool under fire) but without an understanding of the dangers involved an investor is also at risk of making foolish choices.

Here are four other interesting findings about fear and investment and how they might affect your behaviour in these difficult times: 

1. Under emotional distress, people shift towards taking high-risk, high-payoff options even if these are objectively poor choices. So take extra care after a run of losses - you may have become a gambler, not an investor.
2. When self-esteem is threatened (very likely after a poor run in the markets) people lose their capacity to regulate themselves. Don’t let the need to prove yourself override your normal, rational approach to investing.
3. When self-regulation fails people may become self-defeating in many ways, including favouring short-term rewards over bigger but longer-term benefits. Keep an eye on your long-term goals.
4. The need to belong is a central feature of human motivation. When people are rejected they cease to function properly and irrational and self-defeating acts become common. This is why contrarian investing is so difficult. The fear that everyone else might just be right after all can be overwhelming.

At times like these, investors have plenty to fear. But in terms of investor behaviour there’s arguably nothing greater to fear than fear itself.

 

Past performance is not a guide to what might happen in the future. Please note the value of investments can go down as well as up so you may get back less than you invested. The ideas and conclusions in Tom Stevenson’s weekly column are his own and do not necessarily reflect the views of Fidelity’s portfolio managers. They are for general interest only and should not be taken as investment advice or as an invitation to purchase or sell any specific security.