Mind on My Money

How to invest wisely

Bubble Emotions: Where are we with financial stocks?

Investor emotions throughout a price bubble.

The behavior and emotions of investors during a price bubble can be extreme. Consider the cycle of investor emotions spurred by a bubble and shown in the figure. As prices increase, investors become excited and even thrilled. Investors attribute any profits to their own investment skill, and discount the possibility that luck or good fortune is adding to their investment gains. Some investors do not even come off the sidelines and enter the market until stories of easily-made profits begin making their rounds. Euphoria can set in when investors begin to believe that prices can't possibly decline. Detailed fundamental analysis goes out the window; many investors begin to purchase assets without even understanding what they are buying.

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Then, inexplicably, prices begin to fall. First, traders and investors feel nervous anxiety. You may hear, "I am not worried because I am a long-term investor; you don't lose money until you sell." Then there is the denial phase. Denial can be re-enforced in price bubbles that experience a bubble-echo (a second climb in price that is also called a ‘bear trap'). Prices begin to plummet to levels that once again reflect fundamental prospects. Fear becomes widespread. At this point, many previously successful investors have not only lost prior profits ("house money"), but begin to eat away at their initial investment capital. Desperation and panic set in followed by complete despair and capitulation. Investors are dumbfounded about how they could have been so wrong. Investors are so emotionally despondent that the idea of actually buying at bargain-basement levels is simply inconceivable. They wait until prices begin to rise and investor emotions begin to improve.

As depicted by the cycle of investor emotions, psychological influences can cause investors to "buy high" during the thrilling and euphoric stages of a bubble, and "sell low" at the panic and capitulation stages. Buying high and selling low is not a winning strategy. This is why Warren Buffet recommends that you be "fearful when others are greedy and greedy when others are fearful."

Where do you think we are in the financial stock bubble?

John Nofsinger is an associate professor of finance at Washington State University and a speaker, writer, and scholar on behavioral finance.

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