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Anxious Financial Markets: How Fear Drives Investments

How Fear Drives Investments

All of us have been watching the gyrations of Wall Street and the stock market in recent days. With the collapse of Bear Stearns and Lehman, the "rescue" of the failing Fannie Mae-Freddie Mac, and the bail-out of AIG, many people wonder, "Have investors completely lost their minds?" Well, the answer may be, "Sometimes". Here's how we might look at anxious investing during a time of market volatility, uncertainty, bad news, and fear.

How does the anxious investor think? Let's consider two possible investors--- one who is reasonably optimistic and the other who is pessimistic.

Pessimistic and Optimistic Investors

Consider Jones who is considering an investment and who believes that he has substantial assets and substantial future earning potential. He is presented with the option of investing $8000 with a moderate probability of making a 50% return on his investment. He also believes that, even if he does not make 50%, he has a good probability of making some profit and very low probability of losing his entire investment. Jones enjoys the things that he buys with his wealth and he enjoys playing the game of investments. Given the offer of this investment, he reasons that he has substantial resources to absorb the unlikely losses that might occur. He takes the investment.

In contrast to our optimistic, risk-taking Mr. Jones, unfortunate Mr. Smith believes he is down to his last $100. He has suffered some losses recently---most of which he had not anticipated. He is offered an investment of $80, with a possibility of gaining $40 (a 50% return on his investment). Smith believes that he has little likelihood of gaining employment and he believes that he has bills coming due next week. Moreover, he attributes his dire financial straits to foolish investments that recently headed south. Jones is a "Nervous Nellie" and passes on this opportunity to invest.

These two investors---optimistic Jones and pessimistic Smith--- operate from what they believe are rational considerations given the information and goals that they attempt to pursue. The optimist pursues a maximization strategy---that is, a growth strategy---because he is willing to take risks. The pessimist---our "depressed" and anxious Mr. Smith---believes that his minimization strategy is rational, since his goal is to avoid further losses. Perhaps Smith is incorrect (or correct) about his evaluation of his current and future resources, perhaps he is unduly negative of his chances of gaining, but there is an internal logic that tells him that he cannot absorb any further losses. His "self-protective" strategy instructs him to avoid change unless there is close to certainty of gaining.

Strategic Pessimism

In the current market-of salient, unexpected, dramatic bad financial news--- we can see that investors are using what I call "strategic pessimism". What is strategic pessimism? It's an attempt to avoid any further losses by following a set of rules that will minimize risk. We can think of the anxious investor as having a "portfolio theory"-that is, a theory about the current market, the time horizon of investment (how long he can stay in), his perception of how diversified he is, his future earnings and his tolerance for risk and loss. Investors who are currently anxious-and depressed-in this volatile market of recent weeks may be utilizing what I would describe as a "depressive portfolio theory". Their goal is to minimize risk.

In the table below, I contrast the depressed/anxious investor and the non-depressed investor.

Portfolio Theories of Depressed and Non-depressed Individuals

The anxious investor believes he has few current assets-he feels relatively poor. He may also think that he will not have substantial future earnings-so if he loses, he will not be able to recover. He views the market as volatile and unpredictable---he doesn't know what will happen next. And "It could be terrible", he adds. His goal is to minimize losses, so he embraces a risk-averse strategy. In addition, he may not enjoy the gains that he does achieve (they have "low functional utility")-partly because he is anxious and depressed. He doesn't think that he can continue putting money in---he doesn't think he can replicate his "hands", continue playing the game, or take a long-term strategy. And, he doesn't think that he is diversified in his assets. For example, he may narrowly focus on a few stocks or investments and not realize that his real estate or retirement funds have significant value. He is over-focused on one investment that he views through a lens of pessimism and fear.

The pessimistic investor feeds his negativism with a string of worrisome assumptions and beliefs. These are shown in the table below. Examine this table and see if any of these fit you when you are anxious about financial markets. For example, do you view as small decrease in a stock as a sign that things will begin to unravel? Do you set a rule that you will quit early-"while you can still get out"--- and set a stop-loss order in? So, if your investment goes down 5 %, you pull out immediately. Do you think that the world is now characterized by a severe economic downturn of unknown duration? Are there few possibilities out there for further growth? Do you view small losses as permanent depletions from which you may never recover? Do you see "cost-cascades"---that is, one loss will trigger other losses as they cascade over the cliff carrying you under? Is your focus on the short-term---thinking that only what happens this week really counts? Do you lack that longer term perspective that would allow you to see ups-and-downs as part of market conditions? Do you view losses and bad decisions as irreversible--- "What goes down stays down-forever?" And are you prone to severe regret-even self-loathing-when investments don't work out for you?

Loss Orientation in Depression and Anxiety

If these assumptions, beliefs and strategies fit your theory of investments and market conditions, you can bet that there is someone out there with a very different portfolio theory. That would be the investor, loaded up with cash, looking for an opportunity, bottom-fishing and buying up the bargains. That person is not anxious and depressed. In fact, they may feel so good about what is happening that they may actually appear manic to you.

They could be right. They could be wrong. Or they could be lucky.

Sometimes bottom-feeders in a volatile market get very lucky. And sometimes they turn out to be the "bigger sucker down the road".

Place your bets.

To read more about depressive portfolio theories, see my chapter from my book, Psychology and the Economic Mind available by clicking here.

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