Improving your Financial Literacy: Fear, Greed and Investing

November is Financial Literacy Month. When reading financial news recently, you see that many commentators worry that stock prices are too high but the advice is often vague. So, you may wonder, how can “I” become literate if the “experts” appear confused? You should learn what to focus on when making decisions in a market.

Of course, commentators are vague about when the price crash will happen (or not …). That vagueness is because a stock price bubble (if it exists, …) is unstable is due to a conflict between the emotions of “fear” and “greed”:

• always, there are good reasons to be fearful when investing: stock prices go up and down; should I be willing to pay what seems like “too much” because other investors who know more than me?
• always, there are good reasons to be greedy: did you read that recent article about … who became so rich so easily by …?; I do not want to be poor all my life and wage income alone will not be enough.

Warren Buffett notes a fundamental paradox: if you want to become rich, you need to buy stocks when everybody else is fearful and sell when everybody else is being greedy.

Emotions, like tastes, are not a basic principle of economics. They are important and people debate whether stock markets are “irrational” or “informationally efficient”. (You may want to read financial economist’s analysis of the wisdom, or not, of the advice offered by well-known commentators.) Emotions are very hard to measure.

Some people try to summarize the feelings of a stock market using a Fear/Greed Index. CNN’s index combines seven measures to “gauge the mood of the market”. It seems like an example of good marketing, since frequent changes make it newsworthy even though I have never seen a careful analysis of whether FGI can predict trend profitably.

If you think of fear and greed as itches to be scratched or as hungers to be satisfied then you should admit that buying or selling shares in a company will never satisfy. Shortly after buying or selling, you need to make a slightly different decision in a slightly different situation: given the new information, should I buy or sell more? If you have $100,000 then you might expect these emotions to disappear but, when your wealth is $1 million, you will wonder if it can rise to $1.5 million or will it fall to $0.5 million.

When deciding in a market, it is not all about you. Fear and greed are emotions which apply to an individual but a market is not a person with well-defined tastes: every transaction includes a buyer and a seller. An individual’s emotional state always combines both: fearful investors buy if they perceive expected return to be “high enough”.

There may also be “rational” investors lurking on the sidelines waiting to profit from silliness and bots which can react to events within seconds. If the “emotions” of the market can appear to change quickly, and you are not one of the first investors and react to this shift, you will have to compete with others who see the same shift.

So, for Financial Literacy Month, my advice is don’t chase wild geese. While your emotions exist, your decisions are limited to buy and sell (and how much). Since the average investor does not have a competitive advantage in reacting quicker than average, they should not expect emotion-driven decisions to produce excess profits over the long run. If you are an average investor, you should seek to understand the fundamental value of a firm and avoid paying too much too often. While others worry, you will sleep better and isn’t that why you wanted to become wealthy?

PS: If you are like me then you may have heard a lot about an updated version of the Wealthy Barber recently. The original version sold millions of copies since its deceptively simple writing contained lots of wise advice. Here is a link to a recent podcast about understanding your own emotional state when investing.