About 15 years ago, right in the middle of the Great Recession, we extensively researched and produced an essay titled The Psychology of Fear and Greed. This was primarily an exercise to help us at Seamount Financial Group and our clients better understand the emotional and intellectual impacts of fear stemming from poor economic conditions and financial market volatility. Our research showed that fear can overwhelm, which causes irrational decisions when not managed appropriately and calmly.
Today, many discussions surrounding economic and geopolitical events have a measure of anxiety. Recent conversations with our clients, friends, and family revolve around inflation challenges, the war in Ukraine, or stock market gyrations. We felt it was appropriate to revisit our essay written in 2008 as a refresher of the potential implications of decisions based in fear.
In hindsight, we are reminded that periods of great turmoil and uncertainty often present remarkable opportunities for those willing to stay the course. Please contact us if we can help with providing peace of mind and effectively addressing any questions or concerns that may arise.
The Psychology of Fear and Greed
December 31, 2008
Behavioral finance is becoming a force in the world of financial planning. Increasingly, professionals in the planning industry are realizing that dealing with the feelings and doubts of the clients in a therapeutic and sensitive method is an important aspect of the planning process.
The recent downturn has brought to light a renewed realization that the markets are not merely a result of investors using the correct tools to process data and make intelligent choices. Factors driven by the emotions of people, especially the emotions of fear and greed cause people to make irrational decisions. Without people being subject to acting on these emotions, the market would be an efficient trading mechanism. Instead, individuals sell off their securities in a bear market and attempt to chase hot stocks in a bullish environment. Understanding why we have these emotions and how we react because of them may be useful in order to deal with our losses and gain new perspective on facing future decisions that we must make.
The Psychology of Fear
Fear is a very potent emotion, sometimes unable to be conquered or rationally dealt with. Because it is deeply rooted in neurochemical changes in the brain, it is very difficult to “turn it off” and view the flawed thinking from an objective point of view. Basically, defense responses coming from fear are of little use unless they are appropriately elicited. However, false negatives (not acting when action should be taken) are much more costly than false positives (responding fearfully to a harmless stimulus). In other words, it is better off to be wrong and scared than take the time to decide whether that strange sound was dangerous and end up hurt or worse!
An example of this in a financial setting may be a particular investment in a portfolio losing a moderate amount of its value within a trading session. The total impact on the portfolio will most likely be minor, perhaps balanced out by gains elsewhere, but fear has already taken hold. The brain quickly makes a judgment about whether or not this is a fearful situation – and at an irrational surface level it absolutely is. The brain begins to send signals to other parts of the body to be ready for a fight or to flee as quickly as possible. This is not an ideal situation in which reason holds the upper hand in the decision-making process. The financial market is not under any one person’s control, and when a situation such as this is uncontrollable, the fear that is experienced often leads to anxiety. Fear generally has an obvious implicit danger that must be handled. The threat leading to anxiety is more obscure, as in a potential monetary loss, and attempting to alleviate anxiety leaves one feeling hopeless and helpless.
In any discussion of the basic emotion of fear, one must first identify the various biological “players” at work in creating, experiencing, and managing fear. One of the most important sections of the brain is the amygdala. The amygdala is a complex structure involved in a wide range of normal behavioral functions and psychiatric conditions. In addition to its role in emotion, the amygdala is also involved in the regulation or modulation of a variety of cognitive functions, such as attention, perception, and memory. So-called “stress hormones” are also regulated and released by the amygdala. The hypothalamus is also a crucial part of the brain’s anatomy with regard to emotion. It is responsible for controlling the release of neurotransmitters that are involved with many emotions including fear, hunger, thirst, and anger. The adrenal medulla is the main site of the release of adrenaline and noradrenaline, two chemicals whose main effects are increased heart rate, blood pressure, bronchiole dilation (increased breathing) and increased metabolism- all characteristics of a fear response.
These structures, along with a few others, comprise the “limbic system” of the brain, largely thought to produce raw emotional responses to stimuli. The limbic system in addition to the parts of the brain necessary for regulating life sustaining functions like heartbeat and respiratory functions is sometimes called the “old brain”, referring to the fact that all vertebrates have these structures, from reptiles to humans. Surrounding that layer is the cerebral cortex, what we would consider the “human” part of the brain. Because ‘old’ parts of the brain are less developed, and are therefore less part of our conscious mind, they are very difficult to control. Emotions generally originate in this area often from very basic stimuli causing very powerful physical changes, commonly known as fight or flight responses. The cerebral cortex acts as a mediator by interpreting these sometimes irrational feelings in the context of the situation. As stated before, it’s very difficult to suppress fear once it has taken hold.
External stimuli are insufficient to distinguish fear and anxiety. Fear is related to coping behavior, particularly escape and avoidance. However, when coping attempts fail (i.e. when the situation is uncontrollable) fear turns into anxiety. Fear is an avoidance motive. If there were no restraints, internal or external, fear would support the action of flight. Anxiety is unresolved fear. In fear, it is an obvious though perhaps not clearly perceived danger located in space and time that must be dealt with; in anxiety, the nature and location of the threat remain more obscure, as in a potential monetary loss, and thus is difficult to cope with by active defensive maneuvers.
When making decisions involving large amounts of information, the brain sometimes takes a series of shortcuts, rules of thumb, educated guesses or “heuristics” to arrive quickly and efficiently at a conclusion to save time and energy. People are particularly susceptible to errors in judgment because the heuristics they use are imperfect. For example, the amount of media coverage dedicated to the economic situation can have an enormous effect on the psyche of the investor. Recent business headlines in many major newspapers and broadcast media contain words like crisis, loss, bailout, scare, pain, foreclosure, bankruptcy, ponzi scheme, collapse, stimulus, and Troubled Asset Recovery Plan (TARP). To be sure, the economy is in serious turmoil. But some of the stock market’s losses are due to panicked investors selling entire portfolios simply because they are bombarded every day with depressing headlines, devaluing stocks beyond true value. For instance, several companies, globally, are trading below the value of the cash they have on hand!
Another example of a heuristic involves the vividness of a risk. People will pay twice as much for an insurance policy that covers hospitalization for “any disease” than one that covers hospitalization for “any reason.” Obviously, “any reason” includes all diseases, but is more general and vague than “any disease”. The vividness translates into an emotional fear that makes no economic or logical sense.
Fear is a very real, very powerful force to be reckoned with. Investors and planners, shareholders and CEOs, stockbrokers and analysts are all affected by it. Fear, and its by-product panic, is a given when working with money because of what money stands for: from a child’s future, an education, and social influence; to food on the table, clothing, and shelter. Fear can be controlling; it can freeze and confuse logical thought processes that need to be clearest when making decisions about wealth. One of the best ways to conquer fear is not to ignore it or wish it away, but to acknowledge its influence. Jason Zweig, author of Your Money and Your Brain offers some questions to help decide on the next step like: “other than price, what else has changed?” or “what other evidence do I need to evaluate in order to tell whether this is really cause for panic?” Logical answers to questions like these may lead to a more reasonable choice, instead of one driven by fear.
The Psychology of Greed
Like fear, greed has also been acknowledged as a driving force behind the current economic stress that we are experiencing. Greed as an emotion is not inherently immoral; however, it is more difficult to define than fear. There is no doubt that it exists, but a definition of an ambivalent term like greed derives as much from what happens between people as from what goes on within their brains. Greed stems from the natural human desire to gain the most results that one can from one’s efforts. This is a very important concept to capitalism: if we kept all our money in the safest and subsequently the least rewarding investments, we would not have the economic growth that we have been enjoying.
Imagining future wealth often makes an investor happier than actually having it. A psychological study was performed in 2002 where people learned that they would receive a reward upon seeing a certain shape. The subjects’ brains reacted much more strongly after they saw the shape than when they actually received the reward. This notion is supported in a few examples that come to mind. Christmas would not be as much fun if all of the presents were wrapped in clear plastic and we certainly don’t go to Las Vegas planning to win millions, but it’s always nice to imagine the possibility.
Greed becomes dangerous when it is created as a product of impatience. People are very eager to earn lots in order to spend lots and hope that happiness will follow. Think about patience this way: would you rather get $10 today or $11 tomorrow? Most will choose the $10 today. How about $10 in one year or $11 in 366 days? When the question is posed like this people will usually change their answer to $11, even though the rewards are separated by the same amount of time. To our instinctual brains, it makes a lot of sense to live for today; during famines or shortages, tomorrow is a long way off. Greed and gaining wealth quickly is our modern day equivalent of that survival instinct.
The greed responsible for this past year’s downturn began a long time ago and is finally being fully realized. To use the cliché, hindsight is 20/20. The analysts, pundits and politicians said they saw the signs but never realized what they meant. Expecting unreasonable results now can be a sign of impatience and should be recognized and dealt with sensibly.
When making any important financial choice, emotions are inextricably linked to the decisions. Mood, external situations, even the weather can affect the decision negatively or positively. Difficult, emotional situations will invariably arise. A recommended course of action that an investor should take is to step away from the situation. Do something completely unrelated from the current decision- perhaps even going as far as “sleeping on it”. When the brain has a chance to calm down neurologically, the choice is based much more on objective logic rather than irrational emotions.
Bear markets are necessary to have bull markets- the best course is to execute decisions objectively, diversify, be realistic, hedge for the bad times, and most importantly be patient.
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