Friday, September 9, 2011

Fear and Greed and the Recency Effect

“Fear is a darkroom where negatives develop” - unknown

“Hell has three gates: lust, anger, and greed”- the Bhagavad Gita

We tend to remember those events that occurred most recently. And more recent events receive a heavier weighting in our thinking. This is referred to as the “recency effect” and it is present in all human endeavors.

In investing I find that it manifests something like this:

“The stock market is rising, therefore it will always rise and will never decline”

- or –

“The stock market is declining, therefore it will always decline and will never rise”

Rising markets tend to trigger a greed response (“I want in now!”) and falling markets tend to trigger a fear response (“I want out now!” or at least “I don’t want in now!”). Psychologists have proven that in humans there is more pain in a loss or percevied loss than there is pleasure in a gain or perceived gain. One method of avoiding loss is by avoiding risk. There are many different types of risk but most people think of risk as “losing money” which I have seen defined in different ways over the years. Probably the most common way of thinking of “losing money” is to see an investment position trade at a price that is lower than what was paid. Risk of loss is, by definition, present in all investment activity – one can’t expect a particular investment to rise __% without accepting the risk that it can fall by the same amount. Yet I do see investing behavior that contradicts this common sense conclusion. Economics is a social science that studies human behavior. In my opinion, economics is mistaken in assuming that all economic decisions are rational i.e., that the person making the decision has thought through both sides of the decision before coming to their conclusion. The flaw is that humans tend not to be rational creatures but are driven by emotion, by what they see on tv, hear on the radio, read on the web, hear from their friends – the recency effect played out in near real time.

Naturally, financial advisors are humans too and just as susceptible to the recency effect as any investor. I imagine that someday a computer algorithm will be written that will attempt to replace humans as financial advisors but I doubt it will successful. Why? No computer program will be able to deal with the client’s feelings of greed and fear. Helping another human cope with greed and fear requires a great deal of trust, and no computer will ever be able to build trust with another human. Why? Because humans are not rational, whereas computers are nothing but rational. Maybe it will be possible in a far-off future populated by Artificial Intelligence, but certainly not in the lifetime of anyone reading this. So do human financial advisors need to act like computers? Is it even possible? No and no. To be able to help another irrational, emotion-driven human make good choices, the human advisor first must conquor his own greed and fear. Like they say on the plane: “Place the mask over your own face before helping others”. How does an advisor get to this place? The only effective teacher is the school of hard knocks, experience, trial and error. And the trials are never over.

We are experiencing a new round of fear this week – maybe we should call it “Fear of Greeks bearing gifts” - as the Euro Zone comes to a major fork in the road regarding Greece’s sovereign debt. Equity markets around the world have sold off in a typical fear response but remember: for every seller there is a buyer.

If you have an investment plan, stick to it.

If you don’t have an investment plan, get one – and stick to it.

kimm@sweetwaterinv.com