We are usually taught that hope is a virtue, but in the unforgiving world of financial markets it can be a curse. When we are reduced to “hope”, it’s an admission that our investment discipline is starting to slip. Experienced investors will recognise that this also the flip side of the equally dangerous emotion of “excitement”. Let me explain.
Conventional wisdom states markets are driven by greed and fear – but I disagree. In fact they are driven by fear (on the way up) and hope (on the way down). The excitement element is the rocket fuel that drives the fear. How come?
Well let’s firstly consider a strong bull market in stocks; as the trend strengthens more and more investors pile in, previously cautious types join in as they fear missing out. After all if everyone is making money why not me? Egged on by market pundits, economists chartists et al – the fear of missing out on future spectacular gains and its accompanying excitement is just too much. Then curiously when there is no fear left in the market – prices can only go up from here – we are usually at the very top. Having climbed the wall of fear there is only one way to go – down.
When markets are on the slide its Hope that is the dominant factor – all those small losses start to snowball and investor’s instead of cutting their positions start hoping, perhaps even praying that things will turn around. This is the slippery slope leading to losing positions and in some extreme cases spectacular rogue trader fiascos. Only when all hope is extinguished and all the towels have been thrown in, can markets make a bottom and the trend change.
With this insight I think we can start to see how bubbles & crashes manifest themselves. In the downward spiral that is hope the most toxic effect is it can freeze our ability to act. We just can’t bring ourselves to cut the losing position (“after all it may come back, and I’m sure the market is wrong”). Once this spiral starts to take hold of an individual trader there are some tell-tale signs. We almost immediately lengthen our time horizon (“ohh it will recover in time”), we fail to place, or even worse, cancel stop loss orders (“I don’t want to be selling at the bottom”) and we filter out all the news and analysis around us that is contrary to our view. We become experts at only listening to news that suits our (losing) position and blame everyone except ourselves. (“The market is full of idiots!”).
Worse still extensive behavioural research suggests we feel the pain of losses at around twice the rate we feel the satisfaction of any gain. That pain paradoxically is one of the factors that keeps us clinging to losing positions. Although we feel the pain with every tick against us we convince ourselves if we can only just get back to the opening level we will have triumphed and will feel a genuine rush of relief and even ecstatic reactions. It’s the hope we can avoid that pain that destroys our rational investment plans and actions.
Will we ever learn? I’m doubtful!