On Investment Risk & Investor Psychology
By: Nicholas Krapels
Tags: Stock Market, Psychology, Investors, Risk, Investing

On Investment Risk & Investor Psychology

In bear markets or bull markets, investors tend to do the exact opposite of what they should do. Unfortunately, humans have been conditioned since neolithic times to run away as fast as we can from risk, screaming at the type of our lungs, “Do not go there! There is a BEAR over there!”

One minute later, all of our friends are adding fuel to the fire saying, “I don’t mean to cause alarm, but that BEAR over there is coming closer AND he’s baring his big ugly teeth! Everybody RUN!”

A few minutes after that, another friend comes running up to you saying, “You heard about that BIG UGLY BEAR, right? Well, I just heard he was over at the Johnsons rummaging through their kitchen looking for Snickers! Luckily, they weren’t there, but they saw it on their security cams that broadcast to their phones. WE GOTTA GO, BRO!”

One by one, bad news spreads through a community like wildfire. Thus, when markets get hairy, retail investors tend to always overshoot the mark and overcompensate for their losses. In other words, in risky markets, we are more likely to do what we know we should not. We sell low what we bought high. It makes us feel better.

After all, there is a Big Bad Bear RIGHT OVER THERE. 👆🏼

This phenomenon is the classic “moment of despair” that happens when markets panic. Lower prices beget lower prices at a greater speed than higher prices beget higher prices. It’s simple risk aversion psychology. Nobel Prize winning psychologist and economist Daniel Kahneman summed it up way back in 1979, “the aggravation that one experiences in losing a sum of money appears to be greater than the pleasure associated with gaining the same amount.”

He even tried to put a number on the emotional affective loss on losing or gaining the same amount. That number? We are 3.1 times more flustered by losses than gains of an equivalent amount. The phenomenon is called loss aversion.

Investors must internalize the implications of Daniel Kahneman’s loss aversion theory.

In order to be better investors, we have to intimately understand our own personal relationship to risk as well as our own primordial urges as a species. The fight-or-flight response conditions the way everyone responds to stress. There’s no way around it. So we just have to understand it. When we perceive stress, our body’s sympathetic nervous system initiates a series of automated physiological responses: dilated pupils, elevated heart rate, pale skin, and body trembling.

The release of a whole flood of hormones mostly causes these physical reactions. The main hormone that is secreted into the bloodstream is adrenaline, which basically makes a person act like they have drunk a whole case of Red Bull. The more stress you perceive, the more adrenaline your body makes. Why?

The adrenaline helps you fill your lungs with air and pumps blood to all the extremities of your body so you can run away from THIS BEAR. 👇

So it makes sense that in a bear market, most investors are running away as fast as they can. Bitcoin’s recent “Black Thursday” on March 12 is an example of the tendency for selling to beget selling. It becomes a blind rush out the door and all the exits are overcrowded, making it impossible for the market to find a bottom.

But what happens in a BULL market? In that situation, which cryptocurrencies experienced all throughout the latter half of 2017, retail investors don’t even think about risk. It kinda looks like this:

Do you see that little tiny four-letter word below the bull? That’s risk. And in a bull market of screaming gains where even the newest noob is pocketing 400% returns or when rando dudes on reddit are pocketing huge gains on options on companies with absolutely no business model, that’s what risk is. A four letter word that you dare not mention.

That’s the unfortunate part. In financial markets, risk is actually the highest when prices are relatively high and no one is talking about risk. Everyone around us is doing it.

It’s as if they are all saying, “Come on in! The water is fine!”

Then, one way or another, the shit hits the fan.

We as investors have to condition ourselves to do the exact opposite of what our hormones want us to do. We know what we have to do. The greatest investors of all time have told us over and over again exactly what to do. Lord Rothschild. John D. Rockefeller. Warren Buffett. They all say pretty much the same thing. Do the opposite of your fight-or-flight reaction.

Buy when there’s blood on the streets.

Yet, time after time, in bull markets, retail investors never take their gains, almost always top up their investments at the height of the bull market… And in bear markets, they hold on to their losses for far too long, and eventually sell at the worst possible time at the very nadir of the market. It is the very reason that we have such a disproportionate Gini coefficient in the United States. Any time the working class gets even a sniff of life-changing wealth, like clockwork, the markets smack them back down into the workaday life.

How can we avoid the fight-or-flight trap?

Investors must familiarize themselves with their own most intimate, visceral emotions. Study and reflection may help you to dive deep into that abyss. When you do, you turn the bear from that toothy, violent fella above into a cute cuddly teddy that you can deal with.

The essence of contrarian investing is to assume the worst outcome and be prepared if that happens. I’m not exactly awesome at that myself, but I can proudly state that, taking these suggestions to heart, I was far more prepared for the 2020 market crash than I was for the 2008 market crash.

In these times of storm and stress, it’s the little things like that that keep me going.