Welcome to Part Two in our behavioral finance series! We hope you got something out of Part One in helping you understand how psychology plays a major role in your investment decisions as well as found it interesting! In this article we aim to highlight how the stock market itself moves in response to YOUR emotions and decisions, believe it or not you do play a crucial role.
When you’re looking at your next stock investment, how does it make you feel? (don’t worry I’m not trying to be your therapist here). Do you feel excited? A bit anxious? Uncertain? Confident? Fearful? Most importantly, why do you feel these things? If you’ve been keeping up with our posts in our investment series you would have a better understanding of what kind of investor you are and what you’re looking for. It’s good to start with knowing what your ultimate end goal is. (If you’re not sure what I’m talking about, be sure to have a read… and if you think you do then challenge yourself to learn more!).
All your emotions indirectly affect the direction of the stock market (commonly referred to as share market or just “the market” but not the one you buy your apples and oranges from). These may be emotions you don’t even realise you are feeling or have. For example, if you are more concerned with making a bad decision on your investment, this will increase anxiety levels and lead you to feelings of regret regarding your decision. Be careful with this as regret then becomes a powerful emotion and has been proved that increased levels of regret will cause traders to sell their stocks more quickly. With that being said, logical thinking is usually thrown right out the window which we don’t want and we want to try to avoid. So, what does this mean? The stock’s price eventually changes as does its option prices (we’ll talk about options later in the series). While these changes are taking place (decrease or increase) overconfidence, optimism and euphoria can take over an individual as they then begin to dismiss logical and rational thinking, and start following the current trend (otherwise known as herd behavior), even though they are still unaware of the risks involved.
In times of a boom, investors tend to change their investment strategy and take on more risk (risks they would not have taken before) as they begin to react to other people’s behaviors and actions. Don’t feel bad though, you’re not the only one, believe it or not banks do the exact same thing (have you ever noticed with rates increase/decrease banks usually will also increase/decrease if a fellow big bank has?). Financial institutions during these times (booms) sometimes become overly optimistic leading to willingness to offer credit to clients, sometimes overreaching logical lines of credit which then can have severe economic consequences.
If the market starts to crash, banks are then exposed to increased risk provisions leading to a decrease in profitability and capital, in turn affecting lending and credit evaluations. The world saw an example of this during the GFC when the US Federal Reserve lowered their interest rates to only 1.75%. In this time, nearly anyone was given a home loan and the banks decided to take full advantage of this by repackaging these mortgages into collateralized debt obligations and selling these off to willing buyers. This then led to a massive housing bubble which inevitably burst leading to homeowners losing substantial value in their properties and unable to cover their mortgage costs! (Yikes, not good!) If you’re not sure what any of that means, stay with us as we’ll be covering the GFC very soon, and trust us, it’ll have you captivated! In the meantime though if you’re impatient and can’t wait for us to get our sh*t together, watch the movie ‘The Big Short’ – it’ll give you the lowdown.
Essentially, what we’re attempting to get at here, is that when investing (whatever it is you’re investing in), you need to be 110% aware of your emotions. When the market itself is overreacting, take a step back and think logically and then decide if you want to participate. Next week we’ll be releasing Part Three which will delve deeper into the GFC and greed of the financial institutions in the lead up to the stock market crash.