Understanding the cycle of investor emotions

What you’ll learn:

• What sort of emotions you’re likely to experience as your investments rise and fall.
• How the phases investors pass through along the cycle of emotions each can be mapped to specific responses.
• Why we can often end up where we started.

You might expect to feel excited when your investments perform well or disappointed when they fall in value but there’s a wave of other emotions that most of us experience in response to market conditions. We take a look at this cycle and how at each point we make specific trade-offs between our emotional comfort and long-term returns.

We may all be individuals but as investors our responses to the way markets perform are often very similar.

The diagram below shows a typical cycle of investor emotions, or our probable responses to the rise and fall of our investments.

Stage one: Reluctance

Reluctance is the human trait that dovetails the typical cycle of market emotions. For many would-be investors, this is the default emotional state, simply because individuals generally fear taking a risk and getting it wrong, more than they worry about missing out.

Of course, many reluctant investors eventually do manage to pluck up the courage to enter into the market. Generally, most become convinced to invest when they can see the tangible benefits of a sustained market boom, when stocks are posting consistent gains. It’s at this point that many of us will start to feel like we’re actually losing out. This of course can naturally lead us to chase past successes, as was the case during the technology boom and bust at the turn of the century.

Stage two: Optimism, excitement and (irrational) exuberance

Naturally, the better markets do, the more likely it is that our reluctance dissipates. Positive press coverage coupled with friends and colleagues informing us about how well their investments have done can mean we want a piece of the action too. Emotionally this can be an attractive comfort zone because in such a scenario we’re running with, as opposed to against, the herd.

A sustained period of positive market momentum can also help us to put our concerns over losses and perceptions of risk aside – ironically, just when markets may have the furthest to fall. While buying high is very likely to reduce your returns, if you can stick with your investment plan, eventually average returns should hopefully turn positive, although this isn’t guaranteed. Importantly though, if you buy at the top it also has the potential effect of making subsequent short-term experiences seem far more difficult.

You’ll never know whether markets have reached their peak. One way of reducing your chance of getting caught out by the market cycle is to invest smaller amounts more regularly. That way, you buy more shares when prices are low and fewer when prices are high, helping to smooth out volatility.

Find out more about the benefits of making regular investments

Stage three: Denial, fear, desperation and panic

First impressions tend to last and when it comes to investing – the point when we start investing tends to become a yardstick, which we’ll judge future gains and losses against. When markets are soaring, we often have lofty expectations of how our investment will perform. However, when markets turn volatile and reality bites we as investors generally begin to shield ourselves psychologically from the bad news and move into denial. Here, an unwillingness to sell can set in, as we attempt to rationalise any small falls based on our understanding that markets don’t rise forever. Our hope is that markets will recover, but it can mean we fail to look at the underlying investment landscape.

This means markets can remain artificially high for a period, which allows the bad news to accumulate. But under such circumstances transaction volumes can dry up. This pattern is especially evident for example when it comes to property sales, where there’s usually a strong emotional attachment. An individual’s home is likely to represent a large part of their overall wealth and if the property market dives after enjoying a sustained period of gains, people often find themselves unwilling to sell at a price that they believe is below its market worth.

But sooner or later some investors will become forced sellers, which in turn can open the floodgates and cause prices to fall heavily. At this stage investors’ emotions generally switch from denial and fear, to desperation and panic.

Find out more about investing in uncertain markets

Stage four: Capitulation, despondency, depression, apathy, indifference…and reluctance again

When a crisis hits, the typical investor response is to sell out because we’re scared of further losses, rather than because we genuinely need our wealth to be in cash. Of course, it’s perfectly reasonable to capitulate in a bid to remove the extreme anxiety of staying invested in a falling market. At this point you’re deciding that managing your emotions is more important than managing your investments. However not only do you have to accept your losses – you also have to bear the trading costs too.

Of course, there could be a good reason for selling, for example, if a fund manager you were backing is no longer in the driving seat, or the fundamentals of a company you bought stock in have changed for the worse.

Once you’ve cashed in, getting back to a state of optimism is far easier said than done. Many would say that the more natural reaction is to gradually claw our way back while going through periods of despondency, depression, apathy, indifference, and finally back to reluctance. This process can take years too and the danger is that investors miss out on the recovery. It can take a while to be confident that markets have turned a corner.

It has often been the case that when markets are most anxious, the potential upside is the greatest. As the world’s most famous investor Warren Buffett once advised “Be fearful when others are greedy and to be greedy only when others are fearful.” This is when regular investing can prove invaluable, helping you become a more disciplined investor. You invest regardless of whether the price is high or low. This takes some of the emotion out of investing and avoids any delays in putting your money to work.

Find out more about the impact of your emotions on your investments