04 Apr 2018

Fluctuating Stock Markets: Controlling Our Emotions When Investing

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We all know that the key to successful investing is to buy at the bottom and sell at the top. Unfortunately we often get it the wrong way around and end up on the wrong side of the curve with someone else making the money and us losing ours! The point of the above graph “the Market emotions cycle” is to demonstrate that the human side of investing can take over from the practical side.

Efficient markets are based on the assumption that rational people enter trans¬actions with the intent to maximise gains and minimise losses. While this theory is sound, most investors are not the purely rational robots that efficient markets rely upon. Instead, emotions often cloud our decision-making and prevent us from acting in a rational manner.

Knowing we can never conquer our inherent emotional biases, we should seek to understand the range of emotions we may experience as investors and how it affects our interactions with the market. By understanding the stages of this cycle, we can tame the emotional roller coaster.

The 14 stages are:

  1. Optimism — it all starts with an idea, a tip off or a positive outlook that leads us to take the risk and buy a particular company’s shares or invest in a particular market.
  2. Excitement — as things start going our way and we get excited and feel vindicated for taking the risk. We start to anticipate and hope that a possible success story is in the making.
  3. Thrill — the market continues to be favourable and we just cannot help but start to feel a little “smart”. At this point we have complete confidence in our trading system.
  4. Euphoria — this marks the point of maximum financial risk but also maximum financial gain. Our investments turn into quick and easy profits, so we begin to ignore the basic concept of risk. We feel confident that there is only one way for this to go or at least the gains we have made won’t be lost.
  5. Anxiety — oh no, it’s turning around! The markets start to show their first signs of taking your “hard-earned” gains back. But having never seen this happen, we still remain ultra-greedy and think the long-term trend is higher.
  6. Denial — the markets do not turn as quickly as we had hoped. There must be something wrong we think to ourselves. Our “long-term” view now shortens to a near-term hope of an improvement.
  7. Fear — reality sets in that we are not as smart as we once thought. Instead of being confident in our trading we become confused. At this point we should get out with a small profit and move on but we decide to hang on for better gains instead.
  8. Desperation — all gains have been lost at this point. We had our chance to profit and missed it. Not knowing how to act, we attempt to do anything that will bring our positions back into the black.
  9. Panic — the most emotional period by far. We are clueless and helpless. At this stage we feel like we are at the mercy of the market and have absolutely no control.
  10. Capitulation — we have reached our breaking point and sell our positions at any price. So long as we can get out of the market to avoid bigger losses we are content.
  11. Despondency — after exiting the markets we do not want to buy stocks ever again. The markets are not for us and should be avoided like the plague! However, this rare point marks the point of maximum financial opportunity.
  12. Depression — we drink, cry and/or pray. How could we have been so presumptuous we think to ourselves. Some investors start to correctly look back and analyse what went wrong. Reality investing is born here, learning from past mistakes.
  13. Hope — we can still do this! Eventually we come to the realisation the market actually does have cycles (shocking). We begin to start analysing new opportunities.
  14. Relief — the markets are turning positive again and we see our prior investment come back around. We regain our faith (although small) in our ability to invest our money. The cycle start all over again… we’ll get it right this time!