Ask a roomful of people what makes an investor “savvy” and you might stir up a boisterous debate. Does a savvy investor:
- Do homework OR jump in at major news?
- Focus on potential returns OR strongly consider downside risk?
- Diversify OR concentrate on high-performing sectors?
- React quickly to changing market conditions OR stick with a strategy for the long term?
But what about FEAR – recognizing it, acknowledging it, even conquering it? Fear probably won’t come up — it’s just not a concept that comes to mind. But understanding the nature of fear is actually essential to becoming a good investor.
How fear can help and hurt us
Fear is an evolutionary adaptation rooted in our drive for survival. It’s both valuable and necessary — we wouldn’t be here without it! Yet when we feel fear, it can be extremely difficult to focus on anything but self-preservation.
In the New York Times, neuro-economist Gregory Berns explains what happens when we perceive danger. We’re biologically hard-wired to get away from it or combat it, even at tremendous cost.
While fear can protect us in life-and-death situations, what does it mean for investors? On a basic level, our human nature works against us. When we feel stressed about our investments, chemicals surging through our brains can dramatically affect
- our ability to realistically assess threats and
- our ability to respond rationally.
Put another way: that spider in the shower seems far bigger than it really is.
Fear, and the anticipation of pain and regret, is mentally and physically exhausting. So when we feel stressed, our brains conserve energy. We hunker down. (Horror movie victims hide instead of running away, right?) We may retreat and hoard our resources—behaviors that impede our progress. In addition, we may have trouble synthesizing new information, solving problems, and being creative. And these reactions don’t help us think about the big picture or our long-term life goals.
When we understand the biological imperative behind fear and how it short-circuits our decision-making process, the conclusion is inevitable.
Fear isn’t conducive to smart investing.
Let’s consider the age-old rule: BUY LOW, SELL HIGH. Easy, right? Yet when markets are volatile, fearful investors often do the exact opposite. Investors flee stocks in droves, selling when prices are low. In fact, according to Morningstar, outflows from equity funds reached $96 billion in 2008.
Conversely, when markets are soaring, investors may experience “FOMO”—the fear of missing out—and buy when prices and valuations are high.
The statistics are scary. Dalbar and other researchers consistently confirm that individual investors underperform the benchmarks.
Let’s use 2014 as an example. The broader market return was more than double the average equity mutual fund investor’s return (13.69% vs. 5.50%). That means the average investor underperformed the S&P 500 by an enormous 8.19% margin.
As the noted economist and investor Benjamin Graham stated,
The investor’s chief problem – and even his own worst enemy – is likely to be himself.
When it comes to savvy investing, FDR’s words ring true: “We have nothing to fear but fear itself.”