Fight or Flight: Both deadly responses when dealing with investments

Cobus du Plessis of the Institute of Behavioral Finance and Business Development Manager at EFS Investment Solutions writes that 'Fight-or-flight' is the natural law of the jungle. But the same hormones that ensure the survival of the fittest in the jungle are proving to be deadly on stock exchanges around the world, with investors exhibiting a stock market version of the fight-or-flight mechanism; they are selling first and asking questions later.

Anybody searching for cause-and-effect logic in the daily gyrations of markets  will be disappointed. Instead, the market has become a case study in the psychology of herds. In normal times, it runs on a healthy mix of fear and greed. But fear now seems to rule.

For decades, classical economics used mathematical models to explain market theory. Now economists are returning to the view that human behaviour does influence the market because emotions directly impact on the perception of risk.

Fear makes people perceive more risk and take risk-adverse choices. Translating into sell, sell, sell. Fear can be seen at every turn: in headlines raising questions about another Great Depression, and in the crowds gathered around office televisions to track stocks.

The current fiasco didn't start with the flight impulse. It began with "irrational exuberance" in the real estate market in the late 1990s and the over-confidence of money lenders, says Hersh Shefrin, a pioneer in behavioural finance at Santa Clara University's Leavey School of Business, and author of Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing.

'Their reward centre, nucleus accumbens, was really lighting up,' he says. 'That part of the brain drives people to be over-confident. But when things start falling apart, the fear centre of the brain, anterior insula, lights up', he says. People who are over-confident are also most surprised when things change.

Fear is an immensely powerful force, perhaps more so than greed. The loss of R1000 has a much bigger impact than the gain of a R1000. During the 1970s a series of groundbreaking experiments were done by psychologists Daniel Kahneman and Amos Tversky. In one test, they asked students to choose between a sure bet of $3,000, or an 80 percent chance of winning $4,000 (meaning there was a 20 percent chance of winning nothing). Most students said they would take the $3,000.

The same question, framed differently, asked them if they would rather lose $3,000 or accept an 80 percent chance of losing $4,000 (with a 20 percent chance of losing nothing). In this case, they said they would take the riskier bet. In other words, students were willing to take a bigger risk to avoid losing money than they were when they stood to make more money.

But the fight or flight instincts that rule the jungle don't apply as neatly in the modern world where the stimuli are varied and multi-dimensional. Mr. Shefrin argues that this tendency makes it difficult to strike the right emotional balance: The response is either too hot or too cold.

'There wasn't action when there needed to be action to nip the (credit crisis) in the bud,' says Mr. Shefrin. 'Now there is over-reaction.'

The same overconfident investors that drove the markets to highs a few months ago, cannot see the end of the tunnel now, causing them to panic. It is this panic that manifest in the current irrational behaviour. 

What should we do in these turbulent times?

Make sure you distinguish the facts from the noise. The closer markets get to the bottom of the cycle when there are few sellers, the more negative the news and the language describing the markets, become.  Although the markets are more than 40% down since May this year, it does not mean that a good company is suddenly 40% weaker than a few months ago. Many companies are still solid with excellent management and sound balance sheets and remain excellent investments over a longer investment horizon.

Decrease your information consumption. When we panic we tend to read every piece of available financial information in the press and listen to all the news channels. We try to make something of the constant stream of information but the only result is that we increase our confusion as the result of an information overload. Choose two or three reliable sources of financial information and stick to reading them only. Make a habit of asking probing questions and not merely confirming what you believe is correct.

Focus your attention and energy on the aspects you can control. Focus on the bigger picture such as the longer term, your previously  defined targets for your investments and the time you have to reach them.

Stick to the investment strategy you and your financial advisor previously agreed on after careful consideration of your needs. You should have a specific strategy in place with long term, medium term and short term goals. Do not sell your investment in equities out of your portfolio if it were part of your well considered investment strategy.

Understand what risk means. Know the risk you need to take to reach your investment goals. Understand your own attitude and feelings towards risk. Make sure you understand that should your investment decrease in value because the investment markets are down is only one type of risk. Another equal serious risk is when your investment return  is less than inflation.

Use the services of a professional financial advisor who can assist you in constructing an investment portfolio suitable for your unique financial circumstances and behavioral profile.

Externalize you fear when thinking about your investments. Look around you and be able to recognize your own  fear versus stock market fears that influence your fear. See fear for what it really is and reframe it.

If at all possible do not liquidate your investments during these times. Understand that equity markets move in cycles and that it will recover. History has proved that equities deliver the best return over longer periods.

If you have cash in hand make sure to invest it in a disciplined way. Choose a specific time frame and stick to it such as investing a quarter of the money every three months until you have reached your recommended asset allocation profile.

Test your fear and the reasons for it against similar market downturns and experiences you had in the past. You will soon discover  patterns emerging of similar downturns or crashes and sure recoveries over 1, 3 and 5 years after the crashes. All resulting in substantial gains for those who are prepared to ride it out.

Focus on living a balanced and healthy lifestyle during these periods of anxiety and in normal times - relax enough; exercise regularly; eat healthy and enjoy every day.

Have regular discussion sessions with your financial advisor where you talk about the possible feelings you might experience when  markets go up or down. Plan together how you will act if and when you experience these emotions. You will be able to do this only if you have a trusted relationship with your financial advisor. Only then will your financial advisor know you well enough to be able to identify the behavioural biases you are prone to and work on recommended solutions taking these biases into consideration.