What drives investment decision making? It’s actually not complicated.
Most of the time, markets are governed either by fear or greed. Below is a
chart I show to clients: capital allocation decisions are directed toward
preservation strategies, growth strategies, or neither (which manifests as
hesitation or opportunity). Our feelings, indicated by the arrows, swing
back and forth between fear and greed. As the needle swings from fear to
greed and vice versa, people don’t know whether to switch from a strategy
of preservation to a strategy of growth. They settle for hesitation. Not certain
whether fear or greed is governing their markets, they wait too long
and thus miss the opportunity.
In the five years since the collapse of the Internet and telecom bubbles
in 2000 and the post-9/11 rise of terrorism as a global factor, fear has
been the prime mover in the major global equity markets. Many investors
would rather keep their money in cash than put it to work in stocks, so
that while markets have come back from their post-2001 lows, they are only just
beginning to move past their pre-2000 highs, despite record earnings from many
companies and good performances from many more.
Many investors know that the fear factors that drove them into preservation
strategies no longer exist, but they continue to hear enough bad news that
they hesitate to commit more than a minimal amount of their capital to
Someone once said that being successful in markets is not really about
what you know; it’s about guessing right often enough about what other
people think they know. You might be pretty certain that the terrorist
threat to the United States and the rest of the developed world is ebbing
rather than increasing, despite news that pops up from time to time
about terrorist cells here or there. You might choose, on that basis, to get
out of companies that make security equipment and into a sector with
strong growth prospects, such as technology. But what you believe is not
what everyone else believes. Most people, including many experts, would
tell you that the terror threat—not the reality, mind you, but the notional
threat—might be increasing, so that while you are bailing out of security
equipment, the sector records a 99 percent boost over the past five years
against only a partial recovery for the S&P 500. You might be “right,” but
you are fighting sentiment.
Fear and greed are both sentiments and as such are based upon the
collective beliefs of all investors. There are a number of good books about
behavioral finance that you can read, and, in periods when the markets
cannot find direction, an understanding of the ways sentiment influences
investors and the factors that influence the development of sentiment is
useful. Among the factors that most influence fear is the prospect of
change. At the moment, we live in a very fluid world. There are the normal
demographic changes of aging taking place: the front edge of the
dominant baby boom cohort born between 1945 and 1965 is beginning to
reach its retirement years. That generation is losing its role as the dominant
force in American decision making, and it is afraid that the future is
going to lack the growth of privilege to which the boomers have grown accustomed.
Within the boomers there is one subgroup that is even more
afraid of change: the religious right. Without making any value judgments
about whether their fears are reasonable or not, it is safe to say that
this group perceives a constant assault on its values and believes that only
a retreat to more traditional roles will save the country from chaos.
Then there is the population at large, which does fear a lot of the notional
threats—menaces like terrorism, the possibility that Iran or North
Korea will eventually develop nuclear weapons, avian flu, AIDS, a destructive
computer virus, or perhaps the loss of their jobs should their
company decide to outsource. Or it could be any one of a thousand other
things, ranging from the health and welfare of one’s own family all the
way up to the most cosmic. It’s not that the world is filled with millions of
Chicken Littles. It is that for almost everyone, some part of the sky really
Fear is a natural phenomenon. It helps you sharpen your survival instincts.
When humans were still creatures of the wilderness, it took sharp
wits, sensory acuity, and speed to stay ahead of natural predators. In this
endeavor, humanity probably was not as good as its cousins, the great
apes, which is why we were forced to move out onto the plains of the savannah.
There, our vision sharpened, and we learned to see our enemies
from miles away. We learned how to protect ourselves. Whenever we
failed, natural selection kicked in, and over time, fear became a survival
tool. We use it still. Almost always our first reaction to that which we don’t
understand, fear forces us to pull back until we can regain enough
courage to move forward. But if we have to confront too many fears at the
same time, we become paralyzed, either by the fears themselves or by the
decisions we might have to make. Paralysis by analysis.
How do you overcome your fears? I’m not a psychologist, so I can’t really
answer that question easily. But in investment decision making, you
should take what I describe as the civilized approach. Modern civilizations
rest on two foundations: engineering and insurance. Engineering
is about applying science to real-world problems, but more to the point,
it is about taking large, complicated problems and breaking them down
into smaller, more easily digestible problems, solving those, and then
constructing a large solution that includes many smaller solutions. Insurance
is simply the ability to lay off risk, by aggregating small probabilities—
the odds that you will be hit by a car are very small, but the odds
that someone at some point will be hit by a car and require medical atten-
tion are large. If we aggregate lots of small risks, the cost of paying off
any one of them is also small.
So first, take your large problem, and break it down. Let’s say, for example,
that you have $100,000 to invest. The conventional wisdom says
that you should allocate some of it to stocks, some to bonds, some to cash,
and perhaps even a bit to an alternative investment, such as real estate.
Asset allocation is a reasonable approach—an engineering approach, you
might say—because it breaks down the large problem into a set of
smaller ones. But have you really laid off any risk? Yes, because when
stocks go up, bonds generally go down, and vice versa. Sometimes both
are up or down and real estate is busy doing its own thing. Real estate correlates
somewhat to interest rates at large but more closely to location and
local economies, so while the general economy might be down, local real
estate values might be rising. And, of course, in times of fear, it is always
good to have some cash. But what have you really done in your asset allocation
Well, first, you have to choose which stocks to buy. Are there good defensive
stocks? Often in falling markets, “necessity” sectors such as pharmaceuticals
and food do well, because people worry more about their
individual health and well-being when they are in a fear mode, and they
always have to eat. In rising markets, financial stocks often lead the parade.
But still the question arises, which ones? There is lots of analyst advice
available, but then you are taking a risk. Or you could head for the
hills, go completely into cash, and wait for good times to return. You
won’t make much money, but you won’t lose anything either. You could
buy insurance, as we have discussed earlier, but depending upon your
fear level, that might not be enough. Anytime we are faced with the decision
of which stocks to buy in uncertain times, fear can make all of us uncertain
of our decisions.
You could always be a buy-and-hold investor, but that isn’t likely to
work either, as you could lose a lot of money in the process. Markets can
and do go to sleep for years, as they wait for geopolitical events to sort
themselves out. One of the reasons I have become interested in thematic
investing is that it allows an investor to concentrate on a subject whose
outcome might be reasonably predictable. Yes, it is possible that diets in
emerging markets might deteriorate in the face of some event, but once
people are well fed, they don’t like going back to eating poorly. They will
make different kinds of trade-offs than they might have before in order to
keep food on the table. Or, if there is a major demographic shift in a country,
it will be years before another shift occurs, so you can predict fairly accurately
how many people are going to do specific things in their lives,
and then invest accordingly.
Look at Argentina. In 1900, it was one of the ten richest nations on
earth, endowed with fertile soil, oil, grain, beef, and rich mineral resources.
But decades of fiscal mismanagement and class warfare had
reduced Argentina to pauperism by 2000, and in 2002 the nation defaulted
on $75 billion in international bonds. Poverty doubled from 27
percent to 54 percent, and millions of Argentines had their life savings
wiped out. Despite all this, the nation maintained its traditional diet of expensive
beef, which could have been exported to help pay down the debt,
and the government offered twenty-five cents on the dollar to bondholders.
By 2004, the bondholders had largely accepted the government’s
deal, and the Argentine economy had begun to grow. During all that time,
the diet never changed. If it had, Argentines would have brought down
Now let’s look at greed. There are two ways to see greed. One is that it
is the opposite of fear, the desire for more: Alan Greenspan’s “irrational
exuberance,” the feeling that nothing you can do is wrong and that every
decision you are going to make is going to be right. That has happened,
to be sure. Just look at the Internet and telecom bubbles of the 1990s and
the real estate bubble that is now deflating, or the emerging market carry
trade investment bubble of the past few years. All of those bubbles enriched
those who discerned the trend early and cost the laggards a fortune
when the bubble burst. Another way to look at greed is as a subset of fear.
Greed is the desire to have more than your fair share, however you define
fair share. Greed is pathological, while fear can often be constructive and
prevent you from getting into trouble. Greed is really the fear that someone
else will get more than you, deprive you of your ability to get more
than they have. I don’t know how to overcome greed, but I do know that
when you sense it coming on—when you begin dreaming about how
much your investments might make if they can only go up a couple of additional
percentage points—well, that’s the time to exit an investment, because
your decision-making skills have collapsed. If you have to choose
between getting in late or getting out early, always get out early, because
while you lose a bit on the upside by getting into an investment late, you
never lose by getting out early.
From The Either/Or Investor: How To Succeed in Global Investing, One Decision at a Time by Clark Winter, published by Random House, August 26, 2008.