Use this technique to conquer fear and greed in investing
Use this technique to conquer fear and greed in investing
Learn to take control of these volatile human emotions.
Learning outcomes:
Human fear and greed drive stock price changes in the short run.
Most investors get this the wrong way around and fail.
You can measure fear and greed with some simple indices.
I invest in low-cost ETFs when fear dips into extreme fear.
Addendum: This can also be applied to crypto, but I stay away from it.
Human fear and greed drive stock price changes in the short run.
Warren Buffett said in his Berkshire Hathaway shareholder letter of 1986 that wise investors ought to be “fearful when others are greedy, and greedy when others are fearful.”
Investors, especially in aggregate, are driven by human emotions like fear and greed. When confidence is high, investors buy more and push prices higher. Conversely, when confidence is in the toilet, people run away from stocks and sell off, pushing prices down.
This is a natural consequence of the law of supply and demand. When demand exceeds supply (greed), prices tend to increase. When demand drops lower than supply (fear), prices tend to decrease.
But let’s look at this less as some complex phenomenon and more as a simple outgrowth of human nature. Investors are human beings, and human beings respond strongly to their emotions. Fear motivates us to avoid loss. Greed drives the fear of missing out on some form of gain; it is the desire to grab onto a share of something valuable while we still can. See the link with the stock market?
It is important to repeat the point that human fear and greed drive stock price changes in the short run. In the long run, the underlying fundamentals of businesses pull stock prices to their “intrinsic” levels. This is why asset bubbles can only exist for a limited amount of time before bursting.
This is a contrarian approach to investing. Instead of following the crowd, you wait for moments of extreme fear and greed in the market and take advantage of the short run price change.
Most investors get this the wrong way around and fail.
Most investors do the opposite. When they see glowing media coverage of the economy, they invest. When they see portents of doom and gloom in the media and the markets, they sell off. Unfortunately, this tends to mean buying high and selling low. The stock market, in other words, is the only type of shop where sales make the customers run away.
Many of us have a relative or a friend who bought Bitcoin at the peak of the 2020-2022 bull run after hearing some exciting news about the future potential of crypto. They grew sullen as the price then plummeted and sold it in a fit of depression. Maybe, dear reader, this unfortunate “friend” was you.
This is a textbook example of reacting the wrong way to fear and greed: buying an asset when greed pushes the price of it to an all time high, and then selling it when fear pushes the price of it to a low point. Sounds like a great way to lose money!
Our intention is to turn this dynamic on its head. Extreme fear can be, and often is, a buying opportunity. Extreme greed, on the other hand, can be a signal that a downward correction is due.
Put differently, it is often wiser to avoid investing if extreme greed is the emotion of the day, and to consider investing if extreme fear is the emotion of the day.
This brings us back full circle to Warren Buffett’s quote at the start of this article. His point in the 1986 shareholder letter, and a point he has repeated since, was that Berkshire Hathaway’s increasing cash balance must not be spent willy-nilly. The 1980s were a period of continued greed, and Buffett recognised that this limited the number of undervalued investment opportunities out there.
None of us have the track record of Buffett, nor do any of us have the same need to correctly allocate hundreds of billions of dollars in cash. But it makes little sense for us to ignore fear and greed, overpaying for our stocks and finding ourselves blown about by the dominant emotions of the day.
You can measure fear and greed with some simple indices.
The good news for us is that the market has produced some accepted measurements of fear and greed. CNN publishes a free Fear and Greed Index page where you can see whether we’re in a fear or greed moment now, and even track it historically.
Here’s an exercise for you: Use the “Timeline” on the CNN page to compare historical moments of extreme fear and greed with the price movements of the S&P 500. See any patterns?
CNN uses factors such as market momentum, volatility, volume, and put-call option ratios to produce the index. Each of these factors may disagree at any given time, but when they all point in one direction, that produces a strong signal of either fear or greed. For example, when volatility is high, momentum is low, and the put-call ratio is increasing, that’s a good sign of fear.
The CNN index isn’t the only way to determine the aggregate level of fear or greed in the economy. Confidence surveys provide a powerful insight into the aggregate level of fear or greed in the economy, too. I like to look at the PMI business confidence index and the University of Michigan consumer confidence survey in confluence together as decent proxies to the CNN index.
The other great thing about business and consumer confidence surveys is that they’re tracked in a number of different countries. Here is a full list of business confidence survey scores by country, and here is another for consumer confidence.
Across the pond we had a great deal of media-induced hysteria about the British economy in late 2022, and you can see it replicated in the business and consumer confidence survey scores around that time. Again, it is less about using any one of these tools in isolation, and more about getting a “feel” for things as a whole.
If you’re concerned that surveys aren’t objective, then remember that their subjectivity is the precise point of this article. Yes, objective criteria drive price changes in the long run, but subjective forces dominate in the short run. That is why all of these tools in aggregate give you an invaluable insight into the average investor’s mind.
I invest in low-cost ETFs when fear dips into extreme fear.
Enough theory. It’s time to put my money where my mouth is, and describe how I use this method myself.
I wrote some code to track a series of fear and greed indicators and send myself an alert if any of them signal extreme fear. I look at the CNN Fear & Greed Index as well as a custom UK fear and greed index of my own creation.
After that, I look at several low-cost ETFs in my portfolio: the Amundi Prime Global ETF, the Lyxor Morningstar UK ETF, and the Invesco S&P 500 ETF. These ETFs track different markets, and they each have ongoing costs at or below 0.05%, meaning that none of them will eat into their investors’ gains in a meaningful way in the long run. The Amundi ETF in particular gives investors exposure to Apple, Microsoft, and other big hitters at a rock-bottom cost.
I admit that I prefer the S&P 500 ETF because I believe in the power of the US economy over any other. America has a much stronger working culture and is far more business-friendly than the UK or indeed many other countries around the world. But in the autumn of 2022 I decided that UK index ETFs were undervalued, thanks to media reaction to government proposals, and made a little money when those undervalued ETFs rebounded.
When I see that any of my indicator alerts tells me of extreme fear conditions, I make a judgement call on whether to invest in these ETFs. Do I think the fear will get even worse? Do I have enough cash in my portfolio to make the investment? It is by no means an automatic thing. As investors we should always think twice before committing our hard-earned money to any investment.
In the long run, a time horizon of ten years or more, I expect index funds in developed countries to increase in value. I don’t think that’s a uniquely optimistic outlook. My primary goal is to escape the downward pull of inflation over my lifespan and benefit from compounding gains by reinvesting my income. If I can get any edge by investing at a slightly lower price, then I will try my best to take it.
My long term application of this technique, then, is to continue monitoring for extreme fear and then investing in this trio of ETFs when the time feels right. For some, timing the market might seem like heresy. But for me, following Buffett’s advice seems like a smart way to beat fear and greed.
Addendum: This can also be applied to crypto, but I stay away from it.
Those of you who like to trade crypto will be pleased to know that there is a Fear & Greed Index for Bitcoin, and that the emotion principle applies outside of the S&P 500, perhaps to an even greater degree.
I don’t see Bitcoin as a useful investment because, unlike stocks, there is no underlying business to generate a capital gain. It is more like gold, silver, oil, or other commodities. Yes, commodities have their uses, but a lump of gold cannot generate more gold. A solid business, on the other hand, can reinvest its earnings to generate a handsome return on equity.
If you compare the ups and downs of the dollar price of Bitcoin to the fear and greed chart on the page I just linked, you’ll see an interesting pattern. When the FTX scandal hit in late 2022, the index dropped deeply into extreme fear. Conversely, when the crypto space reached peak euphoria and NFTs were being sold for hundreds of thousands of dollars, that index reached into the stratospheric heights of extreme greed.
My point with this addendum is to show the strong link between short run speculation and emotion. Bitcoin is for speculators, not investors, and I don’t want any of my readers to see it any other way. I’m sticking to low-cost ETFs for now.