Investing: the fear factor

Julie Tyios was already a savvy investor by her mid-20s, when the Great Recession hit. “I had played the markets before, and watched my parents live off their stock portfolios,” she says. But the small-business owner wasn’t prepared for seeing half of her portfolio wiped out in 2008, an experience that was, to say the least, “very upsetting.” Since then, Tyios has avoided the stock market altogether. The fear of losing so much again overshadows the possible joy she may glean from a gain. “As much as I would love to invest, the recession did a lot of damage to the market.” And, more than that, it did a lot of damage to the psychology of today’s investors.

In these fragile economic times, Tyios is not alone in her fear. Colin Camerer, a behavioural economist and professor at the California Institute of Technology, says, “During the worst part of the crisis, everybody—from the average investor up to the chairman of the Federal Reserve—was simply afraid.” That fear continues to linger, even with the worst of the recession now a full two years behind us. “My hunch is that the effective memory window, for which fear will impact people’s behaviour, is about three years,” he adds.

The recognition that emotions such as fear can drive investment choices is a relatively new one. Classical economics long viewed people as hyper-rational. But in the 1960s, a new field called behavioural economics emerged to show that’s far from the case. As Dan Ariely, a leading behaviourist in the U.S. and author of The Upside of Irrationality, puts it, “we are more like Homer Simpson” when it comes to our finances. Working at the intersection of psychology, economics, and even neuroscience, behavioural economists study how emotions play into financial decisions and individuals’ perceptions of the economy. As such, they can offer suggestions for how we can save ourselves from those irrational (and, more often than not, bad) choices.

Dilip Soman, a behavioural economist at the Rotman School of Management, has studied people’s beliefs about the market since the recent downturn and notes that they have shifted from normal, economic-based considerations to purely psychological ones. “In the last financial crisis in Asia a decade ago, the average person—when asked about changes in investment behaviour—would report considerations based on their expectations of the market performance: about interest rates, changes in trade, etc.” Today, however, “If you ask people similar questions, most respond not about expectations, but beliefs in the system as a whole. ‘I don’t trust banks, I don’t trust the government to handle what’s going on.’ This is more about psychological than economic beliefs,” he says.

In a similar vein, Peter Darke, a professor of marketing at the Schulich School of Business, has been looking at the effects of fraud on investment behaviour, and he’s found that fraud by one firm induces an irrational suspicion among investors that causes them to lower their investments in other, unrelated firms. In other words, fear spreads fast and can spoil otherwise safe investments in people’s minds. This negative bias even applies to very well-known and otherwise trusted institutions, like Canadian banks. “While rationally you recognize you can trust the Royal Bank, motivationally you’re not willing to take a chance,” he says. “People become irrationally suspicious.”

This lack of trust, says the leading behavioural economist George Loewen­stein of Carnegie Mellon University, is “unfortunate because there are a lot of ordinary people who can be benefiting from the stock market but they no longer trust the market.”

Financial fears can also affect more than just stock choices. At York University, psychology professor Esther Greenglass has been conducting an international study that looks at the emotional and psychological effects of the economic downturn. So far, she’s found that people’s personalities (their fears and anxieties) impact things like their financial health, and even their ability to find a job. “We are finding that debt, employability and financial well-being are all related,” she says. “If a [person] believes they are not going to get a job in the future, their financial well-being is lower.” Feelings of financial doom are also correlated to higher rates of anxiety and depression.

These findings reinforce the view of behavioural economists that “the way people approach the economy is not rational. Emotional factors influence how we react to the economic situation and to our own finances,” Greenglass says.

Learning about the biases that may guide investing can, fortunately, help people become better decision-makers, say finance experts. For instance, one mistaken assumption investors tend to make during financial downturns, explains Terrance Odean, professor of finance at the University of California, Berkeley, is to believe that the recent past reflects what’s going to happen in the future. “People typically buy the asset now that they wish they bought last year,” he says. “As if we are kind of expecting last year to happen again, and we want to be in on it this time.” Or, like Tyios, we stay away from certain investments, believing they will continue to perform as poorly as they have of late.

This tells us that even the most savvy investors “are swayed by past performance and by emotions.” As a rule, Odean tries not to trade very often, and tends to buy and hold low-cost mutual funds. “And I don’t spend my time trying to time the market because I figure, on an emotional level, I’m probably like everybody else, and I tend to get it wrong.” Odean’s studies have shown that active investors who trade more tend to do worse than passive investors; the active investors check their portfolios more often, and react emotionally and instinctively to short-term ups and downs in the market.

Matthew McGrath, the CEO of Optimize.ca, a Web-based financial advisory service, says emotions “have probably one of the largest—if not the largest—impact on anyone’s performance.” He suggests investors focus on the things they can control, such as making sure you’re at the right risk level. “If you’re a moderate investor and your portfolio is moderate, and the market drops, you’re not going to hit the panic button and sell,” he explains. Others recommend taking quiet time to reflect on your investment strategy, and block out the emotive marketing materials investors are bombarded with.

Behavioural economists do see a bright side to the downturn for at least one group of investors: young people, like 26-year-old Tyios. Camerer at Caltech feels investment scares earlier in life may actually be a good thing. “It’s like having a cancer scare when you’re 30. If you don’t die, you’ll be much more cautious for the rest of your life.” Indeed, Tyios says the wounds from the losses she weathered in the recession haven’t healed yet. “I’m much more comfortable investing money into something that will either retain its value or gain over time.” Property, she feels, is a wise investment, and she’s not ruling out playing the markets again in the future. Until then, “The recession was a real wake-up call.”