- "People don't consciously choose to invest with emotion - they simply can't help it," so goes a famous quote by Seth Klarman.
- It is human nature to chase fear and greed in the markets.
- Yet, following those basic instincts is a recipe for long-term losses.
Stock market prices are a consequence of people's actions. And even though it may be hard to admit, we have all seen or been through the complete cycle of market phases.
Green Phase: After a long bull market, everyone is euphoric and all-in on the most trendy stocks—which usually happen to be the riskiest ones.
Yellow Phase: First 5-7% drop comes, and everyone is surprised. Yet, it seems like another buy-the-dip opportunity. The laggards, who until the last fall had not joined the party, go all in.
Orange Phase: The market moves sideways, then rebounds slightly. Everyone thinks: "come on now, I'll get rich too."
The rebound comes but closes below the previous high, and another more severe drop comes—8-9%. A slight rebound follows, and then another 13-14% drop.
The doubt phase begins. What to do? Comparisons start to pop up. Some are bullish (the market will bounce), and some are bearish (the new 2008, the new dot-com bubble, etc.).
Brown phase: The market doesn't give a damn what you think; it just keeps sinking. We are down to -20%, a bear market. Journalists arrive. The usual headlines read: "$500 billion burned in the stock market today," "inflation knocks out markets," and "panic among investors."
Fear begins at 8 a.m. when you buy the newspaper and never leaves your sight. Food gets hard to swallow, and you check Investing.com every 5 minutes, even when the markets are closed.
You start looking at other people's posts and find out that they started selling their holdings yesterday.
As soon as the market opens, you start selling too, or maybe not? No, perhaps wait a little longer; what if it really rebounds now, and you screw them all over? Maybe tomorrow...
Red phase: Tomorrow turns out to be even worse! The markets are down 25-30%. "I should have sold yesterday! I will sell half, then see," you think. From a day trader, you become a "long-term investor" and find that everyone has become one, too, to your surprise. Market gurus have disappeared, and four out of five articles you read are about the bear market.
On the other hand, that one article about buying at this moment sounds utterly crazy to you. Why wouldn't it? You've just lost 30 percent of your capital.
Black phase: Markets don't rebound. It's been months, and the remaining 50% of your capital is almost gone. You are resigned but deep down feeling like an idiot because you didn't sell at the highs. You move on to sell what little you have left. In the meantime, the day traders converted into long-term investors in the red phase are back to day trading—only to lose the money they still had left.
The markets are down 45-50%. Warren Buffett and Charlie Munger are still buying, but they must be out of it because they're old.
Green phase: You've taken up gardening. But one day, while pulling the weeds, you meet a new neighbor who invests in stocks. He tells you how much his money is growing. In fact, the market has recovered from the decline that erased your savings in 6-9 months. Too bad you weren't in it.
You open the newspaper and read that inflation is falling, corporate profits are flying, and markets are exploding. Your breakfast becomes hard to swallow again, but only this time because you missed the party.
You hear your friend from Facebook talk about a great stock pick that will be the next golden goose. What's left in your account deserves revenge, "I'm putting it all in, so I'll make up for what I lost earlier, too."
Yellow phase...