Fear and Greed in Financial Markets

How to navigate irrational exuberance and irrational fear

Warren Buffet famously said: “Be fearful when others are greedy and greedy when others are fearful” - but it is an exceptionally difficult thing to do. Investors cannot help but get caught up in euphoric sentiment in the market and tend to panic when things are not going their way.

What drives fear and what does it look like?

Look outside your window – market sentiment currently is overwhelmingly fearful. The moves are large – pointing to heightened skittishness and volatility. Market participants are actively looking for things to panic about… be it a banking crisis or whatever the Fed is doing.

Fear is usually driven by loss aversion. Investors don’t want to see their investments go down in value. So, they sell, sell, sell. Some savvy investors capitalise on this fear and “short” stocks, creating further downward pressure. As a result, you see these big, outsized moves on a day-to-day basis and very high volatility.

What drives greed and what does it look like?

Greed is a bit more of a grind, investors start becoming confident (and then get overconfident) and continue to buy as markets are going up. Those with FOMO (fear of missing out) suppress their fears of “buying high” and pile into the market as well. The market continues to move up, and valuations become expensive.

As mentioned above, greed is driven by overconfidence – a tragically human bias. Investors may benefit from good returns during a bull market and then begin to believe that it is their superior intellect and skill that has resulted in a strong portfolio performance. Greedy investors are also prone to confirmation bias, where they assign more weight to information confirming a pre-existing view, and assign less weight to “red flags” or information out of line with their investment thesis. FOMO typically relates to herd mentality bias – simply copying what other investors are doing rather than acting on their own independent analysis.

How do you measure fear and greed in financial markets?

The Cboe Volatility Index (VIX) represents the market’s current expectations for the relative strength of near-term price changes of the S&P 500 Index. Because it is derived from the prices of SPX index options with near-term expiration dates, it generates a 30-day forward projection of volatility. Volatility is often used as a gauge for market sentiment, and in particular the degree of fear among market participants. Higher volatility (and a higher reading on the Vix) means that fear has escalated. Conversely, low volatility (and a low reading on the Vix) means markets are calm and could indicate that greed is beginning to flow into the market.

The CNN Fear and Greed Index was developed by CNNMoney to measure whether market participants are behaving in a manner that is fearful or if market movements are being driven by greed. CNN examines seven different factors of fear and greed and scores investor sentiment on a scale from 0 to 100. A reading of 50 is deemed neutral, while anything higher signals more greed than usual.

• Stock Price Momentum: A measure of the Standard & Poor's 500 Index (S&P 500) versus its 125-day moving average (MA).
• Stock Price Strength: The number of stocks hitting 52-week highs versus those hitting 52-week lows on the New York Stock Exchange (NYSE).
• Stock Price Breadth: Analysing the trading volumes in rising stocks against declining stocks.
• Put and Call Options: The extent to which put options lag call options, signifying greed, or surpass them, indicating fear.
• Junk Bond Demand: Gauging appetite for higher risk strategies by measuring the spread between yields on investment-grade bonds and junk bonds.
• Market Volatility: CNN measures the VIX concentrating on a 50-day MA.
• Safe Haven Demand: The difference in returns for stocks versus treasuries.

Both these measures are measuring fear and greed in the US stock market – but stock market sentiment usually translates globally, so there will be a very high coincidence of greed and fear between global exchanges.

How do we manage fear and greed?

1)????To avoid fear catching you out… Don’t panic! Money can be an emotive subject and we can’t help but become emotional when we see our portfolios doing REALLY well or REALLY badly. There is a well-known saying in the market: “If you are going to panic, panic first” - but most investors go their entire lives without being the one to panic first.

2)????Remind yourself that a) markets are volatile (so there will be losses from time to time) and b) financial markets have seen all manner of wars and plagues and crises but have always recovered (and then some).

3)????Always have some cash available for when fear hits. But make sure the trade makes sense fundamentally and you are not just gambling!

4)????To avoid greed getting the better of you have “profit targets” in mind when investing – particularly in opportunistic trades. You can always just take some money off the table (perhaps your capital?) if you think the trade still has legs.

5)????Don’t get married to stocks – if the greed trumps common sense, take profit.