Emotions can be a great asset in everyday life, but when it comes to investing, they may be a liability. Equity investing can feel a lot like riding an out-of-control roller coaster. There’s the thrill and excitement when the market goes up, but also the fear and panic when it falls. As emotions increase in intensity, many investors forget that the equity market tends to move in cycles. Emotions are so powerful that they drive markets more than their fundamentals.
Here’s how emotions create cycles in equity markets..
Risk-averse investors invest cautiously into risky assets. They prefer low risk assets like fixed deposits and gold. In equities they prefer investing in quality companies at lower valuations thereby enjoying a good margin of safety.
Leading to better returns..
High Quality investments with good margin of safety leads to lower accidents and overall better return experience in equities and overall portfolio.
Better return experience from quality investments cause investors to become complacent and risk-tolerant. They no longer worry about valuations and get swayed and this is when greed starts cultivating.
Greed leads to inferior investing decisions
Increase in risk-tolerance and a sense of greed opens investors to inferior investing decisions i.e. investing in expensive and poor quality businesses. They no longer look at the quality of management and barely care about valuations.
Finally leading to inferior returns
Investments in expensive and poor quality businesses eventually is tested by tough economic conditions and gives rise to inferior returns and at times leads to permanent loss of capital.
Back to risk-aversion
Inferior returns and falling stock price have a chilling effect, making investors risk-averse once more. This takes him back to low risk investments again..
This emotional cycle has been repeated endlessly for decades in equity markets and will be repeated in future endlessly. Only one who can control his emotions will be able to turn the cycle in his favour and make fortune in equity investing.