How one emotion can change how you see the world.
Fear can change how you perceive risk, skewing your mental cost/benefit analyses and influencing asset allocation. As investors we cannot eliminate risk entirely, so we must instead learn to conquer—or at least manage—our fears.
Fear has been repeatedly shown to increase perceived risk and risk aversion. Experimenters in various settings have observed that inducing fear in one group results in those people overestimating the likelihood of negative future outcomes when compared with a control group. What’s more, the fear we feel does not need to be related to the outcome we are thinking about. Reading newspaper clippings of tragic events led to people overestimating the likelihood of negative events happening in completely different domains of life (compared with reading about neutral events). In another study, simply showing people pictures of fearful facial expressions increased the expectation of negative events when compared with neutral facial expressions.
These psychology experiments highlight the way our minds operate in the presence of fear. When we are afraid, we tend to believe that negative events are more likely to happen than we did before, and we can become more sensitive to losses in the moment.
“Individuals who feel anxious tend to focus on the potential negative outcomes of future events and believe that those outcomes are more likely to occur.” —Alison Wood Brooks, 2014
All of this matters to investors because fear can alter the way we weigh trade-offs by changing our estimation of the relative costs and benefits. If you believe a stock market crash is very likely in the next six months, you might feel justified in deviating from your planned investment strategy to avoid what you see as very probable losses. The problem is that your expectation of events may be skewed by fears that have nothing to do with market fundamentals.
One cross-country study of investors found that people in different countries had very different beliefs about the riskiness of investment, and their asset allocations reflected these beliefs. In the United States, for example, people expected high returns for what they saw as relatively low risk when investing. Conversely, investors in the Netherlands perceived the same investments to be very high risk and expected relatively low returns. As you would expect, the US investors had far more aggressive asset-allocation strategies than those in the Netherlands. Researchers concluded that culture may have a larger effect on asset allocation than objective risk analysis.
Other studies demonstrate that when people’s feelings about risk change, their investment behavior changes accordingly, but when objective numerical risk evaluations change, behavior is not as strongly affected. This effect seems to be more pronounced when we believe that market prices are affected by other people rather than by objective factors. In a simulated stock market, people who were induced to feel fear sold sooner if they believed that the market price was peer-generated, but not if they believed the stock price was computer-generated. This may help explain why people who believe the market is very efficient are less inclined to move their money in the face of volatility than those who believe market prices are set by the fleeting whims of the herd.
It’s normal to experience fear when faced with uncertainty or an uncontrollable threat. In such situations we may be motivated to take action or seek out more information to reduce uncertainty or eliminate the threat, thus resolving the feeling of fear. Here we face another obstacle because risk communications themselves can induce fear.
Our perceptions of risk can be affected by aspects of risk information itself, and by contextual clues such as color, graphics, and sound effects. Marketers, politicians, and pundits use this to their advantage when crafting messages (often enlisting behavioral scientists to assist) so as to increase the likelihood of action on the part of the consumer.
Easy-to imagine scenarios and stories can be effective fear-inducing strategies. Graphs and pictures are more emotionally persuasive than numbers, and moderate fear appeals combined with the suggestion of a desired action can result in stronger intentions to act than factual information alone.
Information is valuable, and we must do our due diligence as investors and research the products and services we buy. However, we also need to be wary of how the presentation of investment information makes us feel, and avoid doomscrolling and sensationalism whenever possible.
If you are an investor, you cannot entirely eliminate risk. Yes, you can (and should) diversify your investments, research your holdings, and select a strategy that suits your overall tolerance for risk. Even so, if you have any “skin in the game,” you will likely feel anxious from time to time. Learning to manage fear when it surfaces can help you keep your head when others panic. Here are a couple of tips for coping with fear. Future pieces will dive deeper with more-practical strategies.
Fear has the power to change our perceptions of risk, skewing what we think is probable toward the negative. Because fear and uncertainty are uncomfortable, we can be drawn into actions to try to reduce uncertainty. This might take the form of research and information-seeking. Research is great, but we need to be watchful of how the information we ingest is presented because the format, language, and tone can itself magnify our fears. Since risk in unavoidable in investing, we’d be wise to learn and practice emotional coping skills to combat the potential negative effects of fear on our investment behavior. More tips and tactics to come. Stay tuned.