How Fear and Greed Could Make You a Better Investor

Getty Images

Greed is good. At least that's what Michael Douglas's character Gordon Gekko says in the movie, "Wall Street."

You know what else is good? Fear.

Fear keeps investors cautious as they work to avoid downside risks, and sidestep decreases in the value of their assets. It ensures that investors do not get too aggressive or lazy with their investments.

But there's something about greed. No matter how much fear is dumped onto shareholders when their investments decline in value, most people still look for the angles.

They seek out undervalued shares which may have fallen too far.

The dance between fear and greed, or rather the balance, is continually in flux. At times when most people are not feeling confident about the markets, or are expecting some downside, the fear level increases and keeps people from chasing returns with complete abandon.

This is similar to the natural balance between life and death, or push and pull, or on and off — there are a Yin and Yang with every situation. Life could not exist without death, and likewise, greed could not exist without fear, nor can the fear exist without greed.

However, for astute investors, understanding the fear and greed balance can open up a lot of profitable opportunities. When fear gets too great, and greed is too low, there are a tremendous amount of undervalued opportunities which are slated to increase in price in the short term.

At the same time, when greed gets too extreme, just like we saw with the Dot Com bubble, there are tremendous risks.

In such situations, most investments are wildly overvalued, and due for a quick and extreme decline.

The First Step to Mastering the Greed and Fear Balance: Honesty

This part is about honesty. Specifically, being honest with yourself.

If you are in tune with your own greed and fear balance, and you understand when your trading decisions are being driven mainly by greed, you may decide it is most prudent to lighten your investment load.

The more you feel like you want to chase stock prices higher (to avoid missing out), the more seriously you need to consider taking a step back!

There is an expression in the stock market, "the Bulls get some, the Bears get some, and the pigs get slaughtered." This is a haunting moral about the hazards of letting your greed run wild.

At the same time, there's another expression on the stock market — "when there is blood in the streets, there is money to be made." This is absolutely true and typically manifests itself when everyone believes the sky is falling, or have capitulated and thrown their shares away.

When most individuals have given up on their investments, and they just want to get out before they lose everything, there are great opportunities. There is no better time to put new money to work then when everyone else is trying to go in the other direction.

The Next Step to Mastering the Greed and Fear Balance: Guts

This step is about guts. Specifically, having the audacity to do the opposite of what 95 percent of other people seem to be doing.

Human nature suggests that if 100 people run past you one direction, you are absolutely most likely to then suddenly take off in that direction with the crowd.

You will even do this before you know why everyone is running — fear and survival take over.

Don't get me wrong, if a mass of people runs past you in one direction, you probably should consider following the crowd. You won't necessarily have time to find out why they are panicked, but you are also probably being wise by joining the fear. 

However, when it comes to investing, the most profitable approach would be to the do the opposite of the mob. This is slightly different than contrarian investing, which is quite a popular approach to profit by doing the opposite of the conventional wisdom of the masses.

Rather than just doing the opposite of what most people are doing just for the sake of going against the grain, or moving towards trades which are "less crowded" so to speak, an understanding of the greed and fear balance suggests that you invest (and profit) more from the trades which most investors want nothing to do with.

Rather than the crowd selling "A" so you buy "B," it is more akin to the crowd selling "A," and you say "okay, I will take all the "A" that you're trying to dump."

The Third Step to Mastering the Greed and Fear Balance: Seeing Clearly

The third step is one of the most important ones and is all about seeing greed and fear with as much clarity as possible. As humans, we are compelled to "not miss out" when it seems that other people are being enriched.

This results in the successes of our coworkers and neighbors having outsized significance. If they make $1000, rather than being happy for the individual, the subconscious effect on the human mindset is more likely to feel bad that we were unable to achieve the same result.

Typically what happens from the situation is that our greed level cranks up, while we increase the degree to which we can turn down or ignore the fear aspect of investing. Unfortunately, this puts us in a precarious situation, mainly because most of the significant gains come right at the end of an upward run in the stock, or the overall market.

In fact, when you're greed level is at the greatest, and the fear aspect is almost nonexistent, that is precisely the instant when investors should run away from the markets. The potential downside at that point is greater and closer than at any point leading up until that very moment.

The result is almost always a sudden, unexpected, and significant collapse in the asset values. The more greed which fuels a rally, usually the more surprising and damaging the downtrend.

The Fourth Step to Mastering the Greed and Fear Balance: Positioning

This part is a simple way to become a master when it comes to positioning yourself among the push and pull of fear and greed. Specifically, recognize that investor sentiment is a very contrarian indicator.

For example, when 99 percent of people believe that the stock market is going higher, that represents seriously positive sentiment. Considering that most people position themselves to take advantage of their beliefs, there is usually no more money to go into the buy side of investments — most are now fully invested.

The 95 percent of people have made their purchases by now. When there isn't any more new money to push shares much higher, which typically happens near the later days of a bull run, the next move for shares is almost always a crash.

Think of the Dot Com bubble in 1999. That is a perfect example of excessively positive investor sentiment. Your grandma might've phoned you what to tell you about the latest hot stock, and anyone not buying shares of Internet companies would have felt they were missing out, especially considering all the gains that their neighbors and cousins and coworkers were bragging about.

Stock markets usually only increase meaningfully when there is highly negative sentiment. The more people who think the stock market will increase, the more likely it is to fall. 

At the same time, when the masses expect only the worst from shares, that represents very negative investor sentiment and sets the stage for what will likely be a great deal of money to potentially flow back in. Once the fear has matured and greed starts returning, the markets usually do incredibly well.

The Final Step to Mastering the Greed and Fear Balance:

This step is about observing the current environment. From that, you can gauge whether markets are being driven right now by a wave of fear, or a wave of greed.

If your nephew or great-grandmother is talking about the stock market, this may be an indicator that valuations are getting a little overheated. If you get into a taxi, and the driver goes into detail about the latest hot stock, that is typically an indicator that we have reached a market top.

The thing about greed is that people love to talk about all the moves they are making. They want to help you, and so explain how "such and such" stock is going to explode in price. The problem being that at this point in any market cycle, most investments are already beyond the period of significant overvaluation. There is usually only downside from this point.

When fear takes over to replace the greed, the same people tend to change their beliefs. When asked about that incredible stock they were going on about only a few weeks earlier, they will usually change the subject, or not talk about investing at all.

This usually follows on after they've recently been burned. If they even speak of their experience at all, they will do so more as a warning against all the harsh downside that investing can bring in general, rather than admitting that they were wrong previously. 

Anyone of us has the potential to notice the greed and fear levels of the overall society. It is not difficult to do, and if you allow yourself to notice those trends, you will have a much better understanding of what point in the latest cycle we are in, and moving towards.

In fact, people who pay attention to the social trends often perform much better with their investments than the masses. Experienced and intelligent traders who do not see, pay attention to, or understand the fear and greed balance that is going on in society in general typically will have very little success with their stock market decisions.

What to Do With the Fear and Greed Balance

Understand the fear and greed balance, observe it, and react. By having a healthy relationship with your own balance of greed and fear, you will open up many opportunities that you might not have otherwise noticed.

In fact, since the vast majority of investors do not notice nor are they even aware of their own greed and fear balance, they will make trades for the wrong reasons and at the wrong prices. In this environment, it opens up several chances for you to acquire shares at extremely undervalued prices, and ride the wave of growing profits as people's fear begins to fade away, and their greed returns to replace it.

While the balance between fear and greed can most simply be described as a simple Yin and Yang relationship, it becomes much more significant when you understand that it actually can mean something much more. Specifically, it is a direct channel to avoiding losses, and capturing gains, with your investing decisions.