Survival of the Calmest

Fear is one of the strongest primal instincts a person can experience. The instincts on which survival depended in prehistoric times trigger rapid heart beats, sweaty palms, and a “fight or flight” reaction to fearful or stressful situations.

While ancient man worried about falling victim to the claws of a wild bear, modern man (and woman) worries about bear markets eliminating their hard won retirement savings.

Fear is a healthy reaction in moderation.

A little fear encourages us to proceed with caution and prudence. Too much fear, however, leads to loss and destruction. Fearful investors driven by self preservation and urged on by scaremongers will collectively bring about their own demise.

Changes in investment markets are determined mostly by fear and greed, with share prices rising as people see opportunities to make profits and falling as they protect themselves from expected loss.

However the effects of fear and greed are assymetrical. Greed has a much slower effect on markets than fear and as a result, market rises tend to be gradual while market falls can be very sudden.

When greed and complacency abound, markets are generally less volatile and are more immune to both good news and bad news. When investors get scared, they want to sell right now and salvage the remainder of their capital as quickly as possible.

Extreme fear usually signals the bottom of a decline

In the US, a volatility index called the VIX, commonly known as ‘the investor fear gauge’ is used as a measure to indicate the best time to buy shares. A sharp increase in the VIX indicates the bottom of the market.

Knowledge of this gauge has led to extraordinary profits for investors who monitor it and understand it, and who are prepared to buy when most others are panic selling. This is known as a contrarian investment strategy. At the bottom of the last major market correction in 2003, the VIX reached around 35. Over the last five years, the VIX has bottomed out to a low of around 10, but in the last year has shot up to a five year high of around 25. Perhaps The End (of market decline) is near?

It is not only in share markets that we see the effects of fear. The sub prime mortgage crisis and the resulting credit squeeze have been exacerbated by fear.

Closer to home, the rapid implosion of the finance company sector is another good example of the destructive results of investor fear. Now we see the same thing happening in the property sector, where expectations of loss are paralysing the market.

Who are the winners and losers in such markets?

The winners are those who keep their head, who stay resolute despite the scaremongering evident in the media, and who see extreme market fear as an opportunity for substantial gain.