The Markets are spooked

In today’s newsletter, we talk about the psychology of fear and see how the wisdom of crowds can quickly degenerate into the madness of mobs.

The Story

With US Iran tensions on a high, its no wonder that investors everywhere are freaking out. The US market is down. The European market is tentative. Hell, even Indian markets took a beating yesterday. At this point, it's safe to say that threats of an impending war have heightened fears everywhere. And sure, some of this reaction is well within expected norms. For instance, wars disrupt trade and economic activity. It consumes manpower and resources that could have been deployed elsewhere. And yes, all of this makes for terrible viewing if you’re an investor. But when everyone’s on edge it doesn’t take long for the collective conscience of the market to descend into chaos.

The mechanics are simple. When you are primarily driven by fear, all rational assessment take a backseat. You fail to hold your emotions together and investors feed off each other's frenzy and send markets into a tailspin. Take for instance the classic incident that immortalized the words “Irrational Exuberance”

In 1996, Alan Greenspan, the Chair of the Federal Reserve Board (The US equivalent of the RBI), used the term irrational exuberance to describe the behaviour of stock markets. The premise was simple. Greenspan was talking about elevated stock prices and making the assertion that investors were perhaps paying too much for too little. Now obviously when the chairman of the US Central Bank makes a comment like this, it doesn’t go unnoticed. And within moments of him uttering these words, investors across the globe started selling stocks in a frenzy and the markets capitulated.

The story was then used as a telling example to prove the absurdity of the entire exercise. But here’s the kicker. After a brief panic selloff, the markets recovered pretty quickly and then rallied for the next three years. So by all accounts, this brief spell was primarily catalyzed by fear.

But that begs another question — Why can’t rational investors simply tame this basic instinct? Is the modern man still a slave to his prehistoric ancestors? Can we not simply ignore fear and go about our business as usual?

Well… It’s not that easy.

In 1872, Charles Darwin sets himself on a mission to tame his reptilian brain and master fear while at it. He visits the local zoo antagonising a poisonous snake prodding it to strike him. Now bear in mind, the snake is already in an enclosure behind glass panels. So Darwin is safe regardless of whether the snake strikes him or not. And in the comfort of this knowledge, he vows not to flinch when the snake attacks. If he succeeds, this would offer irrefutable evidence that man can master fear after all. However, the experiment isn’t successful. Each time, the snake takes a stab at it, he finds himself recoiling swiftly despite his best efforts to hold still.

And as Darwin would eventually find out, overriding this powerful defence mechanism can be extremely challenging at times. In fact its one of the biggest challenges facing prospective investors. The notion of suffering financial ruin haunts people like you and me every day. You cant dismiss it easily. It's a very real concern. However, when you are betting large sums of money in the hope of generating disproportionate returns, these fears are exaggerated. While you could make progress by acknowledging your fear and trying to bypass some of its negative effects you can never fully conquer it.

So don’t be surprised if the markets suddenly start dipping in the next few days. Because its what markets do all the time. Fear and Greed drives the market and to expect investors to act rationally would be expecting them to change their brain's chemistry. It just won’t happen. We are after all slaves of our reptilian brains. So yeah, let’s just drink some coffee and chill. All will be fine.

Eventually…

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