All of the following terms point to the same general theme – that our investment decisions are often not based on reason or data but on irrational behavior based on what everyone else is doing:
“Madness of Crowds”
The psychology behind our investment decisions points to the #1 problem behind our investment choices: our FEAR. Fear is what drives the markets, and it’s what causes bubbles as well as crashes.
What’s pushing the stock market to all-time highs right now?
Suppose you’re paying attention to others around the water cooler. In that case, the justification for your co-workers and millions of investors across the country jumping into the stock market and crypto is a fear of missing out (FOMO).
You’ll hear one or more variations of the following comments:
“I just don’t want to miss the train on bitcoin or such and such meme stock.”
“I don’t want to be THAT guy who sat on the sidelines while everyone got rich.”
It’s a fact that the stock market is overvalued. It doesn’t pass the smell test. The record Dow is not supported by a solid economy – one where unemployment remains relatively high and one where supply chains are still problematic. The Dow is currently trading at more than twice its historical PE (price to earnings) ratio average, showing overvaluation.
Trillions in stimulus money, free trading platform Robinhood, online trading forums, and the FOMO are all contributing to an unprecedented stock market run. The problem is that the fear fueling the run – FOMO – will eventually turn to another kind of fear that will lead to panic selling and a market selloff.
The fear behind panic selling can be explained by the prospect theory developed by Dr. Kahneman and Dr. Tversky in 1979. Prospect theory is a theory of behavioral finance that describes how individuals make investment decisions based on the prospects of gains and losses. In weighing those prospects, individuals often act irrationally – giving more weight to certain potential outcomes than others.
Within the prospect theory and the irrational weighing of certain outcomes over others is the idea of loss aversion, which – as Kahneman and Tversky described it – “losses loom larger than gains.” In other words, the potential pain from the prospects of a loss outweighs the potential joy from the prospects of a loss.
Loss aversion means investors will play it safe by liquidating their stocks when a crack appears in the market. Then panic selling kicks in when investors see other investors running for the exit. Rational or not, loss aversion says investors will not stick around to see if the panic button that went off was a false alarm or not.
What’s the problem with loss aversion? Herd mentality kicks in, and normally rational and intelligent people start to do irrational things. No one is spared when panic selling kicks in because investors who decide to stick it out get wiped out anyway.
The stock market is the perfect breeding ground for fear-driven investment decisions. It’s highly liquid and highly susceptible to factors such as hype and buzz that have no basis in economic fundamentals.
With panic selling, you don’t have a choice or a say on when to exit your investment. If everyone is selling off, you’re not going to stick around to see the bottom of the crash. Your investment decisions are often made for you. Many investors even put in automatic sell orders if a stock hits a certain price.
History has shown that investors are better off if they ride out the storm. When investors liquidate in a panic, they often wait too long to come back and often pay much more to get back in the game – meaning they have more ground to make up than if they had just stayed put.
Ultra-wealthy investors don’t let the madness of the crowds or their irrational behavior control their investment decisions.
Savvy, wealthy investors eliminate fear from their investment decisions.
How? By investing in assets that are shielded from free liquidity and herd behavior.
Smart investors invest in illiquid assets with long lockup periods, and that restricts transfers. Investing in a private real estate or private equity fund prevents irrational behavior because no one can act on their emotions. It doesn’t matter how panicked everyone else becomes; there’s nothing they can do about it.
With that assurance, investors in private passive opportunities can rest assured, knowing that there’s nothing anyone or any mob can do to drive down the value of their investment.
Illiquid private investments serve three purposes:
- It prevents fear and panic from affecting the value of the investment.
- It allows fund managers to fully execute their investment strategy and roll out their business plan to provide a return to investors.
- It gives investors peace of mind that the exit date of their investment will either be established on the calendar or the date management determines to be the optimum date in the best interest of all involved.
Smart investors love private investments because they never have to worry about when to exit. The exit is out of their hands. There’s no need to monitor what everyone else is doing daily or even hourly to determine whether to stay in an investment or not, like with public stocks.
If you’re tired of letting emotions rule your investment decisions, consider private investments. Contact us to learn more about this investment option.
Kyle Jones is a co-founder and Key Principal of TruePoint Capital, LLC. Kyle is responsible for the company’s strategic planning, investment decisions, asset management, and overseeing all aspects of the company’s financial activities, operations, and investor relations.
Kyle obtained a Bachelor of Science degree from Texas State University – San Marcos, where he also played Division 1 Baseball.