Fear And The Psychology Of Bear Markets

Executive Summary

While it is, of course, a cliché to say that markets are driven by fear and greed, like many clichés this one contains a strong element of truth. The bad news for us humans is that within our brains, emotion appears to have primacy over cognitive function. While this may well have kept us alive and allowed our species to thrive, this uncomplicated hierarchy doesn’t necessarily work in our favour when it comes to thinking about financial markets.

When I first contemplated writing this series, little did I know I would feel the urge to write a second memo so shortly after the first, so forgive me for adding to the burden of your reading. However, you will be relieved to hear that I am not about to turn into an armchair epidemiologist of which there seem to be a positive plethora. Like many others, I have read much of what has been said by the experts, but this doesn’t make me in the least bit qualified to opine on the subject with any authority. Instead I want to write briefly on the psychology of fear as it relates to bear markets.

It is, of course, a cliché to say that markets are driven by fear and greed, but like many clichés it contains a strong element of truth, which is how clichés are born. I have spent much of the last decade talking about the greed side of the psychological equation, but the pendulum swings of market sentiment now leave me exploring the fear side.

The bad news (as if there weren't already enough of that about) for us humans is that within our brains emotion appears to have primacy over cognitive function. Our brains can be thought of as consisting of two different, although obviously interconnected, systems. One is a fast and dirty decision maker (the X-system), the other is more logical but slower (the C-system).

The X-system’s output is often unchecked, or at least checked only too late, by the C-system. My favourite example of this is to imagine I place a glass box containing a snake on the table in front of you. Now I ask you to get nice and close to the glass. Being a very obliging person, you do as I bid. If the snake rears up suddenly, you will naturally jump back, even if you have no fear of snakes. The reason for this is that your X-system ‘recognized’ a threat and forced your body to react, all of which happened long before the C-system had a chance to chime in and point out the protection offered by the glass box. In fact, it appears that the X-system reacts about three times faster than the C-system. From an evolutionary point of view this all makes perfect sense. The rapid response to fear carries a very low cost of a false positive relative to the potentially fatal cost of a false negative.