The Cycle of Investor Emotion

By Financial Advisor Hans Smith | June 3, 2022

Emotion can be a driver of poor investment decision making. Numerous studies show that investors tend to panic and bail out of stocks at just the wrong time.

Here is an illustration of the “cycle of investor emotion:”

Note where the point of maximum financial risk and the point of maximum financial opportunity are located. Here is the key takeaway:

• As markets climb, and average investor emotion builds from optimism to euphoria, a good investor should be less and less excited about forward investment returns.
• As markets decline, and average investor emotion spirals from euphoria to despondency, a good investor should be increasingly excited about forward investment returns.

In other words, what the illustration is trying to tell you is: The riskiest time to invest is when the market looks safest, and the safest time to invest is when the market looks riskiest.

In hindsight bear markets and market corrections are widely considered buying opportunities for those routinely saving and investing into broad-based index funds. It almost never feels like that in real-time, however, and it's easy to get swept up in emotion. Maintaining discipline and purchasing various asset classes at discounted prices is an important piece of long-term investment success.

As legendary investor Peter Lynch once said:

”You get recessions, you have stock market declines. If you don't understand that's going to happen, then you're not ready. You won't do well in the markets. If you go to Minnesota in January, you should know it's gonna be cold. You don't panic when the thermometer falls below zero."