The Boom and Bust of Markets: Is It Simply Human Nature?

Markets appear to have a tendency to follow the emotional sentiment of investors. They occasionally revert back to the mean, factoring in the fundamentals of the businesses and the economy. As the old saying goes, in the short term the market is a voting machine, and in the long run a weighing machine. But is it true? And what drives the feelings of euphoria and greed, and the converse feeling of despair and fear?

In Daniel Blumstein’s book, The Nature of Fear: Survival Lessons from the Wild, Blumstein draws from both nature and the study of different animals to illuminate the problem. It turns out, many animals, such as marmot, have built in fear responses, even to stimuli they have never seen in their lifetimes. This innate instinct passed on from their ancestors alerts the animal to dangers whereas others of the same species—whose ancestors were not exposed to the original danger—do not have their flight or fight responses triggered.  In this situation, not recognizing the danger would result in being killed by the unrecognized predator.

This whole concept got me thinking about financial markets and the emotions of the individual actors. It is hard to sell your shares when the price keeps going up and the general sentiment is positive. Similarly, it is hard to hold your positions when the value of them, and your hard earned money is evaporating before your eyes. It is as though humans have a bias to extrapolate out whatever the recent trend happens to be; whether it be positive or negative. There is a tendency to believe that the good times will keep getting better, and the bad times will keep getting worse: a recency bias.

So I asked myself, what would happen if an investor “ran” or took flight when the sentiment or fundamentals created a fear response? What would the energy expended versus gained yield the human investor? And it’s not just missing out on one acorn like a squirrel who runs from the person approaching the tree. It’s a percentage of returns that could potentially equal someone’s entire livelihood. 

According to Bloomberg, as of March of 2024, if an investor missed the best trading days, their returns could be impaired significantly. For instance, if an investor stayed in the S&P 500 Index, they would have seen 10.4% annualized returns since January 2005.  But miss the best 10 days and that drops to 6.7% returns. Miss the top 20 days and your annualized returns would have dropped to 3.5% .Miss the best 30 days and returns are only 1.3%. Miss the best 40 days and the returns are negative, losing 0.6%. That is the difference between seeing your money compound and grow, and watching it all vanish, later regretting not spending it on something you wanted instead.

However, there are enough historical examples to be aware of which continue to drive fear in human investors today, whether its the Great Depression, the inflation of the 1970s, the dot-com bubble in 2000, or the Great Financial Crisis of 2008. While the market has certainly appreciated over time, it hasn’t been in a straight line. There are pullbacks in time. There are bear markets. And losing money, it turns out, is painful. So painful that many individuals are willing to avoid the pain by selling and pulling their money out of the market. 

According to academic sources from the field of behavioral finance there is compelling evidence that human nature, driven by innate psychological biases, causes emotional trading behavior. Unlike traditional financial theory, which assumes investors are purely rational, behavioral finance acknowledges that emotions like fear, greed, and overconfidence lead to systematic, predictable errors in judgment. 

In a paper from the UCLA Anderson School of Management referred to as the “Capuchin-monkey trading experiment (2006)”, researchers documented that capuchin monkeys, when taught to use a token economy, displayed a clear preference to avoid loss. The monkeys reacted more strongly to a potential loss than a potential gain of the same amount, providing evidence that the biological roots of loss aversion extend beyond humans.

That fear of pain, of loss, has historically guaranteed that result. For those that sell and cash out, unless their timing is impeccable and they have super-human luck on their side, it would appear impossible to predict market timing. So, in conclusion, my research says to fight the urges to run away from potential losses and keep your position, as it will improve over time.