The Psychology of Investing: The Ordeal of an Investor in a Bear Market
When stock markets fall, non-professional investors panic, get insecure and sell. When markets rise, investors rejoice and buy. You probably know the drill. In this article, I want to discuss why this happens in the investor's mind and why this emotional approach is the wrong one. I will also go into the psychology of the investor and the basic methods of investing, which should always be based on a well-considered strategy.
I'm not an investment advisor. Therefore, I am not trying to give investment recommendations in this article, but I am certainly trying to educate the reader in this way, to give a rational perspective where inexperienced investors often use emotions, and also to show that a downturn can be good and a rise, on the contrary, can be bad.
But first things first. I have the confidence to write this article as a person who has been investing for over 10 years himself and has gained insight into the thinking of over a thousand investors (actual and potential) of Probinex over the last three years through in-depth interviews about their investments and investment approaches and strategies.
This is, I think, a fairly representative sample for identifying the basic mistakes investors make in the markets. In this article, I will focus primarily on behavior in declining markets.
How is the stock market price formed?
However, before we get into the psychology of investors, we need to be clear on how the stock market is priced.
Simply put, the price of a stock, a commodity, or a crypto asset (Bitcoin, Ethereum, and others) is formed on the basis of supply and demand. Market equilibrium, the price you see, is where supply meets demand. If demand is greater than supply, the price will start to rise until market equilibrium occurs again.
And vice versa. All other market impulses (FOMO, FUD, quarterly results, fear of uncertainty, and hundreds of other factors) are then reflected in demand and supply and together determine the current price. Adam and Tomas also covered the topic of how price is formed and many other topics in one of the last episodes of their podcast.
Oh, the emotions
From many conversations with clients, I see two of the biggest problems with investors: ignorance and emotion. The common denominator of both is lack of experience. An experienced investor has mastered fundamental or technical analysis and invests based on what they trust and where they feel most comfortable.
Through fundamental or technical analysis, they are able to detect, for example, a stock or other publicly traded title that is overpriced. And through individual analysis, successful but mainly unsuccessful trades, the investor then gains experience. It is not so simple with emotions. Emotions move people even in everyday life, and in investing, emotions are usually an investor's worst enemy. Why?
Put yourself in the shoes of an investor who bought Bitcoin in December 2017 at a price of $19,000. And a month and a half later, at the end of January 2018, he was halfway there (the price had fallen below $10,000/BTC).
An investor who is ruled by emotions and does not have a predetermined strategy would quite likely have sold even earlier and not waited until his investment became half. Moreover, he would have felt cheated, while it was mere volatility, which is quite normal in the crypto world (but also in the world of stocks and commodities), both downwards and upwards.
Let's ask a few rhetorical questions before we get to how an investor, who is in control of his emotions, would react.
- Why was such an investor buying Bitcoin back then? With what goal?
- Why did he buy only after several months of explosive growth? Why didn't he buy at the bottom instead? Wasn't he a victim of FOMO (fear of missing out)?
- What part of the investment portfolio did he put into BTC? If he has put in too large a portion (>5% of the portfolio in the case of an inexperienced investor), it amplifies his subsequent impulsive decisions and moods.
The answer to all questions is the same. He gave in to his emotions and wanted to get rich quickly. But that has nothing to do with investing. That's gambling.
How would an investor who has his emotions under control and maybe even some experience react in such a situation?
He would further divide his capital into that which he wants to invest in BTC and that which he will use in case of any downturns. Yes, an experienced investor who invests without emotion uses the downturn to buy and the upswing to sell.
This is the exact opposite of the emotional investor or the inexperienced investor who recalculates how much money he has lost in each downturn. He hasn't lost money until he sells. Until he sells, he is at a so-called open loss. A closed or realized loss occurs when a client sells a position because he needed money quickly or did not have the patience to wait for a reversal in price.
However, an experienced investor analyzes the title (stock, cryptocurrency...) before investing to make sure (or at least increase the probability) that the company will not go bankrupt or the cryptocurrency will not disappear from the world.
This would then turn a "buy low", i.e. buying on the downside, into a bottomless money hole. So, let's assume that the investor has done this "homework" and knows (for example) that Bitcoin adoption is already unstoppable, and as more and more big players enter the crypto world, there is no longer a threat that the whole world will somehow ban it.
Therefore, an investor can leverage more capital and buy patiently during downturns. By doing so, he lowers his average purchase price and gets back to their balance much sooner than when Bitcoin rises again to $19,000 in the next cycle.
Not for nothing is it said that investing is nothing but a transfer of wealth from the impatient to the patient.
What is Technical and Fundamental Analysis?
Technical and fundamental analysis are the two main methods used to evaluate and predict price trends in financial markets.
Technical analysis focuses on the study of price charts and statistical indicators such as trading volume and price movements. It uses historical price and volume data to identify trends and patterns that may indicate future price movements. The goal is to predict short-term price fluctuations based on these patterns.
Fundamental analysis, on the other hand, focuses on assessing the true value of assets such as stocks or commodities based on various economic, financial, and political factors. These factors may include a company's annual reports, the quality of its management, market conditions, and other macroeconomic indicators. The objective of fundamental analysis is to identify long-term investment opportunities based on an estimate of the intrinsic value of assets.
Both methods have their pros and cons and are often used in combination to make informed trading and investment decisions.
I want to invest, but I can't help feeling emotional. What to do?
If you are a novice investor, you need to gain experience. This is acquired not only by profitable trades but especially by losing ones. Did I sell at a loss because the downturn stressed me out? Then you had too much capital in the investment or you didn't analyze the cryptocurrency or company at the beginning and instead of "Buy low", i.e. gradually buying and averaging the purchase price, you sold.
And quite likely to someone who trusts the company and who got a great purchase price because of you. That's experience, too. And your job is to move from the ranks of "emotional investors" to those who can put emotions aside. Because only they are successful.
But how do I know if it makes sense to buy a certain cryptocurrency/share when it is falling (the "buy low" principle)?
Let's assume that you have already decided whether you own a cryptocurrency or a share of a company before the investment, and not when you panic because of a price drop, which is quite normal in the crypto world. Panic analysis can never turn out well.
Let's see a short checklist on how to identify a company with good fundamentals that makes sense to invest in and then buy in during any downturns:
This is an absolutely crucial parameter in the case of investments. A firm that does not have physical offices or does not communicate with clients is very risky. Look at where the firm you want to invest in is based.
What's the name of the company if you Google the company? Is it full of negative reviews? Or does it have a good name? And how does it approach its products? Are they audited by an authority? Alternatively, does the company give investors or even the public any insight "under the hood"?
Are the owners trustworthy people? Are they people who have already built something or is this their first attempt at business? What experience do they have in the business? And what are their reputation and values?
Are they entrepreneurs who have had one failed project after another and let clients take the fall for it or have they built functional businesses that have worked for years? Do they even know how to build and run a company? Are the owners of the firm even known? Is it possible to meet them?
3. The owners' ability to be deputized
Does the company have quality management or is the company fully dependent on the day-to-day operations and know-how of the founders? The fungibility of the founders is one of the biggest risks at the beginning of the project. And twice as much for a crypto firm or a publicly traded company.
4. Business model
That is, what the company does to make money and what creates its stability. How long will it take the company to get its first paying customers? How long will it take the firm to get to operating profit, which is a crucial milestone in the stability of the project? Does the firm not fulfill the characteristics of a Ponzi scheme? Does the firm plan to be local or does it intend to scale its business and expand abroad? How does the market view their business model? Is their timing good? Or did they come too late?
Bear market, the opposite of bull market is an ideal time to test what you have learned from investment skills (fundamental analysis, patience, "buy low, sell high", suppression of emotions).
It is a period of the business cycle when the prices of titles are falling in the long term. It is not uncommon for some stocks or cryptocurrencies to fall by dozens of percent.
A period when, as we have already said, one does not sell in panic, but instead buys. If it is a company that has undergone a credibility and stability analysis (see above). No, there is no point in trying to hit the bottom with one purchase and purchase at that point. Most of the time no one succeeds in doing that. Especially since in times of major downturns, panic, surrender, and/or depression, and therefore emotion, sets in for many investors.
It is not only in times of downturns that investors are advised to apply the DCA (dollar cost averaging) method. This method consists of successive purchases for smaller amounts, thereby reducing the average purchase price.
Did you buy Bitcoin in 2017 at a high of 19,000 USD (and the investment was e.g. 100,000 CZK)? If you have been buying at 10,000 CZK/month since the beginning of the decline (i.e. from the next month), then at the end of 2018 you had a total of 220,000 CZK invested in Bitcoin, lowering your average price.
You'll be in profit long before the price of BTC hits $19,000 again. DCA is an excellent method that easily eliminates emotion because you always buy on a specific day of the month regardless of price (the opposite of market timing). And in 2021 there was another ATH (all time high), this time at 69,000 USD, so whoever was depressed for months after buying but "sat out" the loss, was suddenly in more than tripled profit.
Markets are cyclical and it is said that history does not repeat itself, but instead rhymes. And given the fundamentals of Bitcoin (halving, massive adoption by big players) it doesn't look like BTC had its last word two years ago.
The bear market is also the ideal time and space for any company to build, consolidate and prepare for the next big growth. It is during these times that new products are created, and the company stabilizes and prepares for the next one. And for investors, it's an ideal time to perhaps lightly educate themselves in the industry they've invested in, or at least to monitor how the invested company is performing against the plans it has set out to achieve.
Note: Even Probinex has already experienced one big correction and subsequent big rise when in early 2023 the price tripled from the bottom of the correction to 200 percent in a month and a half.
Should I understand what I have invested in?
From this perspective, there are two approaches to investment. The first is that I invest in an industry that I understand perfectly. And I invest in a company that is in an industry with which I'm familiar and is innovative, has a unique product, or is developing a product/service that is sufficiently unique that it makes sense for me to choose them and enter into the investment with my own conviction about the merits of it.
The investor then makes a decision based on many hours of studying the economics of the company, the closing financial statements, and the internal and external environments that affect the company. I would classify these as mostly professional investors.
And then there is the second way, which is applied in fields that the ordinary investor does not understand. And here I place the vast majority of non-professional investors. Typically, it's investing in crypto fintechs and cryptocurrencies. Here, there is absolutely no way for an investor to understand the entire industry in detail and be able to trace that a given company/project knows where the entire crypto world is going and has a solution that will make the company (and then the investor) successful.
The cryptocurrency industry has not been aided by the enormous level of fraud, Ponzi schemes, and theft in recent years.
What is a Ponzi scheme?
A Ponzi scheme is a type of investment fraud that relies on "returns" derived from new investors rather than legitimate business performance. It starts with the founder of the scheme convincing people to invest money and promising them high profits in a short period of time. Then the first investors' returns are paid for with money from new investors.
Over time, the founder of the scheme tries to attract more and more new investors to pay the "returns" to the older investors. The scheme is unsustainable and eventually collapses when more money is needed than comes in from new investors. The scheme is named after Charles Ponze, who used this type of scam in the 1920s.
However, the fact that an investor doesn't understand a certain industry doesn't have to be a barrier if someone they trust is behind the project. They trust in their skills and knowledge. And they trust that they will see their investment appreciated in the long run, even with the various waves, corrections, and downturns that are normal in the markets and in business and investing.
On a global scale, this is what you could say about Elon Musk. Even though many non-professional investors can't even tell off the top of their heads how many cars Tesla will produce, with what growth potential, what the company's EBITDA is, or what legislative restrictions it faces in the various countries where it makes and sells cars (plus hundreds of other parameters that affect the stock price), they will still buy the stock.
Because they have confidence in Elon's abilities. And that even if things don't go well, he'll figure out how to turn it around. Another case from history could be Steve Jobs (Apple). It is therefore possible to invest even in an industry I don't know. It makes the whole situation much easier if I know how the owner works, what experience he has, and what vision he has to develop the company.
If I know his value set and personal qualities, and if I know him personally (locally) or have been recommended to him, I can imagine that it is possible to go to such local founders, even if I don't understand their field.
They understand it. And I'm sure you've heard in your neighborhood in the last few months about projects that looked interesting and founders who did everything they could to make the project a success. Outside of the crypto world, Tomas Čupr (Rohlik.cz) is such an entrepreneurial role model, but there are dozens of others in various fields in the Czech Republic alone.
No. Investing is not without risk. But by eliminating emotions and taking the approaches I've tried to describe here, you won't make unnecessary mistakes, you'll reduce your level of risk, and you'll sleep better.
Michal Baturko Olbert
Co-Founder Probinex.com & Earnio.com