Fear is one of the most potent emotions that can seriously mess with your decision-making clarity, especially when it comes to investing your hard-earned money. It often leads to choices that seem irrational later, causing people to miss out on great investment opportunities. Let’s dive into how fear affects investment decisions, backed by data and some psychological insights I’ve accumulated from some of my topical readings. We’ll also look at its impact on different investment options like real estate, investment syndications, and hard money lending vehicles.

Why Fear Affects Investing

First, let’s understand why fear plays such a big role in investing. Fear in investing is rooted in psychological biases and some funky shortcuts our brains take. Behavioral finance, a field combining psychology with finance, has studied this phenomenon extensively. One key theory is The Prospect Theory by Daniel Kahneman and Amos Tversky. This theory says that we tend to value gains and losses differently, making us more cautious about gains and more reckless when trying to avoid losses¹.

Fear of Loss: The Big Bias

The fear of loss, or loss aversion, is a major bias that affects how we take risks. This bias makes people more focused on avoiding losses than pursuing and realizing gains. This fear leads to behaviors like avoiding investments, panic selling, and staying out of the market after a loss. Simply put, if you don’t take risks, you can’t win. Selling out of fear guarantees losses, and not investing at all means missing out on potential gains. Remember, “you got to be in it to win it.”

Avoiding Investments

One clear way fear stops people from making money is by keeping them from investing in the first place. For example, a Gallup survey showed that the percentage of Americans owning stocks and bonds drops during market downturns and economic uncertainty. During the 2008 financial crisis, stock ownership among Americans fell from 65% to 52%². This drop suggests that fear of more losses kept many people from investing, thus missing the significant recovery that followed.

In the real estate market, we see the same pattern. During the 2008 crisis, the housing market crashed, and many potential investors stayed away, fearing further declines. But those who bought real estate during the downturn saw significant benefits as the market bounced back. According to Zillow, home values increased by over 50% from 2012 to 2020³.

Panic Selling

Fear can also make investors sell off their investments during market downturns, locking in losses instead of waiting out the tough times. A study by Dalbar Inc. found that the average investor’s return is much lower than the market average, mainly because of bad timing driven by fear and panic⁴. From 2000 to 2019, the S&P 500 Index had an average annual return of about 6%, while the average investor earned only about 2.5%⁵. This gap shows how fear-driven selling hurts returns.

In real estate, panic selling happens when market conditions worsen. For example, during economic downturns, some property owners sell at a loss, fearing prices will drop further. But history shows that holding onto real estate through economic cycles generally leads to positive long-term returns.

Not Getting Back in the Market

After a big loss, fear can stop people from re-entering the investment market even when things get better. This is linked to “regret aversion,” where people avoid actions that could lead to regret. A study by the National Bureau of Economic Research found that those who lost big in the 2008 financial crisis were less likely to invest in stocks in later years⁶. This means they missed out on gains during the recovery.

This fear also affects alternative investments like investment syndications and hard money lending. Investment syndications, where you pool resources with others to invest in larger projects, can offer big returns. But fear of potential losses can keep people away. Similarly, hard money lending, where you give short-term loans to real estate investors at higher interest rates, can be very profitable. Yet, fear of borrower default can prevent people from exploring this option. These and many other similar investment opportunities realized returns are ultimately driven by risk-balancing and diversification strategies. 

The Role of Media and Market Volatility

The media plays a big role in increasing fear. Sensationalized news and scary economic predictions can make investors more fearful, leading to bad decisions. Research from the American Psychological Association shows that negative financial news increases stress and anxiety, which can unduly cloud investor judgment⁷.

Market volatility also stokes fear. When markets drop sharply, fear of more losses can cause a herd mentality, where investors follow others without thinking independently. This can lead to widespread panic selling, driving prices down further and creating more fear.  All one needs to do is look at the media rhetoric of the past three years under the Biden administration at a time when the markets are reporting record gains and performance, and the media is reporting recession, doom, and gloom.  

Case Studies and Historical Data

The 2008 Financial Crisis

During the 2008 financial crisis, the stock market had one of its biggest declines ever. Many investors, driven by fear, sold their investments at very low prices. But those who stayed invested or bought during the downturn saw huge gains in the recovery. For example, the S&P 500 fell by about 57% from October 2007 to March 2009 but then rose by over 300% in the next decade⁸.

The COVID-19 Pandemic

The COVID-19 pandemic caused massive market volatility in early 2020. Fear of a long economic downturn made many investors sell their portfolios. However, the market rebounded quickly, with the S&P 500 reaching new highs by the end of 2020. Those who let fear drive their decisions missed out on significant gains⁹.

Real Estate Market Opportunities

The real estate market also had big opportunities during both crises. During the 2008 financial crisis, real estate prices dropped, creating a buyer’s market. By 2012, prices began to recover, and those who bought during the downturn saw substantial returns. The Federal Housing Finance Agency reported that home prices rose by an average of 50% from 2012 to 2020[^10].

During the COVID-19 pandemic, some real estate markets declined due to uncertainty. But as the economy recovered, real estate prices surged. Investors who bought during the pandemic downturn saw significant appreciation in property values.

How to Overcome Fear in Investing

To reduce the impact of fear on your investment decisions, try these strategies:

Learn and Be Aware

Increasing your financial knowledge and understanding the psychological biases that affect investment decisions can help you make better choices. Learning about market cycles, diversification benefits, and long-term investing can reduce fear.

Think Long-Term

Adopting a longer-term investment view can help you ride out short-term market volatility. Despite ups and downs, the investment markets have consistently given positive returns over the long term. For example, the average annual return of the S&P 500 over the past 90 years is about 9.8%[^11]. The corresponding real estate market returns for the same period have been in the 50% range.

Diversify Your Investments

Diversifying, or spreading your investments risk across different asset classes, can reduce risk and minimize the impact of market volatility. A well-diversified portfolio can provide more stable returns and lessen the fear of big losses.

Explore Alternative Investments

Look beyond traditional stocks and bonds to include alternative investments like real estate, investment syndications, and hard money lending. Real estate can offer steady income and long-term appreciation, while investment syndications and hard money lending can give high returns in shorter periods.

Get Professional Advice

Talking to financial professionals can help you make rational decisions based on data and analysis instead of emotions. Financial advisors can provide personalized strategies to match your risk tolerance and financial goals.

What have we learned?

Fear is a powerful emotion that can heavily impact your investment decisions, often leading to missed opportunities and lower returns. By understanding the psychological roots of your fears, recognizing the influence of media and market volatility, and using strategies to manage fear, you can make better investment choices. Overcoming fear and exploring various investment options can help you achieve long-term financial success.

Footnotes

Footnotes

1. Kahneman, D., & Tversky, A. (1979). Prospect Theory: An Analysis of Decision under Risk. Econometrica, 47(2), 263-291. ↩
2. Gallup. (2019). U.S. Stock Ownership Down Among All but Older, Higher-Income. Retrieved from https://news.gallup.com/poll/266807/stock-ownership-down-among-older-higher-income.aspx ↩
3. Zillow. (2020). U.S. Home Value Index. Retrieved from https://www.zillow.com/research/data/ ↩
4. Dalbar Inc. (2020). Quantitative Analysis of Investor Behavior. Retrieved from https://www.dalbar.com ↩
5. S&P Dow Jones Indices. (2020). S&P 500 Annual Returns. Retrieved from https://www.spglobal.com/spdji/en/indices/equity/sp-500/ ↩
6. National Bureau of Economic Research. (2014). Do Household Investors Learn from Their Mistakes?. Retrieved from https://www.nber.org/papers/w20540 ↩
7. American Psychological Association. (2019). The Relationship Between Media Consumption and Financial Anxiety. Retrieved from https://www.apa.org/news/press/releases/stress/2019/financial-anxiety ↩
8. Yahoo Finance. (2020). Historical Data for S&P 500. Retrieved from https://finance.yahoo.com/quote/%5EGSPC/history/ ↩
9. CNBC. (2020). How the Stock Market Performed During the COVID-19 Pandemic. Retrieved from [https://www.cnbc ↩