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FINANCIALLY AESTHETIC · GUIDE 32/37
INVESTOR PSYCHOLOGY: FOMO, BUBBLES, PANIC & BEHAVIORAL ERRORS
FA-6.5 · Investing & Wealth Building
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BEFORE YOU INVEST
A good portfolio can still fail when the owner chases hype, sells panic and rewrites the plan mid-cycle.
Behavioral Biases That Influence Our Investment Decisions
As an investor, your choices are influenced by certain reflexes - behavioral biases - that can lead you to make decisions that contradict your investment goals. The best way to correct these reactions? Be aware of them! Our decisions, preferences, and perceptions are influenced by a host of small biases. Of course, we’re all different, and these biases don’t affect everyone in the same way. Recognizing their existence allows you to view your own reactions objectively and make investment decisions that are better aligned with your short- or long-term goals.
Our main behavioral biases are therefore:
- loss aversion,
- present bias,
- herd behavior,
- ambiguity aversion,
- confirmation bias,
- aversion to change,
- overestimation of the probabilities of rare events,
- myopic loss aversion.
FOMO: The Fear of Missing Out
In this chapter, FOMO is the short name given to the fear of missing out on a profit opportunity. This mechanism ties into two behaviors already documented in the corpus: following the lead of other investors and assuming that recent gains will continue. In other words, the term is used here to link herd behavior and the extrapolation of past performance to a decision made under the pressure of “not missing out” on the trend.
Herd Behavior in Financial Markets
Herd behavior, or mimetic behavior, tends to develop in financial markets as a result of new performance evaluation or trading techniques. The concept of mimetic chains formalizes the fact that, when deciding on a strategy, market participants take into account not only their own market-related information and analysis but also the behavior of other traders whose investment decisions are known to the market. In this context, a “majority rule” may emerge, in which the behavior of other participants takes precedence over the investor’s own analysis.
A trader operating in an environment driven by short-term performance has no interest in being right against the rest of the market. Their goal is no longer to discover the true value of financial assets but rather to identify the trends that their prices follow. In this regard, smart mimicking or feedback trading may prove more profitable than fundamental analysis.
Because of their large numbers, “noise traders” can prompt rational investors to behave like them if they feel that these irrational investors will drive market prices.
This mimetic behavior can accelerate portfolio shifts, amplify fluctuations in financial asset prices, and thus lead to price distortions and above-normal volatility. Depending on investors’ risk aversion levels, the situation can change rapidly, shifting from excessive demand to a drying up of demand for a specific asset class.
The Formation and Bursting of Speculative Bubbles
A speculative bubble occurs when the price of an asset - such as real estate or stocks - rises excessively, beyond its fundamental value (a value that is, however, difficult to measure with certainty, as it depends in part on future income streams associated with that asset). A bubble is fueled by speculative behavior: when economic agents anticipate, with excessive optimism, that the prices of certain assets will continue to rise, they invest in these assets in the hope of reselling them at a higher price and making a profit.
A speculative bubble typically develops and then bursts by following a standard four-stage pattern identified by the American economist Charles Kindleberger (1978):
Stage 1: Preparation of the bubble. A sense of confidence in the health of the economy, coupled with investor optimism regarding the profit potential of a product or service perceived as promising and innovative, triggers an initial, moderate rise in the price of a particular asset class.
Stage 2: The emergence of the bubble. The initial rise fuels expectations of future price increases, which in turn attract new investors. Confidence pushes economic actors to take on more and more risk: economists refer to this as the “paradox of tranquility.” Speculative bubbles often develop during periods of apparent economic health.
Stage 3: Euphoria. During this phase, the bubble becomes self-perpetuating, fueled by herd behavior. Even traditionally cautious investors and a portion of the general public join the buying frenzy, hoping to capitalize on an “easy” profit opportunity. In 1996, the Chairman of the U.S. central bank, Alan Greenspan, coined the term “irrational exuberance.” Often, the bubble also grows through debt, particularly in environments of low interest rates: economic agents are confident that, thanks to future capital gains, they will be able to easily repay the loans borrowed to purchase the assets underlying the bubble.
Step 4: The bubble bursts. The bubble bursts when certain investors’ expectations change: they realize that an asset is overvalued, assume that other investors will eventually realize this as well, and therefore decide to sell those assets before anyone else does. This reasoning can be self-fulfilling, as the mere fact that a few investors start selling leads others to sell as well. The shift in expectations is often linked to an unforeseen trigger: a revision of economic growth forecasts, a central bank raising key interest rates, etc. A race (a panic) to sell then ensues: with the supply of assets now exceeding demand, prices plummet. Among the first investors to start selling are often those who had borrowed to finance their purchases: they hope to still recoup enough money to repay their loans. This shift in their behavior constitutes the “Minsky moment,” named after the American economist who studied these phenomena of financial instability in the 1980s. Of course, their massive sales only accelerate the decline in prices.
Thus, the bursting of a bubble can, in some cases, endanger - through a domino effect - many other economic actors besides those who had invested in the assets in question: banks that had lent to investors to finance their speculative purchases, other banks that had lent to the former, companies in other sectors that see the banking sector restrict its lending to the economy (credit crunch), employees of companies facing financial distress, and so on. It is said, then, that the bursting of the speculative bubble triggers a financial crisis and then a crisis in the real economy.
Although this phenomenon is not new, its earliest documented manifestations date back to the 17th century, as evidenced by the famous tulip mania in the Netherlands. Whether it was the dot-com bubble in the early 2000s, the subprime crisis in 2008, or, more recently, the crypto asset bubble, these episodes reveal recurring patterns of excessive speculation and market volatility.
The emergence, followed by the sudden bursting, of major “speculative bubbles” in stock markets and real estate markets in various countries during the 1980s and 1990s (Scandinavian countries, the United States, Japan, etc.) demonstrated that the consequences could be significant for both the health of the financial sector and the overall economic situation. In Japan, the bursting of a major real estate and stock market bubble in the early 1990s permanently hampered economic growth due to the lack of a thorough resolution of the over-indebtedness that had preceded the crisis.
Why Extrapolating Past Performance Is a Mistake
Savers place a great deal of importance on past returns. And when those returns are impressive, financial institutions don’t hesitate to highlight them… When it comes to stock market investments, however, with financial markets constantly fluctuating, there is little chance that strong performance will be repeated exactly as it was. For example, when an equity fund posts a 15% gain over three years, this in no way guarantees that this gain will continue for another three years.
For an equity investment, you should view a strong one-year performance with caution and place greater emphasis on performance over a longer period corresponding to the recommended investment horizon (at least 5 years, or even 10 years). Keep in mind that you should not rely on an investment’s past performance to estimate its future returns. Past performance is useful if you want to get an idea of the investment’s risk, provided, of course, that it is presented over a sufficiently long period.
Knowing an investment’s past performance is useful for any investor, but this information should not be the main focus of an advertisement. Indeed, for any financial product, high potential returns are always accompanied by high risk. To ensure investors are well-informed, any mention of performance must therefore be balanced by information about the investment’s risk.
Volatility, Risk Tolerance, and Concentrated Positions
The value of a stock or fund fluctuates constantly. Volatility is a measure of the magnitude of these ups and downs. Understanding an investment’s level of volatility is therefore helpful in assessing its risk: when volatility is high, the value of the invested capital may decline significantly. High volatility is generally accompanied by the prospect of attractive returns. However, high returns can never be guaranteed.
Stock prices fluctuate to varying degrees depending on investors’ uncertainty about the future of the listed company. Collective investment schemes (funds and SICAVs), which are invested to varying degrees in stocks, also fluctuate. However, they are generally less risky than individual stocks because a diversified portfolio spread across multiple securities fluctuates less than any single security.
With equity investments, it is not uncommon to see declines or gains of more than 20 or 30 percent in a single year. And by investing for just one year, an investor has almost as much chance of incurring a loss as of making a gain. For this reason, equity investments should be viewed as long-term investments - at least five years, and more reasonably 10 years or more - to increase the chances of a return.
Being aware of the possibility of a loss at the end of an investment is one thing. But before investing, every investor must also understand their ability to tolerate fluctuations in the value of the proposed investment over its lifetime. You need to be able to stay calm if your investment suddenly drops by 10%. Talk to your financial advisor: the questions they ask you are designed to determine your risk tolerance and thus assess whether your profile is suited to a more or less volatile investment.
Don’t Give In to Panic During a Crisis
All your decisions must be carefully considered. Don’t panic during a stock market crisis - you risk selling at the lowest point - and don’t wait until the market is at its peak to invest. Keep your cool whether the market is rising or falling.
Investments and Speculation: Two Different Approaches
Although both investors and speculators seek to make a profit in the financial markets, these two approaches are very different.
Investors take a medium- to long-term approach. They diversify their investments to prevent their savings from eroding over time - or even disappearing entirely - due to excessive concentration in a single type of investment or a single security.
The speculator, on the other hand, is a short-term player: they aim to maximize profits in the shortest possible time. They therefore put their savings at risk in riskier financial market products. Remember: there is no such thing as high returns that are risk-free.
“Revenge trading” is not included as a required subtopic: it appears neither in the title nor in the approved sources. The biases that are actually sourced - loss aversion, herd behavior, ambiguity aversion, confirmation bias, and myopic loss aversion - remain the ones used in the chapter.
Be Wary of Promises of Risk-Free Returns
Be sure to carefully review the information on both returns and risks provided in the product documentation. Be wary of investment offers that guarantee high returns without disclosing the associated risks; you may be falling for a scam.
INVESTOR CHECK
Write the rules before volatility arrives, size risk honestly and treat FOMO as a signal to slow down.
RISK NOTE
This guide is financial education, not a promise of returns or personalized investment advice. Products, tax treatment and investor protections vary by jurisdiction.
- Bulle spéculative | Banque de France - https://www.banque-france.fr/fr/publications-et-statistiques/publications/bulle-speculative
- Bulletin de la Banque de France n° 95 - Novembre 2001 - numéro spécial - Le cycle financier - https://publications.banque-france....ulletin-de-la-banque-de-france_95_2001-11.pdf
- Bien suivre ses placements | AMF - https://www.amf-france.org/fr/espac...conseils-pratiques/bien-suivre-ses-placements
- Comment valoriser son capital? | AMF - https://www.amf-france.org/fr/espace-epargnants/preparer-ses-projets/valoriser-son-capital
- Investor.gov - Say no to FOMO - United States - investor behaviour.
- Investor.gov - Beginner's guide to asset allocation - United States - asset allocation and diversification.
