Why Fear Is Good

By Charlie Bilello

03 Oct 2022


“Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy when others are fearful.– Warren Buffett

Greed, for lack of a better word, is good– Gordon Gekko, Wall Street

Fear and Greed.

The two emotions that dictate all of the short-term movements in markets.

During last year’s rolling series of manias, greed was the predominant force in markets, with the only fear amongst investors being the fear of missing out (FOMO). Prudence was an afterthought as investors were behaving as if the future already happened.

But that was 2021. Fast forward to today and we’ve seen a 180 degree shift in sentiment, with fear taking over.

What changed?

Prices…

  • The S&P 500 has now fallen over 25% from its January high, the largest correction since March 2020 and the longest drawdown we’ve seen since the 2007-09 bear market.
  • After 13 consecutive years of positive returns, the Nasdaq 100 is down 32% in 2022, giving back all of the gains from 2021 and more (back to October 2020 levels).
  • High growth stocks (ARK Innovation ETF, $ARKK) have been hit even harder, losing more than three-quarters of their value from peak 2021 levels.

As prices have moved lower and the news has turned negative, sentiment has soured.

Bears now outnumber Bulls by over 43% in the AAII sentiment poll, which is among the most negative readings we’ve ever seen. With data going back to 1987, the only times sentiment was more bearish than today was in October 1990 (a 20% bear market bottomed that month) and March 2009 (the week of the bear market low).

For market participants, that’s good news. For when investors are extremely fearful (bottom 3% of sentiment readings), forward returns tend to improve, with above-average outcomes over the subsequent 3-month through 5-year periods. The opposite tends to be true following periods of extreme greed (top 3% of readings).

Is extreme fear always followed by positive returns?

No, there’s no such thing as always in markets and in the short run anything can happen. Throughout 2008 and early 2009, many bearish sentiment extremes were hit only to be followed by lower lows ahead (typically with bounces in between). We’ve seen a similar pattern this year, with persistent bearish sentiment starting back in January and a number of dead cat bounces along the way.

Still, if given the choice between a period marked by extreme greed or extreme fear, long-term investors should always prefer the latter. Why? Because extreme fear creates the opportunity to add capital at lower valuations and a more favorable balance between risk and reward. On the other side, extreme greed inevitably leads to poor decision making, chasing higher risk securities with little long-term reward.

Which is why when it comes to investing it is not greed but fear that is good.


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Disclaimer: All information provided is for educational purposes only and does not constitute investment, legal or tax advice, or an offer to buy or sell any security. For our full disclosures, click here.

About the author

Charlie Bilello

Charlie is the founder and CEO of Compound Capital Advisors.

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