The Effect of Human Emotion on Investment Decisions and the Overall Economy

Economics is simply "the study of life" and the choices we make. Human emotion is perhaps the strongest force in the economic and financial environment. It gets its appropriate level of respect in the real world--and a very short shrift in the land of academia. Human emotion...the need to stay up with the Joneses...the drive to get a great deal...the drive to make a killing on an investment or a property...all can contribute to positive or negative developments in the economy. nnFear & Greed...Stocks Emotion at times can be the primary driver of stock prices, whether up or down. The powerful emotion of fear can motivate holders of stocks or other financial assets to sell, at times regardless of the price received. The equally powerful emotion of greed can motivate investors to buy various assets, even when the inner voice might suggest the price is too high. Only later, in many cases, can investors recognize that they were "caught in the moment" and let emotion drive their actions. Greed was clearly center stage during the second half of the 1990s and the first quarter of 2000, especially in regard to Internet stocks and the NASDAQ. Greed drove many Internet-based companies to sky-high stock market valuations, even as many of these companies lacked profitability or a reasonable chance to become profitable anytime soon. The overall NASDAQ was pushed to a high of 5049, much higher than many investors and market players deemed logical or possible. At such unsustainable levels, fear soon became the more dominant emotion. The fear of millions of investors eventually pushed the NASDAQ down to 1113, a decline of nearly 80%. Hundreds of thousands of investors saw major losses in their retirement portfolios, requiring them to either stay in the workforce longer or return to gainful employment in order to rebuild damaged portfolios. nnFear & Greed...Real Estate A similar greed-based rise was also found in the nation's real estate market in recent years. Tens of thousands of investors pulled their funds from the stock market and sought a new avenue to riches--real estate was just the ticket. The decline of both short-term and long-term interest rates during 2001-2003 provided thousands of homebuyers with the opportunity to purchase their first homes. Tens of thousands of existing homeowners took advantage of the lowest home financing rates in 40 years to "trade up" to more valuable properties.nnThe Flippers In addition, investors and speculators by the thousands began to push real estate values higher. Many of these investors, commonly known as "flippers," took advantage of extremely low short- and long-term financing rates to purchase additional properties. It was not uncommon in hot real estate markets on the East Coast, the West Coast, and in the nation's Southwest for flippers to appear at announcements of new single-family and condominium developments, with the intent of buying multiple properties. Many of these flippers were successful in immediately bumping prices higher, and were able to pocket significant profits with limited risk. Other flippers came belatedly to the game in late 2005 and 2006, and were ultimately stuck with multiple properties to finance, with limited potential buyers. Many of these flippers, as well as thousands of more legitimate homeowners, faced the bleak task of trying to unload properties at a time when many other investors were engaged in the same process. Their financing plight was made worse by the impact of 17 monetary tightening moves by the Federal Reserve through June 2006. The problems of sub-prime lenders are serious in today's real estate market and are discussed ad nauseum in the media. The additional issue of flippers looking to liquidate investment properties adds to current real estate woes in many formerly high-flying markets.