Fear and greed are the two most powerful sentiments as far as investors are concerned. Individuals with the appropriate combination of these two features should be good investors.

Those with too much greed normally crash and burn while individuals that are gripped by fear achieve sub-optimal returns.

What is the role of fear and greed in investment decisions and what is the best combination of these two characteristics for investors?

In this analysis fear encompasses caution, scepticism and cynicism while greed is a combination of arrogance, extreme confidence and excessive optimism.

The attitude of individual investors towards the New Zealand sharemarket is an excellent example of fear and greed.

Greed was the dominant emotion in the 1980s when New Zealanders poured huge sums of money into the domestic sharemarket. Fear was almost completely absent, partly because companies put a positive spin on their activities but widespread creative accounting also contributed.

The attitude towards the NZX swung dramatically from greed to fear after the 1987 crash as a huge number of New Zealanders turned their backs on the market and invested in residential property.

This was confirmed in the latest ASB Investor Confidence Report where shares were rated well behind rental property, bank deposits and term investments as far as individual investors are concerned.

A generation of New Zealanders have given up on the sharemarket because they fear they will lose substantial sums of money yet again. The Feltex collapse and other corporate disasters have reinforced these fears even though the domestic market has performed reasonably well in recent years.

The country’s greed sentiments have switched to housing with most investors believing that there are no risks associated with this asset class. This is a widely held view even though Japanese house prices have fallen 40 per cent since the early 1990s and residential property prices in the United States declined by 32.6 per cent from the peak in July 2006 to the trough in April 2009.

There is no suggestion that the New Zealand housing market will collapse but a good investor should have some fear or scepticism that the expected outcome does not always occur.

A radio interview last week best summed up our unbounded optimism towards residential property. A young woman, with an upbeat voice, told the interviewer that she was really looking forward to the year ahead because she had a new job and had just purchased her first investment property.

There seemed to be no doubt in her mind that housing prices could only go up and up whereas sharemarket investors take a much more cautious view towards future price movements.

The finance company sector was another area where greed and fear played a major role.

One of the main objectives of Mark Hotchin, Rod Petricevic and many of the other finance company owners was to eliminate the fear factor from investors’ minds.

Hotchin did this through the extensive use of former TV One news reader Richard Long in a high-powered advertising campaign. One should not underestimate the role that Long played in eliminating any concerns or reluctance investors might have had regarding Hanover Finance.

Petricevic used a “minimising the risks” television campaign and the owners of Nathans Finance hijacked the long-established Nathan family name. These strategies were primarily focused on eliminating the fear component from investors’ minds.

The situation was exacerbated by the Securities Commission and its woeful investment statement regime. These investment statements, which have replaced prospectuses as far as most investors are concerned, are hopelessly inadequate documents full of glossy photographs and little substantive information. They fed the greed sentiments and successfully eliminated any concerns or caution investors might have had.

A number of observers argue that finance company investors were greedy. This is true to some extent but it wasn’t internally generated, it was greed only to the extent that the Long advertising campaign, glossed up investment statements and other tactics successfully eliminated any fear from investors’ minds.

Banking is another area where the interplay between fear and greed plays a big role in determining lending policy. Risk assessment is the fear department of a bank while lending is the greed side. In the 1980s the lending division completely dominated with the head of the Bank of New Zealand’s corporate department once making the statement that he was worried that his bank didn’t have enough exposure to Chase and Equiticorp.

As far as he was concerned there was absolutely no fear or concerns regarding these companies or any of the other highly geared high-flyers of the time. The risk management departments of the Australasian banks had almost no power in the 1980s with the same occurring in the United States and Europe in recent years.

The problem with the Northern Hemisphere banks is that senior executives received huge bonuses based on lending growth in the year that loans were made whereas problems associated with the loans only surfaced two, three or more years later.

The risk assessment or fear division of a bank can be completely swamped by the lending department, particularly when there are large bonuses attached to lending growth.

One of the worst combinations is a banking system dominated by lending departments and property developers. Most property developers have no fear, which is why so many of them take huge risks and go bust.

The rarest jewel is a property developer who undertakes major projects but never experiences financial problems. The absence of a fear factor usually sinks most property developers.

The best combination for investors is probably 70 per cent greed and 30 per cent fear. The greed or optimist side has to dominate but there also has to be a strong element of fear or caution. Individuals with more fear than greed will keep their money in the bank and experience sub-standard returns.

The fear factor should be an important input to every investment decision because of what is known as the black swan phenomenon. This is derived from the conviction in the old world that all swans were white until black swans were sighted in the newly discovered America. It indicates that our knowledge is imperfect, that events can and will occur that we do not anticipate.

The Titanic, 1929 sharemarket crash, collapse of the Japanese economy and housing market in the 1990s, 9/11 terrorist attacks on New York, recent global recession and failure of our domestic finance company sector were all black swan events.

The recent Tax Working Group’s recommendations are a potential black swan as far as New Zealand residential property investors are concerned.

An individual with a 70/30 greed to fear ratio will have a diversified portfolio because the fear element will tell him or her that no investment is foolproof – a black swan event can occur at any time.

No investor should have all his or her investments in the sharemarket or residential housing or gold or in the bank or anywhere else.

The first objective should be to have a diversified approach at the asset class level. This means having a combination of residential property, other property, shares, fixed interest securities and cash. These should be onshore as well as overseas.

The second objective should be to have a range of investments within each asset class. There is no point in having one’s offshore investments totally concentrated in a holding in Guinness Peat Group.

Finance company investors would have benefited from having concerns over the potential of a black swan event.

Fear is an important input to the investment decision process but it should never completely dominate the greed sentiment if investors want to achieve superior returns.