In the financial markets, fear is a more potent emotion than greed. And we are currently witnessing the presence of widespread fear. This is making itself felt in a beaten up stock market and the flight to what are considered safe-haven assets. But people's assessment of the risks involved may not correspond with the inherent risks of the situation they face.

The problem is that there has been such a rapid and dramatic change in the environment that people are disoriented and are trying to find their bearings. Under such circumstances, it is not surprising that they would fall prey to exaggerated fears. Inevitably, this will have an impact on their spending behaviour and investment decisions.

Americans, who were notorious spendthrifts in the past, have sharply increased their saving rate. Rising unemployment and falling house prices have convinced them that caution is warranted. Discretionary spending is being cut back and chains like Wal-Mart are doing a lot better than high-end stores. On the other side of the world, the Chinese government is trying hard to persuade households, who are perennial high savers, to loosen their purse strings.

One should emphasise the psychological aspect in this sort of precautionary behaviour. The news stories may be awful, but the vast majority of firms, financial institutions and households are not damaged. Nevertheless, many have adopted a defensive stance. The main purpose of anti-recession policies by the government is to prevent damage from spreading and allow injured entities to repair themselves.

Just a few years ago Ben Bernanke, the chairman of the Fed, called the state of the economy and the financial system to be one of "great moderation", entirely ignoring the developing fault lines that would soon shake the foundations of the entire system. He was not alone in his blindness.

Financial firms and households really did think that a new era had arrived. There was underlying confidence that stock markets and house prices would continue to rise uninterruptedly. And, of course, there was the usual gaggle of analysts who explained why this view was correct and why it made good sense.

As comfort levels with the consensus outlook increased, there was a tendency to disregard warning signs and deteriorating fundamental conditions. People seriously underestimated the risks that they were taking. Given the actual conditions they faced, there was, in effect, the acceptance of substantial risk relative to potential returns.

Even sophisticated institutional investors failed to estimate risks properly in constructing their portfolios. The addition of alternative asset classes such as private equity and hedge funds did little to improve diversification. When the crisis arrived, most of these asset classes became highly correlated in a downward direction. Their returns were primarily fuelled by the same access to cheap and easy credit that eventually came to a sudden stop.

Under the rational expectations hypothesis in economics, individuals are assumed to use all the best information available, apply a sound model of how the world works and to come up with optimal decisions. They are assumed not to seriously miscalculate risks. Why would rational, intelligent and calculating people commit such errors? Except that in the real, rather than the theoretical, world individuals do not behave in a cool-headed analytical fashion. There is plenty of research and evidence collected by the behavioural school in economics to back this up.

The prevailing view about the future economic outlook is decidedly gloomy and the tendency is to discount positive factors and developments. And the danger is that a self-reinforcing negative feedback loop may develop. The authorities have significant responsibility in breaking the hold of a pessimistic psychological state of mind. Thus far, in most countries, they can only be awarded mediocre marks for their efforts.

In the current difficult economic and market conditions, people have developed a high degree of risk aversion. They seek to avoid asset classes that are perceived to be risky, even if the potential compensation is large relative to the inherent risks. As in the boom, so in the bust, emotions and herd behaviour play a major role.

The stock market is currently cheap, in terms of cyclically-adjusted earnings. It is attractive on a longer-term risk/reward basis. But widespread fear has kept the bears in charge. Some people think that a final cathartic sell-off on high volume will signal the end of the bear market. But evidence from the past suggests that the turnaround comes after a series of small declines on relatively low volume. Essentially, the bears would become exhausted after a long period of selling.

Iraj Pouyandeh is a Strategist and Senior Portfolio Manager at LOM Asset Management. He manages the LOM Global Equity Fund. For more information on LOM Asset Management please visit www.lomam.com