Who should you fear - yourself or the market

You thought you had done everything right. Talked about your long-term goals. Had your risk-profile assessed. Bought into the investment strategy of your financial advisor. Then last month the market crashed. And suddenly you wished you had never invested at all. And the reason why? You'd forgotten to research the most important thing yourself.

How you react emotionally to your investment experience will have a critical impact on your investment strategy and how you achieve your financial goals. Your emotions might even play a role in how prices are set in the market. Most of us have been taught that the investment market is an objective place and emotions hardly come into the picture at all (or the emotional biases of individuals are random and cancel each other out). Recent research is questioning this view, and arguing that there are systematic behavioural biases that affect the setting of prices in the marketplace. This research is also demanding that the first thing you need to understand before you invest is yourself.

Most of us pay scant attention to our emotional biases, far less try to do anything about them. Think about it. Do you think it is more important to control your underlying emotional turbulence or control the underlying volatility of your investments?

Most of us would argue that controlling the underlying volatility of our investments is the most important thing. This is in fact the traditional investment approach which takes as variable (and controllable) the level of risk in your portfolio. According to this approach this risk is predictable (i.e. it reflects the underlying fundamentals on the investments) and can be altered by changing the asset and manager mix of your portfolio.

In the traditional approach emotions are quite narrowly understood as your ability to tolerate short-term losses, and are taken as given (and consequently uncontrollable). The task is to find the portfolio that maximises return for the level of risk (i.e. short-term loss) your emotions can tolerate. Emotions in this analysis are something you are slightly ashamed of you find out about them in a risk questionnaire and they seem to get in the way; and something you are slightly scared of, because they might prevent you from taking on sufficient investment risk to achieve your long-term goals.

The problem with this approach is that it doesnt seem to work. Investors invariably find that they experience more risk than they expected. It is actually a lot harder to target volatility than the traditional approach supposes partly because prices in the market do not only reflect the objective reality. More critically, the only way the traditional approach has in coping with emotional distress is to reduce risk further. The client ends up hopelessly too conservatively invested. And distressed by his periodic emotional outbursts when things dont go quite according to plan.

Financial advisors are increasingly realising the importance of understanding and controlling the emotional state of their clients. And that the behaviour of investment markets cannot simply be explained by the underlying fundamentals of the investments. A whole new field of investment research called Behavioural Finance has drawn attention to a number of behavioural biases that most investors exhibit, and given investors ammunition in coping with their behavioural biases. The starting point of course is recognising the basic emotional errors you are making.

One of the most common behavioural errors is anchoring. Anchoring is the reference point investors use in making decisions. We all use anchoring, but it can lead to inappropriate decisions. For instance, investors that attach too much significance to the entry point of their investment can cling to a stock in the hope that it recovers or sell a stock that has outperformed. The recent market correction for instance saw profit taking on stocks that had outperformed. This resulted in investors offloading stocks whose fundamentals were still positive.

As an investor you need to identify which emotional biases are driving your behaviour as it is only by recognising them that you can begin to control them.