Successful investors are able to ignore their emotions when they make a financial decision. This is particularly true with shares. In this synopsis of an essay ‘The Emotions of Risk’ by Richard A. Geist, a psychologist, we think about some of the different kinds of emotions we feel about our investments. Recognizing these emotions and their likely sources can help us improve our decision making skills.
The result of any investment decision is always uncertain because of these unpredictable factors:
- the company and its management;
- other investors in the marketplace;
- the randomness of world events; and
- the psychological reactions of investors and our own reactions to the above factors.
An investors attitude depends on experience. Someone born on the plains expects the ground to always be even, constant, predictable. Someone born in the mountains is much more careful when he goes for a walk, expecting a landslide at every incautious step. It’s the same with investors, some have had an easy ride, others have memories of disaster. They carry their experiences with them as if what happened in the past will continue into the future forever without end.
Definitions of Risk
The way we measure risk is by volatility. If a company’s price is always falling and rising by 20% more than the market, then it is a risky, or volatile, investment. Investors who buy volatile stocks need to be compensated by expecting a higher reward than they would get from the general market (market return).
When looking back at our trading results, in addition to the profit or loss, we should also think about:
- how long the investment lasted;
- how greatly the loss of the investment would have affected our wellbeing;
- the amount of fear we experienced; and
- how much volatility we accepted
among other things.
Some techniques we can use to lower the chance of loss include:
- dollar cost averaging;
- low expenses;
- minimum turnover;
- careful asset allocation;
- buying with a margin of safety;
- sell disciplines;
- careful fundamental evaluation; and
- valuation of companies.
The Psychological Capacity for Assuming Risk
There are two types of risk: systemic risk and company risk.
Systemic risk includes factors such as interest rates, inflation and credit crunches. These are the unavoidable risks which come simply from being in the market.
Company risk includes all the factors that affect individual companies, such as management, product, services, industry and business decisions.
Company risk can be diversified away by owning 10 to 15 stocks in different industries. but this is no guarantee against loss, only against losing everything at once.
How much risk you are willing to take depends on your age, income, savings, future needs for cash, investment time horizon etc.