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martes, 9 de febrero de 2016

The role of fear in investment

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Sure we've all read a book or article on sectors, markets or companies with potential, deep fundamental analysis, or interesting investment systems.

But investors and traders less often discuss a subjet that ultimately has as much or more influence on investment: psychology in general and in particular the fear that an investor feels at some point.

When the market falls hard and savings that has cost so much effort to get lost value per minute, is inevitably to feel fear.

What is fear?

From a physiological point of view, as we notice a potential threat our brain secretes a substance that causes a biochemical change in the flow of dopamine, creating an imbalance in serotonin levels and initiating the perception of an unpleasant sensation. A simple bad smell can trigger this process by inducing a small stress reaction.

A clear threat feeling can significantly alter biochemical balance, so that further increase stress levels. This part of our brain has a highly autonomous response and comes from the remains of the reptilian brain.

It can cause a extreme survival reaction which is known as fight-flight reaction. The body prepares to face the situation as the danger lies ahead. We are ready to fight or flee. That's what has kept up with the evolution of humans. Thus, the most capable individuals to face the danger and fight/escape were those who survived and perpetuate the species.

That jerk reaction of fear stems from the oldest prehistoric times, when our ancestors were walking across the savannah and appeared a hungry lion that directly threatened their safety and that of their fellow people. This reaction have the same sense in our times? The short answer is no. Nobody is going to eat us as a snack in a city in the XXI century; However evolutionary adaptation remains, and we must face other dangers that cause exactly the same reaction we had thousands of years ago. Now is not a lion, but it can be a car, or it may be the fear of losing money which provide us with necessary goods.

Fear on investment

In 2008, during the subprime crisis, we had many media reports and analysts that gave us reasons to fear, a feeling that grips financial markets:
  • Advanced economies will not return to remarkable growth rates over many years.
  • Unemployment rates will remain high at least until 2020.
  • The risk premium of the economies of southern Europe will continue into the air and sovereign debt will be rampant..
  • Europe and the United States are on the wane, their role will be replaced by emerging economies, especially China, but also Russia and Brazil.
  • Oil could continue to rise above $150/barrel with a catastrophic impact on inflation and the productive economy.

In hindsight, we see that none of this has been accomplished, and we simply attended the cyclical downturn that periodically occurs.


Now, after several years of global growth, especially in the United States we have new threats:
  • Employment is recovering too slowly.
  • GDP grows in Europe and the US irregularly.
  • The risk premium has been reduced by the intervention of the central banks, but the debt is too high.
  • Emerging countries are a time bomb, especially their debt.
  • Oil breaks down below $40/barrel, which remains a threat to global stability.
We see that many of the messages are contradictory. In 2008, the high price of oil was a problem, in 2016 the problem is just the opposite. Therefore, we will always find potential threats to our investments.

Some tips to avoid being seized with fear

  • Distraction: In times of stress is advisable not to trade. Likewise it is recommended not to shop in that situation, let alone to manage our investments.
  • Value and price: An investment is neither better nor worse trading at $10 or trading at $15, is the same. Always focus on value, not price.
  • Be aware of your own limitations: If we are very anxious then perhaps it is better not to trade with the open market and use pending orders without looking at the market.
  • Consistency: If we are long-term investors (years), why look at how is evolving our portfolio every day?

Conclusion

Says one of the best investors in history, Warren Buffett, "The most important quality for an investor is temperament, not his intellect."

We all know that to invest in the stock markets with some success is not necesary to be an expert in finance, but it is important to have a defined strategy and follow it with conviction. In this context, the psychology in general and fear in particular have a very important role, so it is important to know our weaknesses and learn to manage them.




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