Nothing is more important to investors, than understanding, how much are they willing to lose. But the hardest part is to achieve this understanding, before it's too late.
The sharp fluctuations in the US stock market this month after three years of steady gains still haven't reminded us all, how unpleasant it is to lose money.
People masterfully distort their memories and forget facts.. Many investors, panicked in 2008-2009, today they firmly believe in their ability to survive another crisis with a stone face. At the same time, the standard test for the ability to remain calm in dangerous situations does not at all allow predicting the reaction of financial managers to losses., if only because different people perceive risk differently.
Scientists are interested in this problem. University College London Research Fellows Team, University of Sydney, University of Pennsylvania, New York University and Yale University published research in the Journal of Neuroscience, which revealed, that the willingness to take financial risks is closely related to the density of cells in a particular area of the brain.
Experiments show, that the thickness of the gray matter layer in the right posterior parietal lobe of the cerebral cortex - a small area near the back of the skull - is directly related to the ability to cope with dangerous situations.
One of the study's authors, neuroscientist Paul Glimcher of New York University says:
"People, with a large amount of gray matter in this area, will, on average, have an increased tolerance to financial risks ".
Duke University biologist Scott Huettel comments on his colleagues' discovery:
"This study is the first to establish a link between brain structure and risky decisions.".
As noted by psychologist Elke Weber of Columbia Business School, the ability to remain calm in dangerous situations depends on the type of activity and context and is not a "fundamental character trait". You can be a gambler in Las Vegas, but invest in cash and bonds.
Probably, the worst risk for most investors is "deviating from the long-term plan in pursuit of short-term emotional well-being during times of turmoil.", as Greg Davis put it, Head of Behavioral Finance Research at Barclays Wealth and Investment Management, a division of Barclays PLC.
What risk can you handle? Alas, science is not yet able to accurately calculate this value and issue personal recommendations, relying on measurements, so try to handle it yourself. For that, to predict your own behavior, you need to decide on a few questions.
What did I do in the last crisis?
Possibly, memories of, how you turned pale and crawled under the table, clutching at the heart, have faded somewhat over the years. The only way to know for sure is to dig up old account statements.. The one, who sold shares in 2008-2009 years, probably, will do the same on a new wave of panic. Definitely, under such prerequisites, it is not worth increasing the share of shares in the portfolio more, than in 2007 year.
How flexible are my goals?
The ability to withstand risks does not only depend on, how much money is in the account, but also from plans for the future. If you are determined to buy that charming cottage next year, your ability to take risks is much lower, than one might think, just looking at the state of the account.
What risks am I protected from??
Financial advisors fill their clients' portfolios with high-yield bonds and debt securities of developing countries and bank lending funds. During the crisis, these profitable, but risky investments lose in value no less, than US stocks. Best Insurance Against Falling Stocks - High Grade Cash and Bonds.
Have I developed the right habits?
If there is peace and quiet around, it is human to believe, that he will do the right thing even in the most difficult situation. However, it is possible to remain calm in the midst of panic., only if your actions are honed and the right actions become a habit. If this month you have already specified the value of your stock portfolio - forbid yourself to check your personal accounts, while the markets are open. If you cannot make this rule your habit - probably, you have invested too much of your capital in stocks.
