Psychological and emotional aspects of investing in today's markets

China's 'Black Monday' wiped hundreds of billions off the world's financial markets last month as shares took a beating - and investor sentiment slumped. Locally, the influence of the weak rand has added to concerns, prompting indecision about what investment strategy to follow.

Individual investors have a tendency to be caught up in the emotion of the moment, particularly when losses start to mount. We all know that fear and greed drive the markets - for example, bias, greed or overconfidence may see investors holding a position for too long, while the fear of loss may cause them to sell at too low a price, or exit the market too soon. In their eagerness to make money (or not lose money), they ignore some of the red flags they would pay attention to if they followed a more analytical approach, as institutional investors tend to do.

Role of intuition

"Increased market volatility leads to emotional responses like fear or jubilation, leading us to make mistakes and acting when we frankly shouldn't," says Simon Brown, director of JustOneLap. Many of the decisions we make on a daily basis are informed by intuition and we may not always realise this, or allow the realisation to inform our behaviour.

Brown says an investor should ideally not bring emotions into play at all - but because we are human, this is obviously impossible. "Typically, when markets move lower, people worry they have made a mistake or think the markets will collapse and they will not get a positive return on their investment. The best investor is ruthless and unemotional so he or she can do the right thing at the right time every time," says Brown.

Research shows that understanding others helps rather than hinders an investor - good investors can work out what people around them are thinking and how they might react under different circumstances. A good investment strategy, then, is to read your own feelings and analyse them rather than simply act on them; being able to regulate your emotions means not giving in to fear or anxiety in a given situation.

"True investors don't worry about volatility," says Brown. "It comes and goes. An investor with a passive long-term holding isn't worried about short-term noise."

Risk-averse strategy

But what about those investors who are so fearful of losing that they fear investment itself? Adopting a risk-averse investment strategy means showing a preference for a known rate of return over a potential rate of return, even if that known rate of return is lower.

There is nothing wrong with this approach - in fact, it will prevent huge losses - but investors should know that any rewards will obviously be limited. "On the plus side, an instrument with downside protection will help nervous investors sleep better at night," says Brown.

Structured equity products, for example, may expose investors to offshore markets while making sure risk exposure is minimal. They are not unlike ordinary bank deposits, except one accepts a degree of risk in exchange for a higher return than available interest rates.

Brian McMillan of Investec Structured Products

"Investors are usually faced with two typical investment choices; investment in shares - which have historically provided a better return than interest but with volatility along the way and capital at risk - or investment in, say, an interest-bearing investment or fixed deposit account in the bank. The latter provides capital protection and known interest payments," says Brian McMillan of Investec Structured Products.

Combined styles

"We have found that it is possible to combine these investment styles within a single product. You have the chance to outperform interest rates, should the equities market increase. At the same time the capital protection means that, at the very least, you will not lose your investment capital."

Such products have been around for a couple of decades but are becoming increasingly popular in today's volatile climate - the ability to extract leveraged returns from equity markets is something of a boon. Brown says investing in these products greatly reduces fear, because fear is all about aversion to downside risk. "But the greed factor can still be satisfied with potential for enhanced upside returns," he adds.

While it is obviously not possible to predict what the markets will do tomorrow, it is possible to analyse how markets have performed today in assessing the likelihood of their performing similarly tomorrow. For example, only the investor with a healthy risk appetite will plunge into China's market at this juncture. The US market seems a safer bet. "US markets are likely moving higher over the next three to five years as the economy looks strong," says Brown. "The USD will potentially strengthen, especially when the Federal Reserve starts to raise rates."