Trade psychology - risk management

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Active monitoring of a portfolio is important for navigating the changing tides of financial markets. Still, it is also essential for individual investors to manage the behavioral impulses of emotional buying and selling that can come from following the market's ups and downs. Indeed, investors seem to have a knack for piling into investments at market tops and selling at the bottoms because it is not uncommon to get entangled in media hype or fear, buying investments at peaks and selling during the valleys of the cycle.

How can investors navigate volatile markets while also keeping an even keel and keeping a portfolio diversified for the best overall returns through all types of market environments? The key is to understand the motivations behind emotional investing and to avoid both euphoric and depressive investment traps that can lead to poor decision-making.

Investor Behavior Investor behavior has been the focus of many studies and numerous theories attempt to explain the regret or overreaction that buyers and sellers often experience when it comes to money. The reality is that the investor's psyche can overpower rational thinking during times of stress, whether that stress is a result of euphoria or panic. Taking a rational and realistic approach to investing—during what seems like a short time frame for capitalizing on euphoria or fearful market developments—is essential.

Bull vs. Bear Markets Bull markets are periods when markets move up relentless and, sometimes, indiscriminately.1 When the bull rages and investor sentiment becomes one of general exuberance, investors might see market opportunities or learn about investments from others—such as news stories, friends, co-workers, or family—that may compel them to test new waters. The excitement might lead the investor to try to obtain gains from investments that are emerging due to bullish market conditions.

Likewise, when investors read stories about a bad economy or hear reports about a volatile or negative market period, fear for their investments can fuel selling. Bear markets are always lurking around the corner and come with many of their own caveats that can be important for investors to follow and understand.2 In contrast to a bull market, sometimes financial markets can trend lower for many months or even years.

Oftentimes bear markets evolve from an environment of rising interest rates that can spur risk-off trading and a transition from riskier investments like stocks to low-risk savings products. Bear markets can be difficult to navigate when investors see their equity holdings lose value while safe havens become more enticing due to their rising returns. During these times, it can be hard to choose between buying equities at market lows or buying into cash and interest-bearing products.

Bad Timing Emotional investing is often an exercise in bad market timing. Following the media can be a good way to detect when bull or bear markets are evolving because the daily stock market reports feed off the activity occurring through the day, which can at times create a buzz for investors. However, media reports can also be outdated, short-lived, or even non-sensical and based on rumors.

At the end of the day, individual investors are accountable for their own trade decisions and therefore must be cautious when seeking to time market opportunities based on the latest headlines. Using rational and realistic thinking to understand when an investment may be in a development cycle is the key to evaluating interesting opportunities and resisting bad investing ideas. Reacting to the latest breaking news is probably a sign that decisions are being driven by emotion rather than rational thinking.

Time-Tested Theory The notion that many market participants buy at the top and sell at the bottom has been proven by historical money flow analysis. Money flow analysis looks at the net flow of funds for mutual funds and often shows that, when markets are hitting peaks or valleys, buying or selling are at their highest.

Market anomalies like a crisis can be useful time periods for observation. During the financial crisis of 2007–2008, investors withdrew money from the market and money flows to mutual funds turned negative. The net fund outflows peaked at the market bottom and, as is typical for market bottoms, the selling created overly discounted investments, which eventually formed the basis for a turning point and the market's next ascent upward.

The Bottom Line Investing without emotion is easier said than done, but there are some important considerations that can keep an individual investor from chasing futile gains or overselling in panic. Understanding your own risk tolerance and the risks of your investments can be an important basis for rational decisions. Active understanding of the markets and what forces are driving bullish and bearish trends is vital as well.