Do you remember that sick feeling you had August 24 when the Dow Jones industrial average plunged over a thousand points only to shoot back up by 900 and end the day down 588?

Remember how you felt after weeks and weeks of the financial crisis in 2008? That was probably the stress hormone cortisol talking and it was working hard to shift how you experience risk. How you manage that can be key to your success as an investor.

A March study by nine British and Australian academics published in the September edition of the Proceedings of the National Academy of Sciences of the United States of America found that prolonged exposure to cortisol can increase risk aversion ( http://www.pnas.org/ ). In contrast, a one-off acute increase in cortisol didn't have much impact on attitudes towards risk.

Risk-taking ability In other words, hit one bump in the road and you will tend to maintain speed; hit a bunch of bumps and you tend to slow down.

Much of this will be intuitive to close observers of financial markets. During bear markets, when future returns are in theory increasing, investors are less and less willing to take on risk. During bull markets, the higher the prices, the more willing to take risks investors seem to be.

Cortisol is known to increase when people are put in new, uncertain conditions or those they clearly cannot control. So if volatility makes cortisol rise, what happens to risk appetite when it does?

This study dosed volunteers with varying amounts of cortisol or placebos and then had them play computer games to gauge risk appetite. “Our findings point to an alternative model of risk taking. In it risk preferences are not stable; rather, they are highly dynamic. Such a model might help explain why the risk premium on equities rises and falls with volatility, and why the appetite for risk among the financial community seems to expand during a rising market, and contract during a declining one,” the authors write.

A lesson well learnt This rather implies that investors, who as a species tend to buy and sell at more or less the wrong time, need to accept that they will have these feelings and develop strategies to make sure they are not overly influenced by them.

One way is simple awareness, another is by delegating investment decisions to third parties.

From a more macro point of view, this is an obvious, though again not counter-intuitive, lesson for policy makers. As for the current bout of market volatility, it is uncertain if it has gone on long enough to make a lasting change in investors’ risk appetites.

It really is genuinely difficult to know what exactly the chemical mindset of the market is right now. On the one hand, clearly we’ve had a decent period of higher volatility. But this is after an extended period of very low volatility, almost certainly due to monetary policy. It would be interesting to see what happens to cortisol levels around the possible interest rate rise by the Federal Reserve this week.

At this point a jolt of risk aversion from the Fed may have a big impact. Reuters

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