investing james saft

Do you remember that sick feeling you had Aug. 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.

Understanding how cortisol can affect investors and the market as a whole can be key to figuring out what happens next.

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.

In contrast, a one-off acute increase in cortisol didn't have much impact on attitudes toward risk.

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.

"We have found that an acute elevation of ­cortisol has no significant effect on financial risk taking whereas a sustained elevation leads to greater risk aversion, with study participants preferring lower expected return and lower-variance bets," the authors write.

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 uncertain conditions they clearly cannot control.

An earlier study by the group of London-based financial traders found that as volatility increased over an eight-day period the mean cortisol level of the subject shot up by 68 percent.

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.

Master yourself, observe others

This rather implies that investors, who tend to buy and sell at more or less the wrong time, need to accept that they will have these feelings and to make sure they are not overly influenced by them.

One way is simple awareness, another is by delegating investment decisions to third parties, preferably institutions with a better chance of operating within frameworks that discourage chemically driven buying and selling.

The study says very little about bull markets and how to avoid the possibly chemically generated ­mistakes they engender.

From a more macro point of view this is an obvious lesson for policymakers. Global central bankers seem to have learned that acute and long financial events require shock therapy to avert panic selling. What policymakers seem less good at is returning to neutral.

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. In China surely, in the United States perhaps.

"One-off stress events won't drive dynamic risk aversion. We need a sustained period of stress and chaos to change hearts and minds," Wesley R. Grey, of asset allocation and investment firm Alpha Architect, wrote in a note to clients.

"The recent turmoil in August, and now into September, may not be enough sustained stress to change minds, but if the drama continues … watch out!"

It really is genuinely difficult to know what exactly the chemical mind-set 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 coming week.

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

James Saft is a Reuters columnist.