It’s no secret that learning to manage one’s emotions is instrumental to both personal and business success. Some of the world’s top investors have cited emotional control as a major contributor to attaining great wealth.

Behavioural finance is a relatively new field which melds cognitive psychology and finance and economics into a single discipline. Traditionally, economic theory has suggested that for the most part investors are “rational wealth maximisers”. But research within behavioural economics has gained considerable traction, refuting the concept of homo economicus or the rational human being.

Professor Daniel Kahneman, the renowned Nobel Prize-winning Israeli-American psychologist, has made great contributions to this field. He and Amos Tversky in 1979 published a paper titled ‘Prospect theory; An analysis of decision under risk’. They found that people reacted differently when it came to assessing risks, that we often don’t consider information rationally, and that people’s attitudes towards risks concerning gains could be quite different from their attitudes towards risks concerning losses.

For example, they found that if one was losing $1,000, one would take certain risks hoping that the $1,000 loss is minimised, but all too often it just gets bigger. Conversely, if we’re making $1,000 in profits, we often minimise the risks of giving profits back and take or realise the gain. In other words, as many of us hate taking losses, we very often allow losses to get bigger (i.e. take risk with losses) but instead of maximising our profits, we realise them, out of concern they may disappear. In short, we do the opposite of the famous trading maxim, which suggests we should “let profits run, and cut losses short”.

In essence, prospect theory suggests most investors are pre-programmed to “cut profits short, and lets losses run”. We tend to take small gains and large losses, not exactly a recipe for success. The ability to take small, manageable losses may intuitively appear easy to do, but in reality loss aversion (the tendency to intensely favour avoiding losses) is quite common place.

Human psychology, if left unchecked, can have negative consequences on trading performance. It’s very easy to get overly emotional, especially during times of stress, or to freeze just as an important decision is necessitated. Discipline is cited by many top investors as an important component to investing success. The ability to think rationally and to follow a predetermined plan is necessary. “Plan your trade and trade your plan” is another often-cited Wall Street saying.

Overconfidence is another detrimental emotion. In a 2006 study of 300 professional fund managers, some 74 per cent of respondents believed their performance was above average, and the other 26 per cent considered their performance average. Not one of the 300 respondents considered their performance below average.  In a 1998 study, researcher Terrence Odean found that overconfident investors believed they were empowered with more skill, and as a result traded more actively than their less-confident counterparts – increasing trading costs and reducing returns.

Although greed, hope and fear are common to the investment process, they are emotions which must be managed. Hope is a dangerous emotion, which often impedes us from realising manageable losses, or staying with an investment too long “hoping” profits get bigger.

Hope is a “crutch” which keeps us from reasoning rationally and making difficult decisions. When greed sets in we often have expectations of unrealistic profit potential or take excessive risks in the hope of seeking larger profits.

Fear, on the other hand, can lead us to panic, or to exit good positions, in anticipation of ensuing normal corrections. For example, the SP500, a large capitalisation US equity index, has since the 1920s experienced 16 bear markets with average 38 per cent corrections. It’s pointless to fear these quite normal events which occur roughly every five years. Astute investors condition themselves to accept these inevitable bear markets, and use such occasions as buying opportunities. It’s also the fear of losing hard- earned savings which often compels us to engineer well-intentioned ‘safe’ portfolios, which produce poor returns. Although capital guaranteed structured products may seem like a wise and safe bet, they also often produce low or no returns. On the other hand, sometimes the fear of losing out on large profits induces us to buy overpriced shares, which have already experienced large runs.

In short, our emotions, if not checked, can have a very deleterious effects on our investment returns. Risk and portfolio management must go hand in hand with the management of our emotions to result in investing success.

Joseph Portelli is the managing director and chief investment officer at FMG Funds (Malta). He also is a lecturer at the University of Malta and Institute of Investment Analysis.