Investing in Frontier Markets: Opportunity, Risk and Role in an Investment Portfolio

CHAPTER 3

Volatility: Not the Same as Risk

Many investors have been deterred from investing in emerging markets due to their perceived high level of volatility. Some believe that such volatility relegates these markets to “risky” status, meaning that due to these markets' sharp rises and falls, potential investors will run a high risk of losing some or all of their capital invested in these countries. To believe this is to confuse volatility with risk, an error that is widely made and entirely understandable but that often prevents people from enjoying the benefits of undervalued investments.

Studies of behavioral psychology by numerous observers, including Daniel Kahneman, winner of the Nobel Prize for Economics, conclude that the inherent mental biases that all of us possess make us bad investors. The human habit of using mental short cuts (sometimes called heuristics) makes us bad judges of the attractiveness of different investments, prone to overconfidence in our decisions once we make them—to the extent of ignoring contrary evidence—and reluctant to incur losses if our decisions are incorrect.

Kahneman and others find that the emotional pain of realizing a loss is between two and three times as great as the pleasure of booking a profit. We therefore have a tendency to sell winners and keep losers, the exact opposite of what is required to become a successful investor.

These traits are reinforced by a natural dislike of sudden changes, which the rational part of the human ...