When making investing decisions, we know it is better to control our investing emotions and use a logically based investing process. When times are good, and we are making money in the market, we tend to let our emotions get in the way. When emotionally based investment behavior controls our investing decisions, count on losing money. Recognizing an investment pattern that causes the investing emotions to get in the way is a crucial first step toward preventing it.
Richard Thaler and Cass Sunstein, in their book titled Nudge: Improving Decisions About Health, Wealth, and Happiness, describe some of the investing emotions that tend to get in our way and how we might deal with them. When the market is trending from the lower left to the upper right, we can easily get caught in some of the following investing emotions.
Following the Herd. It is easy to go with the crowd. If it is safe for them, it must be safe for me. However, we should pay attention to those little signals we get that something might not be right. This is especially true if our investing process tells us to take precautions. When our analysis tells us to be careful, despite what the crowd says, take action to protect your profits.
If your stocks are the ones that everyone discusses at the cocktail parties, then you know you have become part of the herd. That doesn’t mean you should close these positions. It does mean you should reevaluate why you own them, whether you should keep them, and what is your exit strategy.
False Sense of Security. When things are going well, investors can be lulled into a false sense of security. The market keeps going up, and our portfolios are rising with it. We might even take on more risky investments, buying into the hottest securities in an attempt to increase our returns. When the gains come easy, investors tend to think that they know it all and lose their sense of concern. When this happens, it is an indication that you have become vulnerable to letting your investing emotions take over.
Whenever you feel this investing behavior, re-examine your positions on a frequent basis to be sure you are considering what is going right and what could go wrong. Be ready to take action should the positive trend turn against you. Always think about what might change the current good trend. A little contrarian perspective will not hurt.
Risk Avoidance. The best professional investors focus first on the risk they are assuming. Moreover, they formulate what they will do to manage the risk. Then they examine the potential return. This process helps them to keep their investing emotions at bay.
When things are going well, there is a tendency to ignore the risk you are incurring. After a nice long-term rally, the risk of a reversal increases. If you are unable to articulate the increased risk you are assuming, it is an indication that you may be avoiding the growing danger of your positions.
To control this investing behavior, never stop doing your homework. Continue to assess the risk of your positions as they grow in value. Always employ risk reduction strategies that include selling part of your position after a nice run-up. Be sure your trailing stop is where it should be. Consider using covered calls and protective puts when the risk parameters could be higher. No one went broke selling positions that were profitable.
Forgetting to diversify properly. When we are making money in the market, and our portfolio is increasing in value, we tend to congratulate ourselves on what a great investor we are. Over time, our portfolio might become too concentrated on one asset without us even realizing it. This might work if the asset class is a leader in the market. Eventually, the time will come when money will shift to other assets, leaving you behind. Even worse, your portfolio could turn down and in a hurry.
To manage this investment emotion, at least quarterly assess whether you have become too concentrated in any one asset. If it looks like a few stocks have grown significantly, then it might be time to take a little off the table. Consider selling half of each winning position and putting the money to work in another up-and-coming area. The remaining half of your best stock can still keep running with a trailing stop protecting your growing profits. Only now, you are playing with the house’s money.
Investing in emotion is one of the behaviors we can control by sticking to one’s rules. When our investing emotions get in the way, we tend to make mistakes that will cost us. When things are going well, it is easy to forget to follow proper investing rules. Take steps to recognize the symptoms and then go back to your proven investing process. Your portfolio will thank you.
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