When making investing decisions, we know it is better to control our investing emotions and use a logically based investing process. When times get tough, and it looks like the market will never stop plunging, we tend to let our emotions get in the way. When emotionally based investment behaviour controls our investing decisions, count on losing money. Recognizing an investment behaviour that allows the investing emotions to get in the way is a critical first step toward avoiding them.
Richard Thaler and Cass Sunstein, in their book titled Nudge: Improving Decisions About Health, Wealth, and Happiness, describe some of the investing emotions that affect our investment process and how we might deal with them. When the market is trending down from the upper right to the lower left, we can easily get caught in some of the following investing emotions.
Loss Aversion. There is a tendency to believe that if we do not sell a stock that has fallen well below our entry price isn’t really a loss. If we ignore the stock may be, it will get better. By not selling, we do not have to recognize it really is a loss.
Other than calculating a tax loss, it does not matter what price you paid for the stock. The only thing that matters is what it is worth today and what your assessment of the potential for the stock is over the next few months or years, depending on your time frame. Each day you should think, given what I know now, would I buy this stock at today’s price? If the answer is yes, then hold on to it. If the answer is no, then sell it. Do not let the investing emotion of avoiding a loss get in your way.
Head in the Sand. When you hear the market has fallen again, continuing its plunge, there is a tendency to hide from the reality of the situation. Hiding from the market will not make it get better. The ostrich puts his head in the sand to hide from its predators. Do not do the same with your investments.
Make a thorough assessment of the situation. If your prognosis is things will get worse before they get better, then change your portfolio accordingly. Warren Buffett’s first rule of investing is “do not lose money.” By following this rule, you will go a long way in reducing this investing emotion.
Anchoring. People develop attachments to things. To some, a house is the most essential item. Others can become attached to a particular investment, believing it will recover its lost value. Often people place too much importance on what someone told them was an excellent investment. Maybe it is a perception that the company was good for them when the market was going up. Known as the “endowment effect” in behavioural finance, investors tend to assign greater value to what they own than what they do not own, regardless of its actual value.
If you find yourself holding on to a stock hoping it will recover to its prior level, you need to step back and assess your current situation. Stocks are not friends or family. There is no reason to keep them if they do not meet your expectations. Conduct your regular investing process assessment of each stock dispassionately. If your analysis says there is a potential problem, then sell it. Closing out a position for cold hard financial reasons is a good action. It removes the emotional attachment you have for the stock. Once you have withdrawn your investing emotions, you can return to your rules for investment that work.
Following the Herd. Even when the market is falling, it is easy to go with the crowd. If they are sticking with their stocks, 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 sell. When our analysis tells us to get out, despite what the crowd says, take action to protect your capital. Do not let you investing emotions to control what you know is the right thing to do.
Every good investing process has an exit strategy. Execute yours without fail. The herd may believe the market will recover quickly. If your investing process tells you otherwise, stay true to it.
To control this investing behaviour, never stop doing your homework. Especially continue to assess the risk of your positions. Always employ risk reduction strategies that include selling when a trailing stop is hit. 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 fell further in value.
The Bottom Line
Investing in emotion is one of the behaviours we can control by sticking to one’s investing process. 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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