It’s been said that fear and greed are the two key emotions that come into play when dealing with money. This is the case no matter whether we are investing for the long-term or trading with a shorter-term goal to grow our wealth.
In this article, we will look at a number of psychological traps behind some of the emotions that affect people’s investment decisions. Whether you like to admit it or not, these decisions can have an impact on the growth and performance of your investment portfolio.
For most investors, fear manifests in loss aversion. No one wants to lose money.
How does this affect your investment decisions?
For many people, the fear of losing money translates into holding on to losing shares in their portfolio. In other words, sitting on shares that are falling in value.
This goes against the adage of ‘cutting your losses short’ which means getting rid of any losing stock.
Unfortunately, investors are more likely to try to ride out the fall in prices, relying on the hope that eventually their losing stocks will turn around and start climbing once again.
Hope is very dangerous. The problem with the hoping and praying strategy is that not all of the stocks that turned sour will turn sweet again. Some of them continue to fall and remain losers.
In the worst case, they can fall all the way to zero, or a point at which the company becomes insolvent and its shares can no longer be traded.
So, if you are holding on to a stock whose price is in decline, you may simply be prolonging the pain of dealing with losing stocks (and amplifying your losses) rather than cutting them off straight away.
One effective antidote to this fear of losing money is to set a maximum amount or percentage that you are willing to lose on every stock that you invest in. The idea is to have an exit strategy when an investment turns sour.
While no one wants to lose money on any investment, it is much more realistic to be prepared and have a clearly defined ‘exit’ strategy as part of the overall risk management for your portfolio.
For example, if you allocate $10,000 to a particular stock, you may set a $500 or 0.05% exit limit. This means that if the price were to move against you and the investment fell in value by $500 you should then be getting out of that investment.
This is your risk control strategy.
Without a pre-set dollar or percentage amount to limit your risk, you are more likely to let that loss get bigger.
In the long run, this is unlikely to be good for your portfolio.
Fear can also show up as an irrational or uninformed decision to buy into a stock without prior consideration. Just because most of your friends and acquaintances are buying into a stock doesn’t mean that you have to buy without doing your own analysis first.
Even a quick glance at a stock’s price performance – over a 1-year or 5-year period can give you some indication of its health.
The best thing is to do your own analysis and make an informed decision, rather than just buying because your friends are buying.
In today’s digital and interconnected world, there are many sources of information – price charts, technical analysis, fundamental analysis and stock research – that are available online. Many of them are available for free.
So, make the most of the information that is available to conduct your own analysis of stocks before you buy into any of them.
According to psychologists and behavioural finance economists who have done studies on investment behaviour, the fear of being wrong or admitting to being wrong is a strong emotion among investors.
This is one of the main reasons behind many people’s decision to hold on to losing stocks in their portfolio.
The fact is that stocks (and the market in general) can move up or down or even sideways at times. If you bought a stock and the price moves against you, you must not take it personally or fail to admit your mistake.
That is just the market doing what it does. The stock’s movement is not your fault and it is something totally out of your control.
However, for many investors, it is extremely difficult to accept that a stock has moved against them. They may feel a sense of guilt or stupidity or even feel that the market is out to get them.
For these people, it can be easier to quietly hold on to a sinking stock rather than getting out of it to cut their losses.
As an investor, you need to understand and accept those market movements are beyond anyone’s control. Prices move up and down depending on economic factors, political uncertainties, the sentiment of crowds and many other factors that are not within our control.
The reality is that market movements are not a reflection of yourself. It is not your fault if a share price moves against you. By the same token, you should not get caught up in thinking you are a genius when you manage to buy into a stock that moves higher (unless you can do it on a regular basis – In which case, call me).
The most important thing is to respond accordingly to every market move, whether that means getting out of a losing position or continuing to hold onto a winning position.
This article was written by Alex Douglas, Managing Director of Monex Securities Australia (AFSL: 363 972), part of the Monex Group Inc. and published by Rask Media (https://www.raskmedia.com.au) on 19/12/2018
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