Perhaps the greatest obstacle we have when investing is our own mindset. Our psychology acts against us, preventing us from doing the right things at the right time, and actually driving us to do exactly the wrong things. A skilled investor will work to develop the correct mindset to avoid making these mistakes.
The two psychological factors that affect our investing decisions are fear and greed. Fear prevents us from taking enough risk and tends to make us want to stay out of the markets when we should be buying, for example when the market has fallen in price rapidly and securities are selling at a discount. Greed causes us to take too much risk and to be putting more money into the market when we should be moving money out. Greed’s cousin emotion, arrogance, causes us to think we are better at investing than we are, leading to large risks and truly humbling experiences.
To combat fear, we must step back and look at the market from a broad perspective. Looking at the long-term history of the market (see, for example, http://bigpicture.typepad.com/comments/2005/12/100_year_bull_b.html), virtually all of the time, for any ten-year period, if an investor had purchased “the market,” or a sufficiently diversified index fund that roughly tracked the behavior of the market, one would have made money. This even includes buying at market peaks just before major events like the crash in 1987 (in which stocks recovered just one year later) and periods in the dismal era of the 1970’s. The only notable exception is would be buying in 1928 just before the stock market crash that preceded the Great Depression.
If one were to invest regularly – buying shares every year rather than just putting money in one time and then waiting – one would make money at the end of every ten-year period, including during the Great Depression. The reason is that stocks do not tend to stay down for long. Sometimes the best thing to do when there is a significant downturn is to simply stop looking at statements for a while. Remember that time is on one’s side when it comes to investing.
Perhaps more damaging that fear is greed and arrogance. Greed causes us to buy when prices are much too high to be justified. Greed is what causes us to buy during obvious bubbles, and unfortunately bubbles tend to reinforce this behavior by continuing well beyond the time when they become obvious, making us think that they are not bubbles after all. Arrogance makes us take risks and makes us think that even though many others have lost money doing things like day trading, somehow we are different and will succeed.
The best way to fight greed is to make a personal commitment before starting to invest that one will not keep more in a single position than one is willing to lose. If a stock is going straight up, even though it is tempting to wait for a few extra dollars before selling some shares, one should always ask the question, “would I buy this many shares of this stock at this price today?” If the answer is “no,” sell some shares. Some of the best investors have said they’ve made their money “buying too late and selling too soon.”
Unfortunately, the only cure for arrogance is experience. When I make a mistake and relearn some rule that I should have believed from the start, I call it “paying tuition to the market.” All one can do is to make sure not the pay the tuition for the same mistake twice.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.