Knowing what we now know about emotions in investing, we can start to understand how they impact returns. These impacts including
- Buying too late
We might see an opportunity or stock we like, do our research, get comfortable with it, but fail to act because we concerned and paralysed by potential losses. It is important to understand that this is natural and because with nothing else at stake we are more concerned about the pain of losing things than gaining them.
This will often mean, however, that the ‘kick’ we need to jump in is for the stock to start rising! Therefore, we will often do all the hard work, and then let others take the first few moves before we invest.
- Selling too late
Keeping with the same theme as the point 1, point 2 is about selling too late. Because realised losses are more painful than unrealised losses, and because we often ignore and avoid things that bring us pain, we can often let our losses run for too long.
This can mean that when we make a mistake and a company doesn’t perform as expected we might not sell on the first profit warning (and take the one day 15% hit) but convince ourselves it will grind higher in the next few weeks. Inevitably, it doesn’t, and we suffer more losses whilst waiting for the turnaround.
- Painful trades
Unfortunately, its not as simple as buying or selling earlier! There are two things that stop us doing this with ease.
A) Doing either early is painful! To buy a stock down in the dumps requires great mental fortitude and conviction, a belief that the market is mostly wrong and you are right. Similarly, to trade out after the first profit warning requires us to admit very quickly that we were wrong, which is unpleasant, but also to take the losses.
B) Even worse than that – sometimes it is wrong to trade out early and sell at the first hints of trouble! Ultimately, investing is probabilistic. If we knew we had the perfect system we would happily ignore our emotions and stick to the plan. However, none of us has that system, so we look for guidance from elsewhere, including our gut and emotions, to aid our decisions. The examples go both ways, but its not always the case that at the first sign of a stock declining in value that we should sell. It’s about trying to assess the signals – did the stock go down for a reason that makes me change my investment thesis, or is it just noise?
Therefore, sometimes we should tough it out and make those painful decisions to trade/not trade and ignore our base instincts.
How to combat… At Journal.investments we have tried to build a set of questions to consider and answer before making a trade that probes these questions. If you have any others to add please let us know at firstname.lastname@example.org