Whether you are a novice investor or a seasoned, professional investor…you are going to mistakes in the stock market, it is inevitable. Sometimes we buy the wrong stock at the wrong time, we sell winners too soon, we hold on to losers for too long, we overweight a wrong sector, and, worst of all, we get caught up in our emotions and chase a stock price.
It happens to everyone, including me, though with less frequency 😉
I have always tried to learn from my investing mistakes and too often have I been my own worst enemy (here’s a list of investing mistakes you would want to avoid). Two classic investment mistakes I used to make were
1. Chasing a stock price (i.e. I am buying a stock even though it has already increased in price);
2. Holding on to a losing stock for too long.
In both cases, emotions got in the way of rational investment decisions.
In the first case, chasing a stock price, you are eager to buy a stock that has already greatly increased in price and fearful that you are missing out on future price appreciation (this is also called ‘FOMO’, the fear of missing out). So even though the valuation of the stock may not make any sense anymore based on fundamentals, FOMO is so strong that you buy into a stock at a sky-high valuation. Think about buying Netflix at $420/share…
In the second case, refusing to sell a loser in your portfolio, you exhibit what’s called ‘regret aversion bias’, which means you cling on to hope in order to avoid dealing with regret. The psychological reason for this is that you want to avoid the emotional pain and regret that comes with taking a potentially massive loss.
In both cases, obviously, the rational things to do would be 1. Not to chase the stock price if the valuation doesn’t make any sense, and 2. To sell a stock through automated Stop-Loss orders in order to limit your downside.
Unfortunately, our emotions can trick us many times, and that’s especially true in the stock market where wild price swings can affect investors’ moods rather quickly.
That being said, though, there are a couple things you can do to counter the likely negative impact your emotions might have on your investment decisions.
1. Be Aware Of Your Emotions
Once you know that your emotions play tricks on you and negatively affect your investment behavior, it will be easier to keep them in check.
2. Be Honest With Yourself
Honesty is hard for a lot of people, but honesty with yourself will do you a great service in the stock market.
Are you buying a stock because you think the value proposition is great, or simply because of FOMO? Are you avoiding to sell a loser because you cling to hope and want to protect your ego?
3. Use A Checklist
You can ask yourself before you buy or sell a stock whether you adhere to your investment criteria. Like a pilot before his flight, go through a checklist and question your motivation for your investment actions before you do anything.
Does this stock meet your investment criteria in terms of risk and potential returns? Is the valuation reasonable? Does the stock fit into your asset allocation? Develop a checklist to guide you through the purchase and selling process.
4. Use Stop-Loss Orders
Stop-Loss orders are useful to limit portfolio losses if a position quickly turns against you. A Stop-Loss order tells your broker at which price a stock should be dumped automatically. Say, for instance, you bought Apple stock at $160. If you place a Stop-Loss limit at $150, your broker will automatically sell your Apple shares when Apple’s stock price falls below the $150 price level. This way you are automatically protecting yourself against further downside.
Oftentimes, we are our own worst enemies in the stock market. Our emotions interfere with our rational investment decisions all the time, which in turn can hurt our overall financial results badly and put our long-term financial goals at risk. We can counter these negative influences by being aware of our biases, and utilizing checklists and Stop-Loss orders in order to protect us from irrational investment decisions.