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Know Who You Are |
No two individuals are alike. Even two twins have very different emotional and intellectual levels. Remember, your behavior in your investment life will be fairly close to how you handle things in your daily life. So if you see red flags in your fiscal behavior, you might want to address them before you start investing yourself.
Whether you’re a millionaire or have a $5/hour job, a proper investor behavior is the most important factor is your success. Without proper investment behavior, even the most sophisticated investment strategy is doomed to terrible failure. Two most important factors that will shape your financial futures are greed and fear. Some people are greedier than other, just like some people are more fearful than other. Whether you realize or not, these two aspects of human nature are the key to your success or failure as an investor.
Here is an example of how investor behavior can dictate investment success. One of the recent example is the dot com bust. In the late 1990s, the great tech rally attracted many investors. It was easy to understand why many investors would have invested so much in technology, as it was easy money, and high double-digit and even triple-digit returns were commonplace. Things were so crazy that if you bought a stock in January, it doubled or even tripled by March. There was no concern for established stock market benchmarks such as P/E, earning, revenue etc. NASDAQ index went from 2,000 to over 5,000 in less than 3 year. Some people made lot of money and even an average investor would have made decent returns by buying any high flying hi-tech companies. What happened here was that many investors abandoned their investment strategy and poured all or a large portion of their investment capital into tech stock. However, when markets corrected by more than 10% in a small timeframe with no steam to move up again, that would have been the first red sign. Anyone with sound investment strategy should have bailed out at this point. However, most people were driven by greed and not reasoning at this point and stayed in hoping for another quick rise that never happened. Bottom line, billions of dollars were lost with some investor going bankrupt. Moral of the story – keep a close eye on your emotions and don’t let them make your investment decision. Fear is also a main reason why most people can’t make money in stock market. You see a good stock falling and find it well below its intrinsic value but you hesitate and get scared of putting your money in it. What happened next? Well, stock usually recovers quickly and you miss out on a golden opportunity to invest and make money.
Proper investor behavior means not getting carried away by fear or greed, and it is just as critical in bull markets or bear markets. Remember you can lose a fortune by investing in the stock market.
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Understanding Your Investment |
What kind of investor you are? Do you like to research things on your own before you make investment decision or you just read online message boards for stock tips? Don’t get me wrong, you can make money by getting tips from online message board, but who is responsible for your losses? What if tip doesn't work out? You need to figure out why you are buying a particular stock—don’t wait until its price goes up or down to think about it.
Warren Buffett said that when he looked back over his investments in his early partnerships, the larger investments always did better than his smaller ones. He attributed this to a "threshold of examination and criticism and knowledge that has to be overcome or reached in making a big decision that you can get sloppy about on small decisions." If you are going to be an individual investor, it is critical that you stay away from so called “stock experts'. There are a large number of so-called experts floating all around. Stay away from them. Your broker, friend, coworker may suggest hot stocks, listen to them but don’t act on your advice unless you do your homework and agree that it makes sense to own a particular stock. Remember, investing is not for people daydreaming of becoming millionaire overnight. It takes diligent planning and lot of good judgment.
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Plan Your Investment |
Don’t just buy a stock because it has gone up 10% in two days. You need to convince yourself that there is a better reason to buy rather than quick price movement. Do keep in mind that it is not always that you would be able to buy a stock when it is as its lowest price and sell it when it is at its highest. It doesn't work that way. No matter how smart you are or how much planning you do before you make a trade, you will never be 100% right. When selling a stock, there will always be a chance that you got out too quick and when buying a stock there is always a chance that you paid too much. There is no way anyone can time the market every single time so stop worrying about it and take what you can get. Take your time—you are investing for your future.
Buffett once said that he doesn't get paid for activity, just for being right. "As to how long we’ll wait," he continued, "we’ll wait indefinitely." No one makes you buy a stock. If you know what type of investor you are, and why you would buy a particular stock, then you will be better able to determine a reasonable price to pay for it. Then you can quietly wait until Market offers it to you at your price.
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Diversification and Asset Allocation |
It is easier to fall in love with a stock and this emotional attachment can cause you deep financial losses and stress. Remember, you don’t own a company, just a stock so there is no reason to stick with a stock that is obviously in trouble. You need to make your investment decisions based on the performance of a company and not by your perception of this company. Also, there is a good reason why everyone tells you to diversify. You could make lot of money by investing your all your money in a high flying stock but what are you going to do if it falls? Remember, a 50% loss will require you to achieve 100% gain on your next trade just to break even. So it is imperative that you do not take steep losses otherwise you’ll spend all your investment years in recovering from them. Technically you should not invest more than 10% of your money in one stock. Even 10% investment in single stock is considered high by most standards. You should also spread your investment across different industry groups. For example, putting 10% of your money in 10 tech stock s is still a very high risk investment since all tech stocks can fall if technology sector falls out of favor. If you can’t pick specific stocks in different sectors, consider purchasing ETF(Exchange traded funds) for that sector. ETFs provide a great way to leverage your investment dollars without researching every single stock in a sector.
Asset allocation is also a concept that some individual investors tend to ignore. Even in a bull market you should prepare your portfolio for bad times. Asset allocation is a simple technique that allows investors to spread their money across different types of investment such as stocks, bonds, money market fixed income securities etc. Not all sectors perform well in a given time frame and you want to make sure you are invested across the various investment options to provide more stability to your portfolio. Remember, asset allocation can also leverage different markets. For example, if U.S economy is growing at 1% pace, you may want to investigate growing economies such as India and China to see if you have better chance of making a good return over there. You should always stick to respectable brands and names when investing overseas. Do not get sucked in to high flying high risk investment funds overseas as past performance is no indication of future returns.
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Learn Patience |
What's does that has to do with investing? Most people would argue that patience has nothing to do with investment but if you take a closer look, you would find a deep connection. How many time you jumped into a stock because it went up quickly? Only to see it dropped 10-15% after you bought a position. Some would say that that’s just sheer luck. May be it is, but more than likely it has more to do than just being your bad luck. Most of the time, fear is the reason why we lose patience in stock market. You may jump into a stock too quickly because you fear to miss out a big run up. You may also exit a position too quickly because you fear your holding will drop more and lose patience with your stock. Remember, not having patience will only do one thing and that would be more trading activities. More trading activity has nothing to do with your overall returns. For example, if you review all your trades from last year, you would notice that only 10% of the trades were responsible for almost 70-80% of your return. Remaining 90% of your trade made you little or no money. Your stock broker is the only person making money in this case because of the commission paid on every trade.
One of the proven techniques to handle emotions in trading is to set some rules. For example, if you bought a stock and it has gone up 10% in just a week what do you do? One option is to sell and then jump back in when you see it continue to go up. Another option is to sell and be done with it. Both of these options have their downside. In first option, you’ll miss out majority of the gain and would pay a lot more in trading commission to your broker. In second case, you may miss out even more.
One of the way to handle a scenario like this is to use stop orders. For example, if you bought a stock for $10 a share and it jumps up to $15 in a week, you can do couple of things with stop orders. You can set up a stop order to see this stock if it falls back to $12 or less. This would guarantee that you would make at least 20% profit on your investment – not a bad deal. On the other hand, if it continue to go up, you can continue to move your stop order higher. For example, if stock goes up to $18, you can move your stop order to $15, thus giving you a 50% return. Stop orders are great tools to take emotions out of the trading. However, you need to be careful not to set stop order too close to the current price because you might be taken out by market noise and miss out on a big gain.
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Set Reasonable and Specific Goals |
So many times we make 10-30% on a trade but lose it all because we didn't act on time. Developing a successful investment strategy takes time and a well defined roadmap. Your investment goals should act as your signpost on your road to a successful financial future. Before you enter a trade, make sure you understand the reason and expectations. If you’re looking to make a quick 10% on your trade, there is absolutely no reason to stay with your stock if you have made 30% quickly. Take you gain and move on. There is always a chance that you will leave a lot more on the table but it is better to take some with you than lose it all. Refine your definition of investment success? Remember, consistency is also a big factor while measuring your success. In my opinion, an investor with 15% and 18% returns over last two year is lot more successful than the one with 50% and -30% returns over the same period.
Define clearly what do you expect your investments to do for you? A goal could be something like this: "I want my $50,000 investment portfolio to provide me with an overall 15% return in next 5 years." Your time frame is as important as the investment goal itself. Remember, a 20% consistent return over a period of 20 years in far superior than a return on 25% for 5 years. If you make 20% in first year, it should be used as an additional cushion with more carefully investing in coming years rather than as a sign to make more risky investments next year.
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