There are certain things investors can do to trick our brains into making smarter financial decisions. I was reading the latest edition of Best Life (April 2008) and an article by Harry Hurt III caught my attention. In his article he had a sidebar box that listed a number of Do’s and Dont’s to help investors deal with the emotional side of investing.
As I have discussed before, emotions and investing do not mix. Emotional investing has cost me in the past and I have proclaimed that I would never fall prey to a emotional mistake again. The best way to explain what emotional investing mistakes are is to talk about our feelings and the action these feelings cause us to take. For example, let’s say you own Citigroup and your average cost for those shares in your portfolio is $34. Today, you as a Citigroup shareholder are hurting. You feel like an idiot having bought some more on the way down and with the stock hovering around $20 you have lost a good chunk of paper money. The emotions this investor is feeling is disgust, anger, and stupidity for having bought the stock. All his thoughts and feelings are telling him to cut and run. Bail out now and forget it ever happened. This is what an emotional investor would do.
The smart investor would take a step back and get control of those emotions. He would recognize that stocks are volatile. He would also remember that he is a long term investor who has another 30 years of investing left before he retires. He bought this stock for the rising dividends and believes his strategy is solid. A decision to hold or sell still needs to be made, but it must be made for fundamental reasons and not because he feels stupid and ashamed. Facts such as the dividend cut and the subprime mess must be accounted for. Although this investor has not come to a decision yet, the ultimate decision to hold or sell will be made based on the fundamentals and a historical market perspective and not on these feelings.
To help with this decision process, these do’s and don’ts by Harry Hurt III are crucial to understand in my opinion. I give him full credit and thank him for putting together this list for investors:(PUT INTO COLOR CODED TABLE RED=DONT GREEN=DO)
* Don’t allow your reflexive brain to obsess over day-to-day fluctuations in the market or the price of a particular stock. You’ll only rack up unnecessary transaction costs by trading in and out of the market in panic mode.
* Don’t allow your reflective brain to predict long-term trends on the basis of short-term data. Just because a stock goes up two days in a row doesn’t mean it will go up again on day three.
* Don’t allow your reflexive brain to get so caught up in the neural high of reaping a profit that you try to re-create it by taking risks that your reflective brain recognizes as inordinate.
Don’t allow yourself to be “framed” by money managers or portfolio advisors who emphasize only the upside of a deal (an 80 percent chance of success) and minimize the downside (20 percent chance of failure).
* Do subordinate the instinctive impulses of your reflexive brain to the reasoned analysis of your reflective brain. Step back and take a clear-eyed look at what you’re about to do before it’s too late.
* Do allow your reflexive brain to put its instincts to constructive use. If you smell something fishy in the way a portfolio manager always claims personal credit for gains and always blames losses on forces beyond his or her control, reconsider your investment relationship.
*Do take what economist Daniel Kahneman calls “the global view.” Monitor long-term trends in the value of your investment portfolio rather than daily price or market fluctuations.
*Do allow your reflective brain to instinctively question your investment strategies and decisions. As author Jason Zweig puts it: Act like a 4-year-old who keeps asking “Why?” every time you try to justify your decisions to yourself.
I thought that these were very good suggestions and I would recommend following each one of them. Let me know what you think?
(Disclaimer: The Dividend Guy owns shares in Citigroup)