Friday, September 14, 2007

The Importance of Attitude and Planning In Investing

Many investors believe that their success or failure in the market is solely the result of their skill at choosing investments, or their luck, while forgetting to take another important variable into account: attitude and planning. To better understand this area, we can turn to an emerging field of psychology called behavioral finance, which focuses on why smart people do dumb things with their money. Behavioral finance offers plenty of useful insights for those willing to study, but here are a few of the key points from this field that you should keep in mind when investing:

  • If you do not plan for success, you plan for failure: Before you make an investment, you should have a plan for what to do with that investment if it gains value or loses value. For example, in the investment system popularized by Investor’s Business Daily, the rules are pretty simple: if a stock loses more than 8% of the purchase price, you sell and take a loss; if a stock gains over 20% from the purchase price, you sell and take a profit. Conversely, a value investor would generally buy more stock if the price dropped below their purchase price, and would only sell if the underlying business deteriorated or the stock became overvalued. Having a plan is essential, because otherwise you are very likely to sell at a loss when frustrated or afraid, or to fail to take profits when you have them due to greed.

    Remember: your instincts evolved to help you hunt, evade predators, and find food; as such, they are poorly suited to helping you to operate in the stock market. Success requires more than instinct; it requires planning. Your plan can be simple, but it will still be well worth the few minutes that it takes to put it in writing.

  • Don't fixate on the past: We all have the tendency to give great weight to memorable events when making decisions, in a process that psychologists call "anchoring". Anchoring can cause us to make bad decisions when memorable events are irrelevant to the current situation. For example: the stock that you lost your shirt on in 2000 may be the best one to buy right now, but you will find yourself reluctant to even consider buying it because of the pain that you associate with your previous experience, just as a child is reluctant to touch a stove element after getting burned. Similarly, a great stock that you noticed and considered buying at $10 may still be the best available investment opportunity after it has soared to $20, but you will be reluctant to buy it because your mind is anchored on that lower price, and making the purchase now will mean admitting that you probably should have purchased it when you saw it at $10.
    Pull the anchor: The solution to this predicament is to select your investments using screens or other analytical methods that will help you to make sound decisions without regard to vivid, but irrellevant, memories.
  • Be tax aware, but don't let the IRS think for you: Many of us have met or heard of investors who had the phenomenal good fortune to hold the right stock at the right time, and to become wealthy, at least on paper. In many cases, these investors failed to take profits in their stock, even when they thought that it was probably going to lose value for one reason or another, because they did not want to pay taxes on their gains. This makes no sense at all, especially now when capital gains taxes are at their lowest levels in years. Ask yourself the following question: Would you refuse a 200% raise because you don't want to get moved into a higher tax bracket? If your answer is no, as I suspect that it is, then why would you choose not to pay capital gains on an investment that has met your price target, and is now overvalued? The key thing to remember is: If you are paying more taxes than last year, it is because you are making more money than you did last year. Deciding not to follow your plan and stick to a rational investment strategy because you fear losing some of your gains to taxation is basically a decision not to make money.
    Don't obsess over the IRS: If you are deathly afraid of paying taxes on your gains, the market will accomodate you by taking those gains away from you and giving them to someone who will pay taxes on them. This also touches on the first point that I made: people who give away fortunes for tax reasons are generally operating without a plan that tells them when to sell. They make excuses for holding a previously winning investment as it loses value, rather than putting a plan in writing before investing and then sticking to that plan. Besides sound planning, another way to keep yourself from falling into this trap is to hold your largest investments inside of an IRA or other tax-sheltered account, where you will be able to make investment choices without regard for capital gains or other tax concequences.

I could write endlessly on the pitfalls of investor psychology, but Barry Ritholtz has saved me the trouble with his excellent Lessons for the Apprenticed Investor series. If you are serious about investing or trading and have not already equipped yourself with a winning attitude and plan, these free articles are essential reading.

No comments: