Most investors know that a buy-and-hold strategy is better for their portfolio. They spend some time studying out a company’s profit and loss statement, and they commit to a certain course. But the second the stock price plunges, they get spooked and start selling shares off. Or, they double down on their losses and refuse to sell, even when they’re well past the point of no return.
80% of our decisions are based on emotions, and only 20% of our decisions are based on our knowledge. Add into all of that the most unpredictable factor in all of your decision making: you. You can gather all of the data you want, and read every stock tip from your favorite website, but you still remain the weak link in your investment portfolio.
Dr. Richard Smith has a PhD in Systems Science, otherwise known as the mathematics of uncertainty. In 1998, his market portfolio was up 300%, and he couldn’t stop patting himself on the back for his brilliant investment strategy. Then, March 2000 hit, and his entire portfolio plunged 25%, and he panicked about what he should do. He’d had a strategy, and he even had a PhD in the theory of risk, but his emotions still ruled his investment strategy.
Today, Dr. Smith uses technology to help investors close that last mile between emotions and knowledge. You can’t outsmart your fear when you start losing money, but you can understand what’s happening. And you can use technology to prevent your emotions from wrecking your investment strategy.
WHY WE HATE TO LOSE
Two Nobel Prizes in economics have been given out for explaining the same idea: we hate to lose. That means that when your investment properties go underwater or your stock loses money, you don’t want to sell it and cut your losses. Because selling guarantees your losses.
The fact that you hate to lose has different consequences for when you’re losing and when you’re winning. As you’re losing money, you have a behavioral mechanism that resists losing. It makes you double- or triple-down. You’ll even start telling yourself that your short-term investment is actually a long-term investment, and you’ll work extra hard rationalizing why the right decision is to hang on to your losing investment.
On the flip side, when you’re ahead on an investment, the fact that you hate to lose attaches itself to your profits. You become fearful of losing your profits, so you get the urge to sell even when you’re up. Changing your behavior means:
- Being risk averse with your losers.
- Being risk seeking with your winners.
- Inverting your state of mind.
LOSE LESS BY LOCKING IN YOUR PROFITS
If you have a loss and you’re down 90%, do you know how long it takes to recover your money? You need a 1,000% gain to overcome that kind of loss, and how often does that come around? Not only that, but you couldn’t even handle watching your stock go up 1,000%. You would chicken out before you could recoup all of your losses.
Trailing stop loss– Instituting a trailing stop guarantees that you’ll never lose a certain percentage. One of the most popular strategies is to institute a 25% stop loss so that you never lose more than 25% of your investment. On the other hand, your stock can keep going up and up because you’re giving yourself a mechanism to let your winners go crazy. You’re locking in your profits and reducing your losses.
Volatility budgeting– Some of the older established companies, like Walmart or Johnson & Johnson, might fluctuate 12-15% in a given year. But others, like Tesla or Twitter, might fluctuate 35%. On a more volatile stock, you can calculate the historical volatility and factor that into your trailing stop loss. Dr. Smith calls that volatility budgeting or volatility stop loss. It’ll help you cut through the noise and focus on the long-term financial health of a company’s stock.
DON’T BE MARRIED TO YOUR LOSSES
When I was a kid, I remember my dad being up in a mutual fund 80%, and then the next year he was down 45%. I would tell him,”Dad, why don’t you just sell it and move your money into something else?”. I see a lot of investors who get stuck in this same trap. They think that they need to make up their losses in the same investment, but there’s no rule that says you have to make up your loss with the exact same position and the exact same stock.
I’ve even had to take this approach in real estate. Sometimes you get a house that’s just a complete drain on your budget, and you keep trying to make it work. One of my properties was completely sapping my mental energy, so I sold it at a $50,000 loss. I cannot even tell you what a relief it was to have that house off my mind, and I could start focusing on positive things again. I’ve made up that loss twentyfold because it’s not consuming my brain power anymore.
There are 10,000 stocks in the stock market, and millions of homes to invest in. If you lose money on an investment, it’s not a moral failing. It’s not a judgement on your investing abilities. If you’re an investor who is in it for the long haul, then you know that losing a little bit of money shouldn’t change your long-term investment strategy.
Technology is a very powerful behavior shaping asset, says Dr. Smith. Currently, the companies doing most of the behavior shaping are Google, Facebook, Instagram, and Twitter as they steer consumers toward this news article or that strategy, and shape their worldview. You can step outside of their influence by getting your mind comfortable with a little bit of loss, buying when others are fearful, and using technology to minimize emotion in your investment strategies.
WHAT ARE YOU THINKING?
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