Psychology Backed Investment Rationale

How to keep your emotions out and your head in.

Currently stocks are selling at record highs and if you are not utilizing trade stops there is a question you need to ask yourself. The question is, when should you take your money off the table and collect your capital gains?

The key to this question is being aware of your feelings. When emotions are involved, buying investments is easy. Selling is much much harder.

In regards to most people, psychology usually works against your investments. In this blog I will be showing you a psychological pitfall to be aware of when looking to sell for maximized returns.

Take into mind the following scenario, try to visualize what you would do in this situation with high levels of vivid detail. Ss if this was pertaining to you and your own portfolio, as if it were truly happening to you right now.

Say you own two stocks. You bought each at $1000 a share. Over the course of holding these investments, one has raised to $1250 per share, and the other has fallen to $750. Suddenly you find yourself in need of cash. Perhaps, medical bills came in the mail, or you would like to buy a new car. Which stock would you sell?

Most people would choose to sell the stock that is $1250 to capitalize on the gain, and keep holding the $750 loser. The concept behind this phenomenon is an idea that investors believe the loser stock has more upside potential, or at the very least they want to “get even” on the position.

Unfortunately this is a universal human impulse and a terrible investment choice. I myself have even fallen victim to my own emotions. Maybe it was greed? Maybe it was pride? Regardless of which one it was, I failed to listen to reason and psychology.

All too often people sell their winners too soon and keep their losers too long. A behavioral finance study from Berkeley professor, Terry Oden found investors are almost twice as likely to sell a winning stock than to sell a losing stock. Why would you want to sell something that has proven its upward growth potential? Because the brain is predisposed to “grab it while it’s good”.

This impulse can negatively affect a portfolio over time due to a phenomenon called autocorrelation. Autocorrelation studies shows that in a 6–8 month period stocks that are moving up tend to keep moving up, and stocks that are falling tend to keep falling.

This confirms that which we hear often yet choose to ignore: “Let your winners run, and cut your losers short.”

A simple yet effective tip to help keep your emotions out of trading stocks is to write down on an index card why you bought that stock, at what price you realistically plan to sell at, and possibly a mental stop loss that you jot down on the index card. Referring to this card every 6 months or so will help keep your emotions aside because when you have a plan on paper you are more likely to follow through with it. It is especially effective since you wrote it down while emotions were at a neutral and logical state. This acts as a safeguard against your psychological tendencies to go back on your better judgments at the whim of impulse and gainful opportunities.

On top of following the “pen to paper” practice you should always ask yourself this question; would I recommend this stock to my friends and family? If your answer is “no” then it is probably time to sell.

Be smarter than your brain and stay prepared.

Caleb

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