5 Ways Your Brain Tricks You Into Bad Investment Decisions

Submitted by Value Stock Guide as part of our contributors program

You are rational with your money. You spend weeks agonizing over the new microwave oven. You read countless reviews and compare features and prices. You worry about risk and insist on a good warranty. You demand value for every hard earned dollar you spend.

When it comes to buying stocks, however, the story is different. There is something about money and investing that causes temporary lapses in logic and reason. It leads you to sell at the bottom and buy at the top. It warps your perception of risk. You probably think Apple stock at $450/share today is more risky than you thought it was just 5 months ago at $700/share. You are not alone.

“Stock prices have reached what looks like a permanently high plateau. I do not feel there will be soon if ever a 50 or 60 point break from present levels, such as (bears) have predicted. I expect to see the stock market a good deal higher within a few months.”
– Irving Fisher, Professor of Economics at Yale University, Oct. 17, 1929, days before the market crash

When it comes to investing, the so called “experts” operate with the same handicap as the rest of us.

Successful investing is about how you improve your odds

Your investing process needs to continually evolve on two fronts:

1. You need to select investments in a way that removes possibility of losing money as much as possible. You can do this by refusing to overpay for an investment, trading as little as possible, and learning everything about the company that you can before committing your dollars to its stock, and,
2. You need to work on your own behavior and emotional response and find ways to remove it from interfering with your investment decisions

Once you learn how to manage and reduce your downside, your average returns are automatically improved. Ultimately, investing in stocks is betting that the future will turn out to be better than it looks today and the future always has a degree of unpredictability in it regardless of how solid your investment analysis is. Just in case things don’t go according to the plan, you will now know the right way to react.

Make a decision and stick to it

Once you make a decision to buy (or sell) a stock, go ahead and buy (or sell) it right away and then stick to your decision unless there is a material change in the business. Time to agonize is before the decision is reached. Any hesitancy afterwards just sub optimizes your performance.

When I buy a stock, I also set a sell price for the stock. Unless there are overwhelming reasons to do so (and these would be very rare), the stock is sold when the price reaches the pre-set sell price, regardless of how popular the stock may have become. In the worst case scenario, I may leave a few points on the table. By doing this it stops me from getting carried away at critical times and forces the right decision at the right time.

This of course is the key to break the loss aversion behavior. If you have parameters set up in your process that calls for a specific action when a certain condition occurs, TAKE THAT ACTION. If it turns out to be the wrong one, you can come back and modify your parameters. If you need additional motivation, try reframing the question that you ask. You will make mistakes early on, but you will avoid them later in your investment career when they are likely to be more costly.

Get the right time perspective

Investors tend to be short term oriented because the long term seems so far off. With this perspective, they are likely to miss things like debt maturing in next 2 years or a costly drawn out legal case against the company or the results of the new strategic initiative bearing fruit. However these may be the things that are driving some of the business actions and the stock price today.

Despite what is commonly believed, most public companies are managed for the long term. To invest properly, your expectations should be in line with the business. Besides, long term is seldom as long as we fear and it comes soon enough.

Remember, when it comes to investing, you may be your own biggest enemy!