Never Let Emotions Affect Investment Decisions

Don’t let your emotions or lack of nerve dictate your behavior. A stock goes down and the investor thinks, “I’ll get out when the stock goes up enough for me to break even.” The investor does not realize that greed is controlling this decision because greed has negative connotations, but desiring to “break even” has connotations of fairness, justice, and lack of greed. Nevertheless, this antipathy to letting go of a failed investment is tinctured by elements of greed and pride. As a portfolio manager, I once sold a stock just after it broke its trend. During the next few days I got calls from unhappy clients who said in summary: “Why did you sell? Stocks do fluctuate, you know. You have to give them room to breathe a little.” The implication behind their comments was that they were sure the stock would go up shortly and that the sale was premature and unnecessary. In fact, there was absolutely no rationale for them to hold those assumptions. They knew little or nothing about either fundamental or technical analysis. They had simply generalized the concept that if you “buy and hold,” stocks will tend to rise. While that may be true, that does not mean that each and every stock that falls in your portfolio will rise to previous levels if you hold on a little longer. I could name a long list of stocks, like LA Gear, that declined to oblivion or near oblivion.

The market does not know where you bought your stock. It does not remember your past buying and selling activities. Only you know that information. The market has no moral sense of what is “right” or “just.” Those things are wired into your psyche, but they are not market drivers. The market does not owe you any opportunities.

I had a friend who wanted to invest in the market. She had been watching commercials that touted how much money people could make in the futures markets. I happened to mention something about a stock that had come to my attention and that I wanted to investigate. She insisted on knowing the name of the company. I told her I knew nothing about the stock and that I could not recommend it. Against my advice, she insisted I buy the stock for her account. The stock was $12 and it started rising almost immediately. It soon reached a high asking price of $17.125. I told her that the momentum had gone out of the stock and that she should sell at the market. She insisted that I put in an order to sell at $17.125. I told her she would be lucky to get $16.875. She said “stocks fluctuate. Give it time.” I told her that in my opinion the stock was likely to plummet because of the speed of its rise. She said to put in the order to sell at $17.125. A short time later, she called and asked how the stock was doing. I told her that it was at $15. She said, “It’s dropped! What should I do?” I told her to sell at the market while she still had a profit. She decided that the stock would go back to $17.125 and told me to do nothing. The next time she called, the stock was at $12. “I can’t sell now because I would only break even.” I told her that the negative momentum was building and that she would be doing well to break even. I suggested that she sell at the market and take what she could get. She insisted on leaving her order in at $17.125. She reminded me that stocks fluctuate and that it was better to wait than to give up on all the profit that she had. To make this story short, the stock dropped to less than $1. Her position was on margin. She had to sell her car to cover her margin requirement.

This behavior is typical for people who are led by emotion and by popular market lore. One of the first lessons a trader must learn is to never base decisions on what the trader thinks ought to happen next. Instead, base decisions on what is. In the above situation, the stock was falling with increasing negative momentum. That should have been enough to convince the investor that it was time to sell. Her sense of what the stock “ought” to do got in the way of her making a rational decision.

If you are in a stock and using a trend-following system, let the system tell you when to sell. If the stock keeps climbing and you sell because you have said to yourself, “it’s time to get out… it can’t go on like this forever,” then you are not following your discipline. You are following the dictates of fear and apprehension. In a way, you are making the same kind of mistake that the above individual made.

If change is falling through a hole in your pocket, do not assume that it will magically work its way back to your pocket. You cannot be passive. You must act in order to stop the flow. Move your change to another pocket.

Copyright 2013, by Stock Disciplines, LLC. a.k.a. StockDisciplines.com