Correct the Behavior and Don’t Overreact
The answer to this question is very simple: research and human behavior tells us that we are naturally illogical and one-sided, and find it very difficult to remain inactive when it comes to our money. The best thing to do is to step back, and make a decision about when to sell a stock immediately after you purchase it. The reason is because if you take the time to research a company and make a fundamental decision based on value, then you should be thinking clearly. However, if you sit around and watch a stock all day, those clear thoughts will become hazy and challenged, which will create uncertainty, driving even the most intelligent investors nuts. As a result, there are three simple steps that may prevent you from making hasty decisions based on day-to-day volatility:
1) Buy – Perform the research, find a company that is preventing value relative to its sector, and then invest in the company.
2) After purchasing the stock, immediately determine your risk tolerance. If you are investing $3,000 into a very speculative biotechnology stock then your risk tolerance may be 50%. However, if you are investing $30,000 into a large consumer company then your risk tolerance may only be 7%. Therefore, set a “stop-loss” order for the most you are willing to lose on the investment, and then do not alter it!
3) Ignore the stock. You have performed the research, therefore trust your research! Sometimes you will be right with all of your research, but the stock will under perform. This happens, and there is nothing you can do about it. However, on days such as Monday, if you sit around staring at your stocks all day and panicking with every penny of volatility, then sooner or later you are going to make a foolish decision. This process of preparing to sell when you make the investment will allow for much calmer nerves, clearer thoughts, and better decisions.
Conclusion
In my book, “Taking Charge With Value Investing (McGraw-Hill, 2013),” I discuss countless investment strategies such as the one above that are based on the simple psychological mistakes that investors encounter. This particular strategy above is an intro to a much larger process, but protects the investor in the case of a bad investment.
Sometimes your research will be flawless, your timing will be perfect, but you will lose money on an investment. When this occurs, there is nothing you can do, but if you make emotional investment decisions when buying, selling, holding, or assessing, these losses will occur much more often. Sometimes, you may not even give yourself a chance to see if an investment is good, because you sell on the first pop. With this strategy you give your investment time to appreciate, and although you may lose money at first, the investment may turn out to be great. But if you overreact and sell at the first sign of losses, then your frustration will continue to build as you realize your missed opportunity.
The article Correcting the Process of Overreaction in the Market originally appeared on Fool.com and is written by Brian Nichols.
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