There are three essential qualities to sound investing. First is knowledge. You have to know something about what you are doing. The notion of throwing darts at the Wall Street Journal and outperforming the market sounds good, but only worked once in a hundred times. Unfortunately it happened on the first try, creating an investment myth that has hindered the average investor from using his or her intelligence more actively. The second requirement is experience. Frankly, there is no substitute for experience and it is acquired in only one way. The third requirement is the ability to control emotions.
Warren Buffett once said, “To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights, or inside information. What is needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.”
I believe what has made Buffett so good as an investor is not just his brilliance about the field, but also his unique ability to focus himself totally on the investment process while minimizing emotional involvement in it. The truth is that most individual investors have no plan and are very much prey to their emotions.
Buy decisions generally are made during bull markets and tend to be impulsive. Often they are the result of following tips acquired on a social basis without adequate research or due diligence. Sell decisions, too, tend to occur because of emotions rather than rational decision making. Sales often are the result of fear, anxiety, guilt, superstition, and masochism.
Twenty odd years ago I did a research project comparing obsessive people with a normal control group. The obsessives frequently violated the famed Wall Street maxim, “Cut your losses short and let your winners run.” Obsessive people tended to get acutely anxious when an investment rose in price and quickly sold at the first sign of weakness. They didn't understand that when a stock has a quick run-up it often requires a period to consolidate by giving up a portion of its gain before making another upward movement. On the other hand, when a purchased stock dropped, the obsessive investor seemed paralyzed by inaction and suffered through a long decline. Often he or she rationalized, “I will sell it when it gets back to what I paid for it.” Paradoxically that seldom happens because when the price starts to recover, anxiety sets in and the investor will sell a bit below the original purchase price.
From a psychological point of view I theorize that several things are at play. The anxiety experienced when the stock price is rising seems to be a variant on the “success neurosis” in which people cannot allow themselves to surpass their parents or siblings. This can be related to unresolved oedipal strivings in which success stirs up ancient castration
John W. Schott, M.D., is a member of the Boston Psychoanalytic Society. He is director and portfolio manager at Steinberg Global Asset Management. He also publishes a monthly newsletter on investment psychology, The Schott Letter.
anxieties or it can be related to guilty feelings for doing better than parents or siblings. The feelings stirred up when prices are declining are masochistic and are sometimes related to the expiation of oedipal guilt.
I have not done formal studies on other personality types, but informal observations and the anecdotal reports of others lead me to think that personality plays a big role in investment decision making. Hysterical women tend to treat an investment like a date. If things are going well all is OK, but if the stock (read “date”) doesn't treat her right, then take it out and shoot it. Narcissistic people do well in bull markets when they buy the leading names, but suffer terribly in bear markets. The narcissist sees the stock as an extension of himself or herself and rejoices in rising stocks, attributing the profit to self brilliance, but a bear market creates unbearable feelings of depression. How can you the reader profit from this? Keep the three necessary ingredients for investment success foremost in your mind. If you are going to buy individual stocks, research and careful thought is necessary. Buy a number of stocks limited to your ability to follow them carefully. For most people 15 to 20 stocks are the maximum number possible to do this. Utilize investment experts to help you by reading their books and newsletters. Check on their performance figures and know what their investment styles are. Choose a guru whose style fits your personality. (E.g., if you are value oriented, choose advice from value oriented managers. Ditto if you are a growth style investor, choose a growth oriented newsletter.)
Many people prefer mutual fund investing because they don't feel competent to select individual stocks or they don't want to devote the required time to do a good job. Start by picking funds according to your preferred style. Or, perhaps choose two value funds and one growth fund to give you more balanced returns. Check the funds long term records aiming to select ones that have achieved compound returns greater than 13 percent per annum. Be sure that the manager who attained those figures is staying at the helm.
Finally, pay attention to your self awareness when it comes to investing. Note what makes you happy or depressed. Do some investments generate anxiety in you? Establish a written plan. Consider dollar-cost-averaging, an investment system in which an individual invests the same dollar amount at regular fixed intervals, e.g., monthly or quarterly. The advantages are that discipline is enforced to reduce the affective component in the investment decision making process and that by investing the same amount of dollars rather than buying the same number of shares, the investor will buy a larger number of shares when prices are down resulting in a lower average price. This system has worked very well in the past and will discipline you to buy when the market is down.