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Learn more: Advanced investing

Getting a grip on emotions Add to ...

This is the fifth of a six-part course on advanced investing that we publish every week.

Considering how important it is to long-term investing success, very little is written about the emotional side of investing. That's a shame, because for most investors, the biggest obstacle they face is the person in the mirror.

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Who hasn't sold in a panic when the market plunged, or bought a high-flying stock just in time to watch it plunge in price? The fact is that, when our emotions get the better of us - whether it's fear or greed - the outcome is seldom positive.

Studies have shown, for example, that the vast majority of mutual fund investors make far less than the funds' actual returns. Why? Because investors tend to buy high and sell low, which, of course, is precisely the opposite of what they should be doing.

. Stop looking for bargains, renowned growth investor says. Time the market instead, and know when to cut your losses

A recent study, reported by my colleague David Berman, shows just how destructive this tendency can be.

So if emotions are so dangerous to investors, what can we do about them?

Here's a tip someone passed along during the financial crisis: If you find that emotions are taking over your investing decisions, deliberately enter the wrong password three times on your online brokerage account. That will block your access, and you'll only go to the trouble of unlocking your account if you're really, really sure you want to buy or sell something.

That may be extreme, but there are other ways to keep your emotions in check. One of my most illuminating interviews as an investing reporter was with Jason Zweig, author of Your Money & Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich .

The main thrust of Mr. Zweig's book is that, as investors, we are slaves to the ancient parts of our brains that were designed to maximize survival. Millions of years ago, if we were threatened by a predator, our brains told us to run like hell.

When an investor is watching his portfolio plunge in value, it's as if all the red minus signs on his computer screen are a pack of hungry lions trying to eat him for dinner. That's because the losses stimulate the same part of the brain - the amygdala - that responds to mortal danger.

So what does the frightened investor do? He sells, which is the investing equivalent of running for the safety of the nearest cave. It may make him feel better temporarily, but from an investing standpoint, it's the worst thing he could do, because he locks in a loss and misses out on future gains.



Learn more about investing from John Heinzl The 2010 Investor Education series for beginner investors:

  • Part 1: Want to invest? Learn to save first
  • Part 2: Mutual funds: A good place to start
  • Part 3: Why ETFs are booming
  • Part 4: Sleeping well with GICs
  • Part 5: Why buy and hold is (still) the best approach
  • Part 6: Death, yes. Taxes? Not necessarily.

The 2010 Investor Education series for advanced investors:

Gail Bebee's weekly mentoring for our investor education contest winner:



Our brains also trick us into making mistakes when stocks are rising.

"The neural activity of someone whose investments are making money is indistinguishable from that of someone who is high on cocaine or morphine," Mr. Zweig writes.

Moreover, when a particular stimulus is repeated - a stock price that ticks higher a couple of times, for example - "the human brain automatically, unconsciously and uncontrollably expects a third repetition."

Result: Investors buy stocks after they've already climbed in price, instead of buying them when they're selling at bargain levels. Remember all those investors who piled into tech stocks in 1999 and 2000?

Mr. Zweig says the trick to successful investing isn't turning off your emotions, but "turning them inside out." To understand what he means, he recommends investors keep a journal of their feelings about the market. One or two sentences a day is all that's required.

Imagine if you'd kept a journal in the fall of 2008, when Lehman Brothers was going under and all hell was breaking loose on financial markets. A journal entry might have gone something like, "I'm scared out of my mind because my stocks are plunging day after day."

Now, consider what has happened since then: Stocks have come roaring back. It turns out that the best time to buy stocks was when you were gripped by fear and wanted to sell. Learning to bet against your own emotions is one of the secrets to making money on stocks.

"What this book is really all about is becoming more mindful, just becoming more self aware," Mr. Zweig told me. "If you make a financial decision in the grip of hot emotion, you are likely to regret it later."

 

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