With the information available on the internet, it's never been easier for people to find information and educate themselves on investing. However, the biggest challenge investors face is not from the mind but the stomach.
Famous investor Charlie Munger once said, “A lot of people with high IQs are terrible investors because they've got terrible temperaments. You need to keep raw, irrational emotion under control.”
Emotional impulses can cause investors to make bad decisions with stocks, so here are three common mistakes and how to overcome them.
1. Fixating on price
Imagine you are at the mall, and you see a pair of jeans with a sign that says “regular price: $50, on sale for $40″. For most people, their first reaction is thinking the jeans at $40 must be a bargain because $40 is less than $50. Few people look at the jeans themselves and ask: “are these jeans actually worth this price?”
This emotional response is called price anchoring — when a person decides based on a previously established figure instead of new information. Investors often fall into this trap by getting hung up on the original price they paid for a stock.
Let's say that Joe buys a share of XYZ stock for $100. It can be tempting for Joe to continue buying shares as the share price falls to $90, $80, $70… and sell as the price goes to $110, $120… etc.
The $100 price that Joe initially bought shares at can make anything less feel cheap, and anything higher feel expensive. This has nothing to do with the company's fundamentals behind the stock, which can often lead investors to double down on “losing” investments and sell “winners” too early.
2. Catching falling knives
Much of the past 10 years has been spent in a bull market, where stocks spend a lot more time going up than going down. “Buying the dip” has proven to be an effective strategy for investors.
But sometimes, a stock can rapidly go down in price, and investors underestimate just how low a stock can fall. This is called catching a falling knife; it's when an investor jumps into a stock in the middle of a steep decline.
In mid-2007, American International Group, an insurance company, was trading at more than $50 per share. By the summer of 2008, the stock had fallen more than 50% to about $20.
You could have bought the stock, thinking, “wow, this is beaten up; it has to be near the bottom, right?” During that time, the Great Recession began to worsen, and AIG fell another 90% from that point to less than $1.50 per share. The lesson? A stock can always fall further.
3. Here today, gone tomorrow
We've all seen the “meme stock” craze, with stocks like AMC Entertainment Holdings and GameStop shooting up tenfold or more in a matter of weeks. The frenzy of rapidly increasing stock prices creates a feeling that one has to act because they are “missing out.”
This is called irrational exuberance — when investors drive a stock's price higher than its fundamentals can justify. Another term for this is “FOMO,” or the fear of missing out.
The meme stocks made money for many people when prices shot up, only bringing more buyers to the action. However, the problem is that when fundamentals can't justify a share price, investing becomes gambling, a game of “musical chairs” that will end poorly for those who get in at the top.
Sure enough, the share prices of AMC and GameStop have come down from their highs, and those who were the latest to the party learned an expensive lesson.
How to overcome them
There is no shame in making these mistakes; these are emotion-driven errors that speak to our natural reactions as human beings.
The good news is that investors can overcome them by focusing on what's important: buying and holding a diverse portfolio of high-quality companies. Don't buy and sell based on the stock price; instead, look at how the business behind the stock is performing. You can learn a lot about a company by reading its financial statements.
Daily, the stock market can seem like a casino, but over time stock prices will reflect the quality of the businesses they represent.
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