If you are a recovering alcoholic, you should not go out to bars with your drinking buddies. If you are on a diet, you should not leave a dish of M&M's on the table. If you want to overcome your psychological investment biases, you must control your investment environment.
Do you check your stocks every day? Every hour? So many people are doing this that companies are limiting their employees' Internet access so that they are not distracted by looking up their investments all day. To control your environment, you need to limit those activities that magnify your psychological biases. Here are some tips you can use to help to control your environment.
■ Check your stocks once a month. By checking your stocks once a month instead of once an hour, you inhibit your behavioral reactions of feeling snake bit, seeking pride, and playing with the house's money.
■ Make trades only once a month and on the same day of the month. Pick one day of the month, like the 15th, and place buy and sell trades only on that day of the month. This helps you avoid the misconception that speed is important. Speed is only important if you want to chase a stock on a rumor and get into it just before its bubble bursts. On the other hand, trading once a month helps to overcome overconfidence trading and info bombs.
■ Review your portfolio annually and compare it with your specific goals. When you review your portfolio, and you should do this on an annual basis, keep in mind the psychological biases of status quo, endowment, representativeness, and familiarity. Does each security in your portfolio contribute both to meeting your investment goals and to diversification? In addition, keep records so that you can overcome cognitive dissonance and other memory biases.
If you just can't bear to do these things, then you are probably addicted to the gambling aspects of playing the market. You should consider taking a small amount of your portfolio and placing it in its own brokerage account. This will be your play money. It should be money that you do not need to pursue your investment goals.
If you do set aside some play money, definitely put it in its own account. This is an important aspect to controlling your environment. If you don't keep it separate this way and instead decide to play with a small amount of money in your main brokerage account, you will no doubt be tempted to use more. If you have some successes in your playing, remember that it is probably just luck. Playing the market (as opposed to investing) is like playing a slot machine in Las Vegas. You win, or you lose, but skill has nothing to do with it. And, on average, you lose. Of course this makes sense now, but it is hard to believe when you are winning.
ADDITIONAL RULES OF THUMB
Also consider implementing these rules to shield you from your own psychological biases.
■ Avoid stocks selling for less than $5 a share. Most investment scams (particularly the pump and dump scheme) are conducted in these penny stocks.
■ Chat rooms and message boards are for entertainment purposes only! It is on these boards that your overconfidence is fostered, familiarity is magnified, and artificial social consensus is formed.
■ Before you place a trade on a stock that does not meet your criteria, remember that it is unlikely that you know more than the market. Investing outside of your criteria implies that you have some informational advantage over others. Are you sure you know more?
■ Have a goal to earn the market return. Most active trading is motivated by the desire to earn a higher return than everyone else is earning. The strategies for earning a higher return usually foster psychological biases and ultimately contribute to lower returns. However, the strategies for earning the market return, like fully diversifying, are successful because they inhibit your biases.
■ Review Table 15.1 annually. This action will re-enforce Strategy 1: Understand your psychological biases.
Successful investing is more than simply knowing all about stocks. Indeed, understanding yourself is equally important. Investors who think they are knowledgeable frequently fail because they allow their psychological biases to control their decisions. In the first chapter of this book, I proposed overcoming this problem by reading this book, which was written to help you
■ Learn the many psychological biases that affect decision making
■ Understand how these biases affect investment decisions
■ See how these bias-affected decisions can reduce your wealth
■ Learn to recognize and avoid these biases in your own life
I hope this book has given you the knowledge, motivation, and strategies to overcome your own psychological biases and become a successful investor.