Sunday, December 21, 2008

Learn from my investment mistakes

When I look back on my track record of stock market investments over the past 20 plus years, I am amazed by the sheer number of downright idiotic mistakes that I have made.

Without trying to sound immodest, I consider myself of above-average intelligence. Most of my friends, and I dare say a few enemies, will probably corroborate that.

So how did I end up making so many mistakes in stock investing? And was I in a minority of one? Turns out that most amateur investors, and several professional and acknowledged experts, have made their share of similar mistakes.

Why do apparently intelligent and experienced people make ridiculous and stupid investing mistakes? The answer may lie in an area of study called 'behavioral finance', which studies the effect of human psychology on financial decision making.

Have you ever bought a share only to see its price going downwards? Or, decided not to buy a share (or bought only a small quantity) at a particular price, only to see the stock zoom up? This happens because the market has no idea - nor is it bothered - about your buy price. The market moves as per its own logic. But we tend to 'anchor' at a particular price.

If we buy at a higher price and the stock falls, our 'loss aversion' prevents us from selling it. Keeping a loss making stock in the portfolio does not seem like a real loss, whereas selling it would incur an actual cash loss. The way out is to have the discipline to stick to a 'stop loss' figure (it could be 5 or 10 or 25% below the buy price - depending on the stock's volatility and your risk tolerance), and sell as soon as the stop loss figure is hit.

What if the stock you buy starts zooming up, up and away (which usually happens in a bull market, but can also happen during sharp bear market rallies)? The smart investor's way is to keep moving the 'stop loss' figure upwards by the same percentage as the stock's price and ride the rally. During the next market dip, sell when the now much higher stop loss figure is reached.

One of the biggest mistake of all is to 'water the weeds and cut off the flowers'. This means selling off the good performing stocks too soon, and hanging on to the loss making stocks for long periods in the hope of a recovery.

This mistake is often compounded by another big mistake. That is over confidence in your stock picking skills. During bull markets, any stock that you touch seems to fly upwards and you start feeling that you are a genius at stock picking. When the market tanks, some of the high fliers - specially small and mid caps - lose as much as 80-90% of their peak value.

It is no wonder that Benjamin Graham in his 'The Intelligent Investor' has written: "The investor's chief problem - and even his worst enemy - is likely to be himself." (Haven't read Graham's book yet? Buy it tomorrow and then carefully read it, and then re-read it again and again.)

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