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Friday, March 24, 2017

How to become a better investor by avoiding mental mistakes

Bulls are on a roll. The stock market is touching new highs. Every one seems to be making money. How can you stay away when exciting things are happening all around you?

You jump in and buy 1000 shares of a Rs 80 stock, expecting to turn a quick profit in a few days. Your friend said it was a 'sure shot' winner. Experts are recommending it. The price is moving up daily.

The day you buy, the stock starts falling. It falls Rs 3 on day 1, then Rs 4 on day 2 and again Rs 3 on day 3. You're down Rs 10000 in 3 days. What is going on?  What to do now?

You have three options: 
1. Sell, and take the loss. 
2. Buy more to 'average' your 'buy' price.
3. Wait hopefully for the price to go back up so you can recoup your losses.

Chances are, you will choose option 2 or 3. Why? Because no one likes to book a loss - particularly if it is a substantial sum. What will you tell your friends? Won't they laugh at you? 

Now, imagine another investor in a slightly different situation. He buys 500 shares of a Rs 100 stock. The stock catches market fancy after a recommendation by a popular expert, and quickly rises to Rs 140 in 2 days.

He feels proud about his smart choice and plans to book profit at 150. But the stock price dives to 120 on the following day. In one day, his profit of Rs 20000 is halved to Rs 10000. What will he do now?

Again, there are three options:
1. Sell, and book the smaller profit.
2. Buy more because the price may rise up again.
3. Wait for the price to rise back to 140 so that the full profit of Rs 20000 can be booked.

Chances are, either option 2 or 3 will be chosen again. 

In both instances, selling would have been the smarter option. Small investors get mentally 'anchored' to a price - either the price at which they bought or the price to which a stock's price has moved up or down. It prevents them from making a rational decision.

An entire field of study - called Behavioural Finance - has evolved because of apparently irrational behaviour of human beings when money is involved in decision making.

Some familiarity with Behavioural Finance concepts can help small investors avoid mental mistakes that prevent them from getting superior returns from their investments.

In a recent article in investopedia.com, Cathy Pareto has discussed a few common mental mistakes that small investors make. Knowing about and learning from these mistakes will help you to become a better investor.

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