We investors often tend to get excited when the markets are doing well and get depressed when they are not. And yet, since all returns from stocks are made by buying low and selling high, this is actually the opposite of what we should do. We should get as excited about equity markets that are depressed as shopaholics are when they enter a mall where lots of stores are running big discounts.
There's nothing new in this. We all know this at an intellectual level and yet so many of us don't actually manage to overcome our emotions and act in a rational way. In fact, that's the story in the case of so many bad habits that investors develop.
Let's talk about two other habits that investors have which prevent them from getting the most benefit from an environment like today's. There are bargains aplenty and you could buy them all. As time goes by, it's certain that some of them will work out and some will not. Some will rise and go on rising and some will fall a long way. So which of the two groups will you continue to hold and which will you sell out? The answer is obvious, isn't it? It should be, but it isn't.
It turns out that many, many investors do the exact opposite of what they should do. They sell the winners and they hang onto the losers. This sounds foolish but it's actually the net result of two concepts: profit-booking and loss aversion. When a stock starts rising, many investors want to 'book profits', that is, sell the stock and get the gains into their own bank accounts. As the stock price rises, they get nervous about future falls and feel that a bird in hand is worth two in the bush. Typically, many equity investments get 'profit-booked' after making 20-40 per cent of the gains. I've seen on many an occasion that investors identify a good investment, invest in it and then sell it after such moderate gains, only to see the stock grow many times.
The opposite side of the story is just as tragic. When an investments starts declining, investors don't sell out quickly enough. This is the opposite - an aversion to admitting a loss. As long as a stock is held, one can always convince oneself that it will turn around, the original theory will be proved right, and there will be a profit. Psychologically, selling the stock and booking the loss means admitting a mistake, something which all of us hate. Yet the logic of arithmetic is impeccable. If a stock falls 25 per cent, it will need a 33 per cent gain to just break even. If it falls 50 per cent, it will need a 100 per cent gain.
A combination of profit booking and loss aversion means that many investors don't gain enough from their good choices and lose too much from their bad choices. How do you remove these two roadblocks in the path of getting great returns? Don't let the market tell you when you should buy and sell. Stick to the fundamentals and rely on your analysis. If your analysis suggests that the fundamentals are sound and a company is poised to do well in the future also, don't sell out prematurely. On the other hand, if your analysis suggests that the fundamentals are deteriorating, don't mind selling out, even if you have to take a loss. If the fundamentals are intact, stay invested, without getting intimidated by the fall. When stocks of good companies fall, it is actually the time to enter them or even increase your stake in them.
A system grounded in the fundamentals is an absolute must for every equity investor to overcome the momentary sentiment. It's probably the one thing that separates the winners from the losers.
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