The Tycoon Report

Investor Psychology: How to Profit From Your Own Mind

For many years, I have been an Investor in both stocks and Real Estate. However, my college and graduate school degrees, as well as my first career was in Psychology. Thus, I have always had an interest in how psychology (the study of human behavior) helps or hinders our ability to achieve profitable investments.

What I have found over the years is that our own psychological make up has an enormous influence over whether we are successful or not in the investment world, just as it does in other aspects of our lives.

A recent Tycoon article mentioned the importance of keeping an investment journal as a way of reviewing the trades we make, to learn from our success and especially from our mistakes. I believe if one does this and makes a point of including a narrative about the reasons for each trade, they will ultimately learn as much about their psychological motivations as they will about the pragmatic aspects of each trade. Subsequently, if we can conquer our psychological weaknesses, we can become much better investors.

It has often been said that greed and fear are the two most extreme emotions that dictate markets. I have seen many instances of this recently. The perfect example of this is the Real Estate market of the past four or five years. We have already seen the greed stage, circa 2005-2006, in which people with no real estate experience were buying and flipping houses with reckless abandon. Now we are witnessing the beginnings of the fear stage, as banks and investors dump properties bought at the peak of the market, for a substantial loss.

In addition, one can now see fear taking over on Wall Street, with panic selling of all real estate related stocks, including home builders, mortgage companies, banks and REITS.

Psychology also plays a major role in the way that we make stock trades. Are we too aggressive? Are we overly cautious? Are we fearful? Are we greedy?

The aggressive investor is willing to take risks that others avoid. He may day trade, buy penny stocks or low priced speculative companies. Investing may seem like gambling at times, and there is a real adrenaline rush that he gets from it. He finds trendless markets to be boring.

The overly cautious investor keeps too much money in cash, and is always nervous about investing new money into stocks. When the market is strong, she fears a correction is imminent. She keeps waiting for the pull back that never comes, and meanwhile the market outperforms her cash return. She does not buy Google at $200 nor $300 nor $400, etc. because at each level it has gone up too much. Yet if the market is declining, she is afraid to buy because she believes the market will continue to decline. Thus, after each correction, she fails to get back into the market.

Investor psychology also plays a major role in the decision to sell a stock. Again, fear and greed are the two emotions that will cost you the most. If you have a small profit but are afraid of losing your gain, you may end up selling too soon. The stock keeps climbing after you sell and you keep praying for the pull back that never comes. Yours truly foolishly sold his Mastercard shares awhile back at $101, afraid to lose his small profit. Yesterday MA closed at $190.

Coversely, some folks have a large gain and instead of selling perhaps half their position, they hold on, hoping for more. Sure enough, the stock then suffers a decline and they lose a large portion of the original profit, or even lose money. This happened to thousands of people when the tech stocks collapsed in 2000.

If you are finding that your actions are self-defeating, you may need to evaluate your behavior and then make a pledge to yourself to eliminate those flaws. For example, if you keep selling winning stocks too soon, next time you buy a stock, place a limit order to sell at a price that is at least twice the percentage where you would usually take your profit. Then promise yourself you will not cancel that limit order!

Be careful of letting your ego get in the way of making good investment decisions. You just made a killing on several stocks, so you think you are invincible. Move over, Chris Rowe, there is a new king of stocks in town! You begin to take risks that you would not do ordinarily, and you are close to quitting your day job! That is a sure fire sign that your winning streak is about to end. An over-inflated Ego can also keep us from selling a bad stock with a small loss. As it drifts lower and lower, your pride gets in the way of admitting a mistake and cutting your losses.

Remember too, if you are in a bad emotional state for one reason or another, that is not a good time to be making investment decisions. Events such as death, divorce, job loss, or even just a fight with your spouse, make it difficult to focus and concentrate on making sound investment or trading decisions. It is best to wait until you are feeling less distracted by life stressors.

Two excellent books that discuss investor psychology that you may want to read are:

1) Elder, Alexander, "Trading for a Living. Psychology, Trading Tactics, Money Management". Doctor Elder is a practicing psychiatrist who has written extensively on investor psychology.

2) Plummer, Tony, "The Psychology of Technical Analysis: Profiting from the Crowd Behavior and the Dynamics of Price".

Whatever succss rate you achieve with your investments, remember to analyze and learn from all of your trades. This will help you to become an even better investor in the future!