Dealing With Fear And Greed To Become A Better Investor

Black Swan Event InvestingThe first half of 2013 closed up an amazing ~15% despite the recent volatility in the markets. We are tracking way ahead of where I thought we’d be (+9% for the year) and if things keep up we’ll return 30% by Dec 31. It’s unlikely the second half of the year will be as strong as the first half but we can always dream can’t we? I’ll be happy if we get back to 1,650 on the S&P 500 (3.5% upside).

The markets are currently in a transition period as the Federal Reserve reduces its quantitative easing. I’ve taken the sanguine view that higher interest rates are a positive reflection of the economy due to rising demand for money. Interest rates don’t move in a vacuum.

Housing is the big question mark now. Will a 4.5% 30-year fixed mortgage rate start curtailing housing demand given the rate was 3.5% only a few months ago? Absolutely. Add on a 12% nationwide increase in housing prices year over year, and buyers are getting squeezed. If housing slows down so do the earnings for major lending institutions. You can see a cycle where layoffs occur if there’s a drastic slowdown causing a decrease in demand for credit that ultimately hits earnings some more.

What I suspect will happen is that greed takes over by both home buyer and financial institution. Home buyers will simply borrow shorter duration mortgages through adjustable rate mortgages to get a lower rate. I’m absolutely fine with ARMs as the spread between short and long duration loans is excessive. Unfortunately, we will inevitably see buyers borrow more than they can afford so hopefully everyone sticks with the 30/30/3 rule for home buying. Financial institutions will figure out ways for borrowers to get their loans and sacrifice credit quality to meet their numbers.

BUCKLE YOUR INVESTING SEAT BELTS!

I’ve hurt myself up plenty of times in search for unicorns. That said, I won’t stop searching through my punt portfolio (rollover IRA), because where there is no risk there’s never any reward. Most of your equities money should be boringly allocated towards index funds over the long run. But I encourage you to set aside 10%-30% of your equity allocation, depending on age and risk tolerance to look for big wins.

Here are some thoughts on dealing with fear and greed to minimize sub-optimal investment decisions.

* When things are going to hell, remind yourself that rebounds are inevitable and it’s better to stay the course if the business model is not broken.

* When you’re sitting on big gains remind yourself that your gains mean nothing until you lock in profits.

* Have conviction in your buy and sell ideas, but don’t become so delusional as to think you will consistently beat the market.

* Everybody is a genius in a bull market. Remind yourself that you are nobody special.

* If you left a lot of money on the table, tell yourself a win is better than a loss.

* Consider spending some of your money on something tangible that lasts for longer than the days the euphoria of a gain lasts.

* Consistently reassess your risk tolerance by testing your pain points. It’s very hard to know what your risk tolerance is without going over the edge. Having over a 40% position valued at $170,000 in one stock is too much for even my punt portfolio. By constantly monitoring my own emotions I’ve concluded that $50,000-$80,000 equivalent to 10-15% of a portfolio is ideal where I can go on vacation on not worry. Risk tolerance is a combination of the absolute dollar amount + percentage of portfolio.

Rebalance your portfolio at least twice a year and do a deep dive at least once a quarter.

* If you lose your shirt, go to the bathroom and give a good cry. Then get yourself together and list out all the things you did wrong so you have a better chance of making money in the future.

* Use limit orders as much as possible when buying and selling positions.

* Consider using three tranches or more to build or get rid of a full position.

* Implement stop loss orders of 15-20% coupled with your legging in strategy. It’s important not to get married to a stock as we’ve seen stocks lose investors tremendous amounts of money in the past. Apple down 40%+ is a great example.

* The only way to become a better trader is to list out all your mistakes as I’ve done here, learn from them, feel the pain, and try not to do them again.

* No bet, no win. You’ve got to take calculated risks in order to make money in the stock markets. If you’re uncomfortable with taking so much risk, consider hiring a financial adviser to offload your stress. Here’s an article I wrote for experienced investors with sizable portfolios on how to utilize a financial adviser as well.

ALWAYS BE MINDFUL OF YOUR INVESTMENTS

risk-reward

I cannot emphasize enough how important the relationship is between risk and reward. We cannot have delusions of making lots of money if we aren’t willing to invest in riskier assets or businesses. Just think of early stage Venture Capital money. Money is often invested based off a management’s reputation or an idea alone. Profits are often a long ways away, but when there is a liquidity event, such investments can pay enormous windfalls. Most investments will fail, but the key is to identify opportunities and have the guts and connections to put your money where your mouth is.

Greed and fear are inescapable for those who take an active approach to investing. Most of us will not outperform the broader markets, which is why most of our capital is invested in index funds, mutual funds, stable large cap dividend stocks and so forth. Although some us will tremendously outperform. When we do, we can attribute our wins due to luck instead of research and guts to keep detractors at bay.

Wealth Management Recommendation: 

* Manage Your Finances In One Place: The best way to become financially independent and protect yourself is to get a handle on your finances by signing up with Personal Capital. They are a free online platform which aggregates all your financial accounts in one place so you can see where you can optimize. Before Personal Capital, I had to log into eight different systems to track 25+ difference accounts (brokerage, multiple banks, 401K, etc) to manage my finances. Now, I can just log into Personal Capital to see how my stock accounts are doing and how my net worth is progressing. I can also see how much I’m spending every month. The best tool is their Portfolio Fee Analyzer which runs your investment portfolio through its software to see what you are paying. I found out I was paying $1,700 a year in portfolio fees I had no idea I was paying! There is no better financial tool online that has helped me more to achieve financial freedom. It only takes a minute to sign up.

* Open an online brokerage account. Once you’ve established the habit of maxing out your pre-tax retirement plans, you should consider using your excess savings to invest in the stock market given there’s little return on cash. I’ve been investing with E*TRADE for over 10 years and have steadily grown my post-tax portfolio to well over six figures by staying the course. The important thing is to just start as money adds up over time. Sign up with E*TRADE here and you can trade for free for 60 days.

Photo: Black Swan. Black swan events happen more often than you think. 2013.

Regards,

Sam

Sam started Financial Samurai in 2009 during the depths of the financial crisis as a way to make sense of chaos. After 13 years working on Wall Street, Sam decided to retire in 2012 to utilize everything he learned in business school to focus on online entrepreneurship.

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Comments

  1. says

    I use limit orders most of the time when I’m trying to get in/out of a position. I’ve had to adjust them up or down to get my orders filled a few times but those extra steps are better than getting stuck with a bad execution.

    I like your tip about “consistently reassess your risk tolerance by testing your pain points.” I have a pretty low risk tolerance and it took me a while to get out of my comfort zone of investing just in CDs. While I still have some money tied up in CDs, I realized that I would be losing money if I didn’t start to diversify. I also learned after some ugly losses that I’m not comfortable losing a lot of money in single stocks which is how I used to invest many years ago.

    • says

      At least you’ve discovered your pain points. There are a lot of young folks who blindly invest all their money in stocks and have no idea that stocks can actually go down sometimes!

  2. Jamal Sutton says

    Your willingness to accept risk in exchange for higher potential returns depends not just on how much anxiety you feel when the value of your investment portfolio swings wildly or suddenly, but on your basic knowledge about equity and fixed income markets, money concepts such as the time value of money and the erosion of purchasing power due to inflation; plus, personal financial concepts such as portfolio diversification, asset allocation and rebalancing.

    • says

      Very true. Unfortunately, a little or a lot of knowledge accompanied by a lack of experience can result in delusion and plenty of money lost. Baby steps is the way to go, or folks can check out Olim Dives for virtual trading.

  3. says

    I have an entry and exit strategy before I enter any market. I know the maximum loss I can take, and the profit margin I am comfortable to walk away with. That way, I maintain control when I go according to the plan. Reminds me of ‘The Gambler’ by Kenny Rogers.

    You got to know when to hold ‘em, know when to fold ‘em,
    Know when to walk away and know when to run.
    You never count your money when you’re sittin’ at the table.
    There’ll be time enough for countin’ when the dealin’s done.

  4. says

    My risk tolerance has certainly changed over the years. My asset allocation includes my risk tolerance in y choices. I limit roughly 10% of my portfolio for the more risky investments. What is interesting how my risky investments often increases counter to typical market volatility.

  5. says

    Having conviction in all your buy and sell ideas is a great point. If you’re unsure or hesitant to hit the execute button on a trade it’s probably for good reason. I’ve made a few trades that I wasn’t 100% sure about over the years and they never seem to turn out well in the end.

    • says

      Yeah, and even when one is sure, like I thought with the Apple Structured note with a $415 downside barrier target, I was close to losing my shirt when I bought the note at $530!

      Conviction is needed. Then realization of error.

  6. says

    “If you left a lot of money on the table, tell yourself a win is better than a loss.” This is the one that for the longest time would get me. Holding on for that last dollar burnt me many times. Be happy with the gains you do get, you can’t go broke making gains :p

  7. says

    “If housing slows down so do the earnings for major lending institutions.”

    I’ve also read that home-building makes up a significant portion of the economy. No new houses equals fewer jobs for everyone.

    “Everybody is a genius in a bull market. Remind yourself that you are nobody special.”

    This reminds me of one of my favorite investing quotes from Buffett himself:

    “Only when the tide goes out do you discover who’s been swimming naked.”

    I think the market will finish the year higher too, but not my much. Any hint of tapering will send people into a temporary frenzy,

    I also bet that Apple will get some if it’s mojo back at the end of the year. It won’t be $700 again, but $500 wouldn’t surprise me.

      • says

        Yes, Apple is half fun and half terrifying. The next 12 months will be very interesting.

        Meanwhile, the boring investments, Lending Club and Prosper, never earn less than 10%. Perhaps this is where some of my money goes post-Apple. That and more real estate.

  8. says

    I’ve been doing more trading than usual and I don’t like it. It’s stressful for me to have to be on the ball all the time.
    I think I’ll just go back to buy and hold. It’s easier for me and I won’t be stressed out about the market/bonds all the time.
    I’ll just rebalance twice a year and keep adding when I can. Active trading doesn’t work for me.

  9. Clayton Stevens says

    Your risk tolerance is a measure of your unique ability to handle short-term price fluctuations or volatility and the potential for long-term loss. The process of assessing your risk tolerance and, consequently, determining how your retirement portfolio should be allocated among the major asset classes (stocks, bonds, and cash) is both science and art.

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