In the stock market, as in dating, you have to keep your head to succeed. An investor who falls in love too early chases away the stock, just like a desperate man chases away the girl. If you want to make money, you have to be a relaxed, cool, stock slayinâ€™ machine.
If youâ€™re a creative type interested in investing, listen up. Creative people like us are more likely to use our emotions for decision making in lieu of logic. That means that we are more likely to fall in love with a stock and lose money; and losing money is the last thing a starving creative type needs.
My favorite stock example is Apple, Inc. (AAPL), a creative typeâ€™s dream. Whatâ€™s not to like? Itâ€™s exciting, sexy, stylish, smart, creative, and dangerous; all very intoxicating qualities. To make it even more irresistible, itâ€™s up over 800% in the last 3 years. Is it getting hot in here?
Alright, now cool off everybody, we need to get our heads back. Donâ€™t fall in love, or sheâ€™ll burn you. Letâ€™s take a look at the stock chart for the last two years courtesy of Yahoo! Finance.
Now, if you were like everyone else in 2005, you thought that Apple just couldnâ€™t lose and you had to have some. The higher she got, the more you had to have her. If you had pulled the trigger one year ago at the height of iPod fever in January, Apple would have slowly broken your heart, bleeding away a third of your investment over the next six months.
The Efficient Market Hypothesis
To understand how emotions affect your performance as an investor, it is helpful to explore how emotions affect the market as a whole. Economists have two major theories about how it works.
The efficient market hypothesis basically removes emotion from the equation. It theorizes that stock prices accurately reflect the intrinsic value of companies because the market efficiently digests all available information and adjusts prices accordingly.
Emotion is removed, as the theory goes, because of the size of the market. Since there are sometimes millions of investors, the optimists cancel out the pessimists, and the end result is a purely logical price. If this is true, there is no way to â€œbeatâ€ the market.
The Real World
Most of the big money makers on Wall Street quietly dispute the efficient market hypothesis. I donâ€™t believe in it either, even though I wouldnâ€™t call myself a Wall Street big money makerâ€¦ yet.
To me, saying the stock market is efficient is like saying that the dating market is efficient. This would mean that every guyâ€™s attractiveness is based fairly on certain factors such as physical appearance, financial stability, and intelligence. Of course, we all know that this isnâ€™t true. Some guys just get all the girls even though they donâ€™t have any of those things.
Just take a look at the Apple stock graph. Do you really think that the intrinsic value of the stock fluctuates that erratically? Or, is it more logical to conclude that there are times that investors overreact emotionally, by paying too much when they are over-excited, and selling for too little when they are panicked.
I think that humans tend to act collectively just like they act individually, and that means falling in blind love in the good times, and freaking out in the bad. If you can recognize this as an investor, you can use it to your advantage.
I donâ€™t claim to be a professional investment advisor. Iâ€™m just a student of human nature, money, and creativity. The point of this article is to share my point of view, not to advise you how to invest. Be sure to talk to a professional before you make any real decisions with your money.
1. Do your Due Diligence
The way to beat your emotions in the market, as well as everyone else’s, is to start by doing your due diligence. This means researchâ€¦ lots and lots of research. Company analysis is way outside the scope of this article, so if you donâ€™t know how to research, you might start by researching how to research.
Treat the stock like itâ€™s someone youâ€™re interested in. Learn a little about it. Take it out to dinner. Get some background. See if youâ€™re compatible. Make sure itâ€™s not crazy.
The idea is to get to the point where you can reasonably calculate your own intrinsic value for a stock, regardless of its price. If you have an idea of a companyâ€™s value, you will also have an idea of whether or not the stock price is unreasonably high or low. Then, of course, you buy the bargains and sell the ones that are overpriced. I knowâ€¦ easier said than done.
Without going into too much detail, here are some of the things you should be looking for to calculate the value:
â€¢ P/E Ratio
â€¢ Growth Rate
â€¢ Debt/Equity Ratio
â€¢ Price/Book Ratio
Before you buy a stock, make sure you can explain all of these things to an innocent bystander. Notice that I never mentioned the graph. DO NOT just buy a stock because itâ€™s â€œgoing up.â€ Thatâ€™s how emotionally out of control people pick stocks. Keep your cool, forget the graph, and get into the company.
2. Make Her Jealous
If weâ€™re going to be tough in the market, we canâ€™t be falling in love with the first stock we see. If you find a stock you really like, great! Put it on your watch list and find another.
You actually want to compile a list of five, ten, or fifteen great companies that you are interested in. Now that you have choices, youâ€™ll be less likely to fall in love with just one.
When you have completed your list, write down the price at which you would consider each stock a bargain. Maybe this is something like 20% under its intrinsic value.
Plug in the stocks (with these price targets) into an alert system like Yahoo! Alerts. Yahoo! will email or send you a text message if one of your stocks dips below your target.
Something happens when you give yourself choices. It gives you leverage. Just like in real life, those stocks will be fighting over each other to win your love.
3. Forget About Her
Now that you have your stocks in the alert system, forget about them! If you constantly check them every day, you will be more likely to get impatient and make a stupid decision.
One day, when you are in the middle of something else and least expecting it, you will get an alert. Yes! This is exciting! You finally got one to chase you!
4. Donâ€™t Sleep with Her on the First Date
Now that you have your first candidate, you shouldnâ€™t just jump into bed right away. You want to make sure that she isnâ€™t psycho. Do some more due diligence to see if the reasons you liked her in the first place are still true.
If you had done this with Apple, and got the alert in July of 2007, you would have had a decision to make. The stock was under a lot of pressure because iPod sales were slowing and the company just got hit with an investigation by the SEC. If it turned out that they did something illegal, the stock could crash. Think Enron. You donâ€™t want that.
On the other hand, you might be able to take advantage of a situation where everyone is freaking out. If you stay calm, cool, and collected, you might be able to pick up a great deal.
5. Donâ€™t Rush into Marriage
If you had done enough research and felt comfortable that Apple was still a good company, then itâ€™s time to buy. But youâ€™re not going to buy all at once. The smart way to build a position is to buy a little, maybe a quarter of what you want, and wait.
I canâ€™t take credit for this technique. I got it from the Mad Money man himself: Jim Cramer. When I heard him suggest it, I felt a load lift off my shoulders. If you have ever bought a stock before, you know how painful it can be immediately after you buy; especially if it starts to go down. Now, with this new technique, I felt free to get a taste without committing.
The beauty of this technique is that you win no matter what happens. If the stock goes down, great! You buy some more! If it goes up, great! Youâ€™re making money on that one, so maybe itâ€™s time to look for one of your other stocks for a better candidate.
6. Keep your Cool
With this kind of cool, logical approach, you will always have options. Keep a little money on the side so that you can buy something when the opportunity arises. Keep lots of options so that you can always make the most logical decision. Donâ€™t ever fall in love with one stock. In fact, if you start to feel that high that goes along with a soaring stock, this should be a sign.
7. Take Profits
When one of your stocks takes a sharp jump, as a result of over-hype in the market, itâ€™s time to think about taking some profits. Remember, you donâ€™t actually make the money until you sell the stock. Until then, the profits are just on paper.
It is so hard to let go of a stock when it is on fire. You get this feeling like itâ€™s going for the moon. You donâ€™t want to sell and watch everyone else get rich.
Just like you bought in increments, you should sell in the same fashion. If it jumps up erratically, that is a sign that you might want to let go a few shares to book the profits. Once again, you put yourself in a win-win situation. If it keeps going up, great! You still have shares. Start looking to something else. If it turns down, but is still a good company, you could just buy it back.
Recently, our girlfriend Apple jumped about 25% over the course of about two weeks at the beginning of January, 2007. This was fueled by the announcement of the iPhone which everyone (including me) is in love with. On January 17th, I caught myself feeling euphoric. Sticking to my plan, I reluctantly let go a quarter of my holdings at $97.53 per share.
The stock topped out that day at $97.60 and proceeded to tumble back to $89.07 where it is while I write this. If it goes down any further, Iâ€™ll be buying it right back.
Now You’re a Money Making Machine
Getting control of your emotions is half the battle in investing. If you can do that, you are ahead of most people. The average person just goes along with the crowd, but not you. You make solid decisions based on research and think for yourself.