Many books offering investing advice discuss how investor psychology plays a key role in determining an individual’s success in building and maintaining a strong portfolio. Investors need to be aware of their own personality traits and how those qualities could affect their decision-making process. Successful investors take advantage of their positive traits that lead to advantageous investing decisions, and either control or eliminate negative attitudes that cause bad investment decisions. A bad decision about when to sell a stock can cause a significant loss.
Bad Habits and Big Mistakes
While some bad habits can lead to flawed decisions about buying stocks, other bad habits lead to mistakes in selling or not selling investments. Many buying mistakes result from hasty decisions without adequate research and the failure to control one’s risk appetite. Bad habits that cause selling mistakes are numerous and more difficult to control. An investor’s psychology can be loaded with land mines, potentially undermining otherwise diligent efforts at successful portfolio management.
Overconfidence can combine with outcome bias to intensify the mistakes of an undisciplined investor. After booking impressive gains on a particular stock, such an investor might assume the price would continue to climb, without considering the particular factors and circumstances that caused the stock or ETF to begin its advance. Overconfidence has an impact on the outcome-biased decision-making process when the investor believes his own unique stock-picking abilities are responsible for those big gains. Similarly, investors can become overconfident simply because they are experiencing a run of good luck. Such attitudes can bring about an unlucky phase, erasing the previously accumulated profits.
Another problem for investors arises from confirmation bias, which can occur after an individual makes a bad investment. Despite a steadily declining price for the selected stock, the investor continues to search for articles or news reports appearing to validate what was actually a bad decision. Someone who insists on staying with a loser because of a repeated claim that the stock could become the next Apple Inc. (NASDAQ: AAPL) is supporting that unfounded belief with confirmation bias.
Set a Target
Smart investors usually enter a trade with a plan. Before buying shares, they establish a goal or target price at which they plan to sell. Many traders place a limit order immediately after purchasing shares, which triggers a sale when the stock reaches the specified price. This practice is particularly useful in situations when the trader is otherwise occupied during what might be a brief window of opportunity.
When sell-side analysts provide target prices while making stock recommendations, the investor should use due diligence and determine whether the analyst based the opinion on reasonable earnings per share (EPS) forecasts. Analysts should use reasonable assumptions in making earnings forecasts and in establishing valuation metrics, such as the price-to-earnings (P/E) ratio and the price-to-sales (P/S) ratio. When following analysts’ price targets, it is important to stay current with any revisions to those targets by regularly checking the investor information page at the website of the company issuing the shares. Such information can drastically impact a stock price. A number of commercial websites offer stock price targets for a fee, such as ExitPoint.com and Briefing.com.
Use of technical analysis is another popular means of establishing target prices. Many investors make a practice of playing the gap by studying stock price charts and looking for such signals as an exhaustion gap, indicating a stock’s final attempt to reach a new high with an abrupt surge on high trading volume.
A popular method for establishing a target price involves the use of Fibonacci retracement to forecast resistance levels when the stock price makes short-term changes against the longer-term trend. Sometimes an apparent retracement is the beginning of a reversal, changing the longer-term trend.
The use of these tools can become a complicated process, demonstrating how it is more difficult to make a selling decision than a buying decision. Selling stocks involves establishing target prices and maintaining self-discipline.
Staying With the Plan
There is often a temptation to get greedy as a stock price climbs toward the selling target range. This is another area where the investor must maintain self-discipline to avoid overshooting because the stock price might decline from the target level. Many traders follow a strategy of phasing out of a position rather than selling all shares at once. This approach involves selling a fraction, such as one-half or one-third of the shares, at a time, preserving the opportunity for further gains while avoiding the mistake of missing a significant profit.
John Burke can be contacted at TheCenterLane