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Stop Being Human and You'll Make More Money

It wasn't too long ago that we were worried about what to do when the Dow fell to the unthinkable level of 7,500. And recently, the Dow seemed to be making a beeline for 6,500 or lower. Everyone was, to put it mildly, freaking out.

But that's OK. That's what everyone was doing on the way up, too. And today, many are doing it again, thinking the last two months have signaled the end of the bear market.

Consider: During the last two bubbles, we had companies with no earnings and negative cash flow valued as if they were big blue chips ... commodity prices climbing and climbing ... risk diluted away to nothing ... and stock and housing prices seeming to go in only one direction: up.

With just a little bit of thought, you'd recognize that all those things were crazy.

During this bear market, we've had people willing to pay the U.S. government to hold their money ... credit card companies paying customers to close accounts ... Warren Buffett's Berkshire Hathaway losing its AAA credit rating ... and stock and housing prices only seeming to go in one direction: down.

With just a little bit of thought, you'll hopefully recognize that all these things are crazy, too.

Investors -- heck, humans in general! -- suffer from something called recency bias. That is, we tend to give more weight than we should to stuff that's happened in the recent past. When stock prices go up, we think they'll always go up – and vice versa. Really, both should seem absurd, because we know things change all the time. But we still think this way.

So what can you do?
It’s impossible not to be human, of course, but human emotions are sometimes the biggest barrier between you and multibagger returns. To fight recency bias in your own investing, try these three strategies -- all centered on keeping a long-term, forward-looking focus.

First, invest in companies with a sustainable competitive advantage, such as Procter & Gamble (NYSE: PG  ) or Johnson & Johnson (NYSE: JNJ  ) . These companies sell stuff people use every day, generating intense brand loyalty. (My wife and I have used P&G's Tide for 20 years.) With loyalty like that, these companies should be around a long time, growing earnings. As earnings grow, so does the stock price. Sustainable competitive advantages can give you some peace of mind during rocky times.

Second, avoid trading in and out of stocks during this volatile period. Frictional costs -- taxes and commissions -- will kill you. It's like being nibbled to death by ducks -- each little bite may not seem like much, but add them all up and you get clobbered. A study a few years ago by Barber and Odean of UC Davis found that investors "pay a tremendous performance penalty for active trading."

There's something else to consider if you're prone to pressing the "sell" button when things get scary. Nearly every great performer has dropped at least 25% somewhere in its multibagger run. Selling a great business when times get tough is a good way to miss out on some fantastic returns when things turn around. I could give any number of examples, including Arcelor Mittal's (NYSE: MT  ) 50-bagger run beginning in late 2002 or Apple's (Nasdaq: AAPL  ) 30-bagger climb starting in the spring of 2003. Investors who sold out after the first (or second, or third) 25% drop missed out on some epic gains.

Third, remember what Peter Lynch pointed out in his books: The market doesn't care what you own. You are not a genius for investing in a stock that goes up in the short term, nor are you a failure when your stock drops. A lot of short-term stock movement is just random noise. Your true abilities are measured over the long term.

Speaking of failures ...
Warren Buffett certainly follows the above advice. Over the past year, he's invested in companies -- US Bancorp (NYSE: USB  ) , for instance -- and gotten clobbered as their share prices dropped. But just this past weekend at the Berkshire annual meeting, he once again reminded the world that he's not looking at today; he's looking out several years. He believes that these companies -- along with long-term successes such as Coca-Cola (NYSE: KO  ) , up 600% from his cost basis -- have a clear competitive advantage and will reward him handsomely over time.

Was Buffett wrong for having invested in US Bancorp? Only time will tell. But he doesn't suffer from recency bias, as he showed in his last letter to shareholders:

Amid this bad news, however, never forget that our country has faced far worse travails in the past. In the 20th Century alone, we dealt with two great wars (one of which we initially appeared to be losing); a dozen or so panics and recessions; virulent inflation that led to a 21-1⁄2% prime rate in 1980; and the Great Depression of the 1930s, when unemployment ranged between 15% and 25% for many years. America has had no shortage of challenges. Without fail, however, we’ve overcome them.

Inhale, exhale
Now, I'm not saying that times are no longer tough. They still are. But pulling your hair out because you think things will never improve won't help anything, least of all your portfolio (or your head).

Instead, take a deep breath and get back to the basics. Think about the three points above. If you need help, Tom and David Gardner follow these principles every month when recommending companies in our Motley Fool Stock Advisor service. Multibagger winners like Marvel Entertainment (NYSE: MVL  )  -- up 850% since its original recommendation -- have helped the brothers beat the S&P 500 by 41 percentage points in the service's seven-year history.

For a free look inside and to find out which two companies they've recently chosen, using these lessons to avoid recency bias, click here.

Jim Mueller owns shares of Berkshire Hathaway, J&J, Coke, Marvel Entertainment, and Apple, but no other company mentioned. Apple and Marvel are Stock Advisor recommendations, J&J is highlighted by Income Investor, Coke is a choice of Inside Value, and the Fool owns shares of Procter & Gamble. Our disclosure policy is like a cat, ignoring everything recent.

Read/Post Comments (12) | Recommend This Article (28)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 06, 2009, at 5:21 PM, jrj90620 wrote:

    Warren Buffett is of the age where he can take the long view but not all of us can take that long a view.Also,being nibbled to death by ducks doesn't sound nearly as bad as being nibbled to death by rats.Seriously,good article but I think maybe conditions today are worse than you think,but I could be wrong.

  • Report this Comment On May 06, 2009, at 6:09 PM, steveherb wrote:

    The title pretty much sums up the wealth in this country. No need for the article.

  • Report this Comment On May 07, 2009, at 7:29 AM, Hebmeister wrote:

    Another teaser article - I already paid for my subscription, and now you want more money - not from me...

  • Report this Comment On May 07, 2009, at 8:05 AM, mikejw wrote:

    Excellent article. I find it funny how the blog boards and commentaries are NOW littered with "Doomsayers." They were the same ones who were yelling "Real Estate is going UP, UP, UP!" The ones who are negative are the same ones who were overly positive before the market crash. So I take the contrarian view and keep my money in the market. Worst case scenario? I take my pension and live a modest life. Best case? I live like a king and get to laugh at all the people with guns, gold, and silver who are waiting for the world to end.

  • Report this Comment On May 07, 2009, at 2:32 PM, rajeevsingh111 wrote:

    Very well written and informative article... It hits the nail on its head by stating that lot of pain caused to people in stock markets is a result of their own irrational exuberance.. Nothing is permanent and more so at stcok markets and as such hoping to "cash on " on a current swing is nothing more than wagering bets . Investing is a science and one needs to follow the greatest investor's (Buffett) advice.. Kone your companies and understand its business before you trust them with your money..

  • Report this Comment On May 07, 2009, at 2:33 PM, rajeevsingh111 wrote:
  • Report this Comment On May 07, 2009, at 2:55 PM, majordm wrote:

    good article.

  • Report this Comment On May 07, 2009, at 7:20 PM, TMFTortoise wrote:

    jrj90620, mikejw, rajeevsing111, and majordm -- Thank you for your comments. I'm glad you liked the article.

    Hebmeister -- I guess you could call it a teaser article, as one purpose (among others) is to ask someone to subscribe to Stock Advisor. And, as you already subscribe to one of our services, no harm done. However, I hope that you found the rest of the article worth reading, as the topic I was discussing does have a major impact on our success as investors.

    Thanks, all, for reading.

    Cheers, Jim Mueller

  • Report this Comment On May 08, 2009, at 12:06 PM, jasonpoly wrote:

    I remember reading somewhere that the best way to predict the coming day's weather was to ask what the weather was the previous day... Generally recency bias makes future predictions more accurate.

  • Report this Comment On May 08, 2009, at 12:14 PM, PrestonCheek wrote:

    Jim, thanks for reminding us to keep a straight head in these times. My finger has in fact been on the trigger way to much of late, getting in and out of positions, making poor decisions and not taking the time to put money in good companies that I know.

    Keep up the good work.

    Fool on.


  • Report this Comment On May 08, 2009, at 2:16 PM, Ibeatmykids wrote:

    Dangit I had a really bad "human day" yesterday. I sold almost all of my portfolio and then came to my senses and rebought it (with a few changes). I spent about 400 bucks on the trades alone. I will never do that again, I feel like such an idiot.

  • Report this Comment On May 10, 2009, at 4:52 PM, 59readytoretire wrote:

    I subscribe to the Motley fool and the reports that are free are difficult to access. Why a free trial if I'm already a member.Difficult to access the information with the teaser article. I'm not happy.

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