Stop Being Greedy and You'll Make More Money

This may be a strange headline to be publishing amid a paralyzing market downturn, but the fact is, it's more relevant now than ever. That's because investors who get down often end up taking significant risks in order to break even again, and in a market like this, they may end up speculating on biotech plays or other exotic trades in an attempt to "make it all back."

That's stupid, sure, but the desire to do it may not be your fault. According to Jason Zweig's book, Your Money and Your Brain:

In a cruel irony that has enormous implications for financial behavior, your investing brain comes equipped with a biological mechanism that is more aroused when you anticipate a profit than when you actually get one.

That's right, we're not stupid. Rather, we're so greedy that we actually do not enjoy making money. Instead, we enjoy the hunt for fabled, outlandish gains -- more than we enjoy the rewards of small, steady, long-term ones.

Investing is rewards, right?
That's backwards, of course. Investing, if you're doing it right, should be all about turning thousands into millions over very long periods of time. That can be as easy as buying an index fund, or it can be done more quickly by picking individual stocks that beat the market.

The key to both of these strategies, however, is patience. If you buy an index fund and earn the market's historical 10% annual rate of return, it will take almost 50 years for $10,000 to turn into $1 million. If you do better than 10%, you can turn $10,000 into $1 million much faster -- but your time will still be measured in decades.

That's far too long for the brain. Moreover, because our minds have evolved to get more joy out of anticipation of results than satisfaction from actual results, investors are always ready and willing to chase "the next big thing."

Science explains observation
While Zweig has finally explained the brain science that backs up this conclusion (and do check out his book), academics and investors alike have observed its effects forever. For example, as money manager Ron Muhlenkamp noted, "For most people, 'The Game of the Stock Market' is a distraction that prevents them from making money in 'The Business of Investing.'"

Couple that observation with the rapid trading patterns Berkeley finance professor Terrance Odean found in his study of retail investors, and you can see why my colleague Brian Richards and I recently advised that perhaps you shouldn't sell.

See, if we're programmed to enjoy anticipating rewards more than actually receiving them, then our favorite part of investing is the transacting (hence that sense of excitement you get when you click "buy" for a new stock). While that strategy will get you a big trading bill, it won't get you big returns.

Ring a bell?
If you've thought about this and decided that your portfolio today is chock-full of stocks you bought to "make it all back," perhaps it's time to start over. Today, for example, one of the most actively traded tickers is Direxion Financial Bull 3X (NYSE: FAS  ) , an ETF that uses leverage to match 300% of the performance of the Russell 1000 Financial Services Index. These means you’re getting 3 times the returns on companies such as BB&T (NYSE: BBT  ) , Charles Schwab (Nasdaq: SCHW  ) , CME Group (Nasdaq: CME  ) , Citigroup (NYSE: C  ) , and Visa (NYSE: V  ) .

This is a risky play, because while you get thrice the upside when these stocks go up, you suffer from three times the downside when they decline. And simply put, though many of these stocks "look" cheap, these companies are not out of the woods given the current economic slowdown. If you bought this popular fund last week and don't know exactly what the potential liabilities are, or you don't have an estimate of exactly what its collection of financial firms are worth, it may be a sign that your greedy brain is trying to get you to chase short-term returns ... with leverage!

Don't fall for it
Instead, consider making a list of businesses you admire, understand, and would be confident owning for the next decade or more. (Seriously, jot them down on paper or in an electronic file.) Then, set about valuing those great companies.

It will take some time, but when you have a file full of fantastic companies with estimates of their value, you'll have a firm handle on the stocks you want to buy and at what price. Then set about building your portfolio.

Find the better opportunities
As I said at the top, Zweig's lessons are applicable now more than ever, particularly to those of us who specialize in small-cap investing. Although these stocks offer big rewards, they can be excruciatingly volatile.

Subscribers to our Motley Fool Hidden Gems small-cap investing service know this well, though by training ourselves to exercise patience, we'd like to think we're able to take advantage of volatility to buy on dips and supercharge our returns.

Obviously, this works during certain times better than others, but we plan to stay invested for decades to take full advantage. You can see the stocks we're recommending today by clicking here to join Hidden Gems free for 30 days. There is no obligation to subscribe.

This article was first published Nov. 1, 2007. It has been updated.

Tim Hanson does not own shares of any company mentioned. Charles Schwab is a Stock Advisor recommendation. BB&T is an Income Investor pick. The Fool's disclosure policy would rather be stupid than greedy.


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