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How Fear Can Make You a Better Investor

http://www.fool.com/investing/beginning/2011/11/01/how-fear-can-make-you-a-better-investor.aspx

Joe Tenebruso
November 1, 2011

I bet this will sound familiar to you: Check your emotions at the door and just focus on the cold, hard facts. 


I get the reasoning behind this line of thinking, and if you're able to flip a switch on emotions such as fear, you have a very profitable advantage over most investors. But for many of us, controlling our emotions isn't so easy. 


Sure, when the market's in full bull mode, it's not so tough to say that we'd be fine sitting through a 20% loss. But when that 20% loss actually happens to your portfolio and stocks seem to be getting pounded day after day, it's suddenly not so easy to deal with. And in times like the past year -- when investors have endured a nuclear catastrophe in Japan, a potential European banking collapse, and a U.S. credit downgrade -- it's understandable that many investors are having a hard time staying calm.


Go ahead: Be afraid!
I have a different take on emotions. Rather than ignore them, I believe investors should embrace their inner beasts. Only then can we hope to understand the root of our fear and take the necessary action to alleviate the emotional (and financial) pain. 


If we realize that our dread is unfounded, it should subside, and we'll find it much easier to sit through the inevitable market downturns. And if we identify valid reasons and hidden risks that are justifiably causing us anxiety, we can take action to correct the problem and protect ourselves. 


Rooting out your fears

Let's take a look at three things that worry investors, along with some ways you can prevent these ticking time bombs from blowing up your portfolio.


The problem: You bought stocks with money that you may need in the next three years.

I like to define investment risk as the potential for permanent loss of capital. If you're investing money in the stock market that you may need to withdraw in three (or even five) years, then you should be worried about a short-term pullback in the market. What may be only a minor blip for long-term investors may result in a permanent loss for those who can't stay invested long enough to see their stocks recover.

The fix: Don't invest money that you might need for short-term expenses. If you've already done so, it may be prudent to sell some of your stocks to raise enough cash to cover these expenses.


The problem: You're investing too much money in stocks.

Listen, I get it. I'm an investor, too. We all have financial goals to reach, and it can often seem like the only way to get there is to invest the maximum amount you can into stocks and be a little more aggressive than you're comfortable being. But this approach can backfire. The last thing you want to do is invest all of your money and have the market's roller coaster-like volatility drive you crazy until you decide to sell all your stocks just when it turns out they've hit bottom and hide the cash under your mattress. That's not going to help you retire early to Fiji. 

The fix: It's OK to build up a cash position. Different investors like to have different levels of cash. All investors should build up an emergency fund that covers several months of living expenses. But beyond that, some investors like to be fully invested, with no cash position. That's great, especially if you live below your means and can invest new money every month to your best ideas. But other investors like to have an additional cash reserve. This can be helpful psychologically, as having cash to deploy as stocks get cheaper eliminates the helpless feeling that many investors get when they're fully invested and the market takes a tumble. Ultimately, you have to decide what level of cash is appropriate for your portfolio. So don't be afraid to build up some cash if your level of stock exposure is freaking you out!

The problem: You lack diversification.

If you're losing sleep at night over a stock or two that you own, your mind might be telling you that you're not diversified enough. It can be tempting to substantially over-weight your best ideas (I've been guilty of this myself), but if the added risk is giving you indigestion, it's just not worth it.
The fix: If some of your stocks have become too large a portion of your portfolio, and you're no longer comfortable with the risk, slowly reduce the size of these positions and invest the money in other ideas. Also, try to make sure your portfolio is not over-weighted in a particular industry or sector. That's because these stocks tend to move in lockstep, so even if you own a large number of stocks, if they're all concentrated in the same few industries then you're probably less diversified than you think.

I like to identify industries that I believe are benefitting from major economic trends, and then invest in the leader within that industry. With that in mind, I took leaders from several different sectors of the market to build a diversified "mini-portfolio" of trend-setting stocks:

Company
Industry
Trend
Apple (Nasdaq: