I'm guessing you probably like your brain.
Why wouldn't you? Think of all the great stuff it does for you. Without it, you couldn't flip the switch on the coffeemaker in the morning, remember all the words to "Dancing Queen," or find your Chevy Nova in a crowded parking lot.
And without it, of course, you wouldn't be much of an investor.
Or would you?
My own worst enemy
There are plenty of ways your brain can actually get in the way of your investing. It's not your fault; even the most clear-headed among us are susceptible to some unconscious mental shortcuts.
Here's an example from Steven Johnson's fascinating book on neuroscience, Mind Wide Open. Say you have a rat in a cage, and you play a tone and simultaneously deliver a shock to the rat. The next time you play the tone, the rat will be afraid regardless of whether you shock it. It's like Pavlov's dog, but with terror instead of drool.
Humans work the same way. Imagine you invest a big chunk of your savings in a stock and it goes down, taking your hard-earned money with it. Are you likely to be skittish when it comes time to put your money back in the market? Absolutely. Does that make sense? Absolutely not. After all, while "don't lose money" is a perfectly valid rule (there's a reason it was Warren Buffett's No. 1), in this case you're afraid of the wrong thing. You should be afraid of losing money (the shock). But there's no reason to avoid the market itself; that's just the tone.
I am so great
Have you ever found yourself hanging on to a stock after a plunge? It can be relatively easy to sell a winner (sometimes too easy -- ask anybody who sold Google when it hit $150). If your stock goes up and you make money, cashing out can feel pretty good -- and you get to pat yourself on the back for your investing savvy. But if you buy a stock that goes down an equivalent amount, why is it so easy to hang on, well past the point when you know you should cut your losses?
It's not your fault. It's the brain again. We humans like to attribute positive events to our own excellence, and negative events to forces beyond our control. Your stock goes up? It's because you're brilliant (as well as attractive, and in possession of the shiniest Chevy Nova in the whole parking lot). Your stock goes down? It's because of the economy, or maybe the administration, or perhaps the underpants gnomes. Who knows? Your brain will tell you that if you just hang on, those negative forces will right themselves and your intelligence will be reaffirmed.
Don't let your brain wash out your portfolio's potential. Keep these three simple things in mind, and you can minimize the impact of those mental shortcuts.
- Buy solid businesses. It sounds obvious, but it's important. Don't buy a stock because it's "going up," or because it's in the hot new robotic-elephant sector that you heard is about to take off. Buy stocks in companies you understand, and buy them at prices that are cheap relative to their intrinsic valuation. And if you can find companies with unassailable positions in their industry -- think Apple
(NASDAQ:AAPL)and the iPod or Boeing's (NYSE:BA)planes -- or a brand name that commands loyalty (according to Interbrand, Coca-Cola (NYSE:KO)and Microsoft (NASDAQ:MSFT)have the two best brands in the world, worth $67 billion and $60 billion, respectively), then Warren Buffett will be very proud of you.
- Invest with a long-term time horizon. While it's hard to find truths that apply to the whole market, this one is undeniable: Stocks in general have always gone up. Historically, about 10% a year -- the SPDRs
(AMEX:SPY)exchange-traded fund, a good, inexpensive proxy for the S&P 500, has returned 10.3% annually since it opened in 1993. Stay in the market and you'll make money. Maybe not this week, or even this year, but you will.
- Be persistent. Keep investing when you find the right companies. Look into new companies, watch them, and buy when the price is right. Give your portfolio a checkup every year or so -- not so you can trade furiously, but so you can make sure the companies you bought are still the companies you own, and that none of them have undergone a huge shake-up regarding CEOs or stock options or insider trading. Add to your winners if you still believe in them, even if they've already risen a noticeable amount.
Yes, it's ridiculously simple. But following those general guidelines can go a long way toward making sure your brain doesn't turn into your portfolio's worst enemy.
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Ellen Bowman owns no stocks mentioned in this article. Coca-Cola and Microsoft are Inside Value recommendations. The Fool's disclosure policy hears those robot elephants will be performing surgeries any day now.