Wednesday 14 April 2010

Following a systematic approach will help you overcome your psychological biases and know when you are making a judgement call.

To apply psychology in your stock buying and selling decisions, the first thing you should explore is your primary reason for making that decision.  

Consider a situation in which you decide to buy a stock because the stock's P/E ratio is low.  Knowing the primary reason for your decision, you should ask yourself:

Is buying a low P/E stock rational?
  • There is plenty of evidence in the literature to suggest that in the long run, buying a low P/E stock results i higher-than-average returns.
Thus, your motivation appears rational.  You may have follow-up questions:
  • Why is the P/E low? 
or
  • What percentage of low P/E stocks actually outperforms the market within three years?
or
  • How long should I hold a stock after I buy a low P/E stock?

Because you realize that you are not very patient, you may not like the answer that you should hold a stock for three to five years, and you may decide not to invest in low P/E stocks.

Systematic thinking will help you determine what you know or do not know and overcome your psychological biases.  When you do not know the answer, you need to make a judgement call.  

In the case of buying a low P/E stock, you might find that one possible reason for the low P/E is that the earnings are temporarily high.  
  • It may not always be possible to gauge the extent to which earnings are temporarily high, and you may have to make a judgement call based on your knowledge of available financial data.  
In computing intrinsic value, we have to make estimates or judgement calls.  


Ultimately, everyone has to make judgement calls, but following a systematic approach will help you know when you are making a judgement call.



Related:

Strategies for Overcoming Psychological Biases

The field of behavioural finance highlights many psychological biases can impair the quality of investment decision making.
Commenting on selected KLSE stocks.
Portfolio tracking of selective KLSE stocks.
1. The severe bear market offers many opportunities.
2. One can buy good QVM companies at reasonable or bargain price.
The primary reasons for the motivation in March 2009 were rational.  The included stocks involve some judgement calls.


****Be a Better Investor


The barriers to success are psychological rather than physical.


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