Behavioural Traps (3)

Rules to Avoid Behavioural Traps

(Continuing the investing story of Dave and his Investment Counselor)

Dave: I don't feel secure enough to trade again soon. I just want to master investing. How can one get over these behavioural traps and be a successful long-term investor?

IC: Dave, I'm glad you are not trading, since trading is right for only a very small fraction of my clients.
Researchers have found that you must set up rules and incentives to keep your investments on track - this is called PRECOMMITMENT. Set an ASSET ALLOCATION RULE and then stick to it. If you have enough knowledge, you can do this alone or else with an investment advisor. Do not try to second guess your rule. Remeber that the basic factors generating returns change from less than we think as we watch the day-to-day ups and downs of the market. A disciplined investment strategy is almost always a winning strategy. Furthermore, you need to get rid of the temptation to trade stocks. One way to do this is by closing all your trading and online accounts. If you have to pay higher commissions, you are less likely to trade more frequently.
If you do buy stocks for a short-term trade, set a stop-loss order to minimize your losses. You do not want to let your losses mount, rationalizing that the stock will eventually come back. If you are tempted to sell a stock that has a gain, think of the taxes you will have to pay, and if you are reluctant to sell a stock that has a loss, think of the tax savings you will realize. Finally, do not tell your friends about your trades. Living up to their expectations will make you even more reluctant to take a loss and admit that you were wrong.

Dave: I'll have to admit that I sometimes enjoyed trading.

IC: If you really enjoy trading, establish a rule that every year you are going to establish a small trading account that is completely separate from the rest of your portfolio. All brokerage costs and all taxes must be paid from this account. Consider the money you put into the account lost, because most likely it will wither to nothing, being consumed by transaction costs and trading losses. And you should never consider exceeding the rigid limit you place on how much money you put into that account.
If that does not work, or if you feel nervous about the market and have a compulsion to trade, seek help. There are some reformed traders establishing Traders' Anonymous (TA) programs designed to help people who cannot resist the temptations of trading too frequently.

Related:
Behavioural Traps (1)
Behavioural Traps (2)
Behavioural Traps (3)

Ref: Stock for the Long Run by Jeremy J. Siegel 3rd Edition Pages 316-327