"The 4 Diseases" of Investing - Evenitis (holding to losers), Taking profits (selling winners), Over-trading and FOMO

Teaminvest Co-founder Professor John Price, recently recorded an informative 4.5 minute video about the behavioural biases that often block rational decision-making about investments.

It’s titled “The 4 Diseases”. In the video he explains the four common behavioural biases and fuzzy thinking affecting the way we assess investments. He calls them:

• Get even-itus
• Consolidatus-profitus
• Trade-a-filia
• FOMO

Watch the video and see if you suffer from any of them? - Self awareness will improve your investment decision-making!

Click on John's pic

https://lr220.infusionsoft.com/app/hostedEmail/21336/90e5395442506435?inf_contact_key=bfe1f769afcc1ca46d38151bc79936d7f17975b54721e97cab312e8b684f90d3

Regards

Mark Moreland Co-Founder NOTES: Stock selection - Read the annual reports - Read all the analysts reports - Visit the stores or use their products and services If you find that at the end of the day, the performance of the portfolio is not that good, or mediocre at best, in many cases there are various reasons. They often have not taken into account behavioural biases, the sort of fuzzy thinking that is automatically in their mind that blocks out their rational decision. These are the 4 behavioural biases, which we refer to them as:

• Get even-itus
• Consolidatus-profitus
• Trade-a-filia
• FOMO

Get even-itus

The disease of hanging onto a stock when the price has gone down until you can get even.  "Don't worry dear, it is going to come up back again."   The problem is, if the stock has gone down, the chances are it is going to continue to go down and best it is going to be a mediocre investment.  It is much better to face the fact that you have a loser, you lost money and to move on.

Consolidatus-profitus

This is the opposite to get even-itus.  This is the disease of always taking a profit when the price goes up.  It looks great and you can tell your friend at the dinner party that your stock went up 20%, 40% or 50% and you sold it.   The problem is what you are going to do with that money.  Studies have shown, on average, people who sell just to take a profit end up putting their money back into the market in a stock that underperforms the one they got out of.  #

Get even-itus and Consolidatus-profitus are two sides of the one coin; generally hang on to losers and sell winners.  The opposite would be better, that is, sell your losers and hold on to your winners.  They water the weeds and cut the flowers.  It would be better they  water the flowers and cut the weeds.

Trade-a-filia

This is the disease of just loving to trade. Most people who would never dream of going to casino betting on roulette or any of the casino games or machines,yet when they are on their internet and looking at their stocks, they trade far too often.  It is so simple to trade on the internet and they get drawn into it.  But studies have shown that on average, the more a person trades they worse they do. I am not referring to their transaction costs but actually their performance diminishes.  Instead of looking for great companies that are going to make you money year after year, they think they can get a short term profit.   In the short term, the share prices are much more random than most people believe.  So this is a disease of trading too often.  In this regard, women are better investors than men, because overall, women trade less than men.  

FOMO

This is the 4th disease, the FEAR OF MISSING OUT.  You read about a particular stock and its price is going up and you think, if I don't get in now, I am going to miss out, instead of taking your time and evaluating the stock properly.   

These 4 diseases really work together and at best give you a mediocre performance that is far far below you optimal performance.  

You should work to eliminate these 4 investing biases or diseases, consciously.  Use tight filters to filter out the best companies to concentrate in.  

Be alert that you are not slipping into these investment biases.  Eliminate these investing biases and your performance will be much better. 

# Reinvestment risk.

'Being human" costs the average investor around 3 - 4% in return every year.

The cost of being human

When it comes to investing, human nature doesn’t help. Our innate need for emotional comfort is estimated to cost the average investor around 3–4% in returns every year.* And for many, the figure can be much greater.

This shortfall in returns is partly caused by what is known as the Behaviour Gap. It explains the difference between long-term financial returns (if we were only to stick to sensible and simple rules for investing) and actual returns (which are determined by all our short-term decision-making, often based on our emotional needs).

A good example is how our investment strategy often goes off course in turbulent times. So despite the obvious costs, we can often end up buying high and selling low.


*Source: Barclays Wealth & Investment Management, White Paper - March 2013, ‘Overcoming the Cost of Being Human’.

http://www.investmentphilosophy.com/fpa/

Cognitive Biases That Cause Bad Investment Decisions

Henry Stimpson

Published: Tuesday, November 29th 2011

---

When it comes to investing, you might think your emotions don’t play a role, but they do without you even realizing it. Everyone has emotional and cognitive biases that shape their choices, and only by spotting them can you overcome them so they don’t cause bad investment decisions, according to Ben Sullivan, a certified financial planner at Palisades Hudson Financial Group.
Sullivan recalls a number of clients who have made mistakes in the past. A middle-aged banker had more than half of his $500,000 portfolio in a few bank stocks. Another prospective client sold his business to a big consumer-goods company had almost all his money — many millions — in that company’s stock. An employee believed his 401(k) plan was diversified because he owned four funds — all large-cap stock funds.
“Investor mistakes have predictable patterns,” says Sullivan. “Our pervasive emotional and cognitive biases often lead to poor decisions.”

Overconfidence
It’s easy to overestimate your own abilities in picking stocks while underestimating risks. Even professional money managers struggle to beat index funds. The casual investor has little chance, Sullivan says.
“It’s almost impossible to have a day job and moonlight as manager of your individual-stocks portfolio,” he says. “Overconfidence frequently leaves investors with their eggs in far too few baskets, with those baskets dangerously close to one another.”

Self-attribution
This is a cognitive error leading to overconfidence. Someone who bought both Pets.com and Apple in 1999 might dismiss his Pets.com loss (it went bankrupt) because the market tanked but believe he’s an investment whiz because he bought Apple.

Familiarity
Investing in what you “know best” can be a siren song leading investors astray from a prudently diversified portfolio. That was the case with all three investors mentioned above. They were familiar with banks, consumer goods and large-cap U.S. stocks respectively, Sullivan says, and unwisely put all their eggs in that familiar basket.

Anchoring and loss aversion

Investors may become “anchored” to the original purchase price. Someone who paid $1 million for his home in 2007 may insist that what he paid is the home’s true value, even though it’s really worth $700,000 now. The same holds for securities.
“Only the future potential risk and return of an investment matter,” Sullivan says.
Inability to sell a bad investment and take a loss causes investors to lose more money as the hoped-for recovery never happens.
“You’ll also miss the opportunity to capture tax benefits by selling and taking a capital loss,” he adds.


Herd fever
When the market is hot and high, the media and everyone else say buy. When prices are low — remember March 2009 — everyone says sell. Following the herd leads investors to come late to the party so that they’re buying at the top and selling at the bottom. Following the herd is a powerful emotion.
Today, Sullivan says, the herd is buying gold and U.S. Treasuries.

Recency
According to a study by DALBAR Inc., the average investor’s returns lagged those of the S&P 500 index by 6.5% per year for the 20 years prior to 2008 largely because of recency bias. People invested in last year’s hot funds, which often turn sour next year, instead of taking a steady course, he says.
(Ed: Read about how the recency effect has been influencing the housing market.)

Counteracting your biases

Having a written plan is the key, Sullivan says.
“Create a plan and stick to it,” he says.
Hewing to a written long-term investment policy prevents you from making haphazard decisions about your portfolios during times of economic stress or euphoria. Selecting the appropriate asset allocation will help you weather turbulent markets.
All investors should invest assets they will need to withdraw from their portfolios within five years in short-term liquid investments. Combining an appropriate asset with a short-term reserve gives investors more confidence to stick to their long-term plans, he says.
If you can’t control your emotions — or don’t have the time or skill to manage your investments — consider hiring a fee-only financial adviser, Sullivan says. An adviser can provide moral support and coaching, which will boost your confidence in your long-term plan and also prevent you from making a bad, emotionally driven decision.
“We all bring our natural biases into the investment process,” Sullivan says. “Though we cannot eliminate these biases, we can recognize them and respond in ways that help us avoid destructive and self-defeating behavior.”

http://www.physiciansmoneydigest.com/personal-finance/Cognitive-Biases-That-Cause-Bad-Investment-Decisions

Are You an Investor?

By Bonnie Biafore, Contributor, BetterInvesting Magazine On July 16, 2012 

Successful investors tend to possess certain characteristics.  Do you have them? What do you do, if you don’t? The first step to successful investing is knowing your strengths and weaknesses in the investment game. That way, you can work on those shortcomings and make better investment decisions.  The MarketPsych website offers free tests you can take to measure your suitability as an investor as well as other aspects of your financial life.

To take any of the tests, you have to register with the site (it’s free). If you’re concerned about privacy, you can register anonymously.

The Investor Personality test helps you understand your personality traits as they apply to investing.  The report you receive gauges your suitability as an investor and offers suggestions for improving any behaviors that could undermine your investment success.   The test takes about 20 minutes and includes 60 questions about your personality followed by 15 questions about what you would do in different investment situations.

The personality questions cover a lot of ground.  Do you tend to think things through? Do you plan? How do feel about change? Are you usually relaxed or easily stressed? Do you like excitement and adventure? Do you enjoy abstract ideas or prefer practical information? Are you confident? Can you juggle several tasks at once? Can you make decisions or do you vacillate?  Do you take others’ feelings into account? Do you react quickly?

The investment questions are a bit tougher because they don’t offer answers for the gray areas we all live in.  For example, one question asks whether you would choose to spend more now and have less in retirement, or spend less now and have more in retirement.  My answer is neither of those alternatives.  Another question asks what you would do if you bought a stock and its price increased significantly over a short period — without any news or information about the company.  Yikes! I’m an engineer, so it’s almost impossible to make a decision without any information. Some of the questions include one possible answer: watch the company in order to determine a reasonable purchase or selling price, and then make a decision.

The report you receive rates your personality in several ways, such as how conscientious you are, how emotional you are, whether you are an extrovert or introvert, and your openness and agreeableness.  Ratings that appear in green (see screen capture, this page) indicate suitability as an investor, whereas yellow ratings are traits that could inhibit your investment success.

The bias section of the report rates your confidence, risk-taking, discipline, thinking, and herding instinct.  For example, the hypothetical results include a below-average score in loss aversion.  You can click the Click here link to learn how this trait might harm your investing.  For example, the Risk-Related Biases Web page discusses the common mistakes many investors make with their investments, such as holding onto a loser hoping for a comeback.  Then, it includes specific advice for high scorers and low scorers for each aspect of risk-taking, including loss aversion, emotional vulnerability, risk aversion, and cutting winners short.  In this case, the explanation warns that low scorers for loss aversion might take excessive risk.

http://blog.betterinvesting.org/?p=2020&utm_source=MailingList&utm_medium=email&utm_campaign=BI+Weekly_7-16-12

My Investor Personality Test Results  :-)

Print

Investor Personality Test PERSONALITY FACTORS Conscientiousness : High  Emotionality : Below Average  Extraversion : Below Average  Openness : Above Average  Agreeableness : Below Average For Details Click here BIAS REPORT Confidence Biases Overconfidence : Above Average Over-Optimism : Below Average For Details Click here Risk-taking Biases Risk Aversion : Above Average Emotional Vulnerability : Below Average Cutting winners short : Below Average For Details Click here Impulse-control Self-discipline : Above Average Immediate Gratification : Below Average Excitement-seeking : Very Low For Details Click here Intellectualism Intellectualism : High For Details Click here Herding Trend-following : Below Average For Details Click here

The Genetics of Investing

By James D. Miller, Contributor, BetterInvesting Magazine On April 16, 2012 · 

Are you one of the better investors?  The answer might lie in your genes.

Investors frequently fall prey to a myriad of asset-damaging biases, such as engaging in excess trading, being inadequately diversified or thinking that recent success proves you’re a genius unconstrained by the normal rules of sound financial management.

A recent academic paper titled “Why Do Individuals Exhibit Investment Biases?” by finance professors Henrik Cronqvist and Stephan Siegel argues that around 50% of the variation of biases among people comes from their genes.  What this means is that if you try to explain why some people make certain kinds of financial mistakes, about half of your explanation should point to genetics and the other half to environmental differences.

A key implication of the authors’ analysis is that you can’t trust your intuition with regard to investments because your genes probably push you to make irrational choices.  When deciding how to invest, consequently, you should be open to going against what feels right in favor of following sound investment advice such as buy and hold, diversify and don’t mistake luck for financial acumen.

The really interesting implications of this genetic analysis, however, won’t kick in until a lot more people get their genes sequenced.  The cost of digitally transcribing someone’s DNA is exponentially dropping.  It’s reasonable to predict that within 10 years, most everyone in rich countries will for health reasons have their DNA analyzed; after all, if your genes make you susceptible to a certain kind of cancer, you really want to know this so that you can get yourself tested.  But once you know your DNA and understand the genes that cause specific biases, you could learn exactly what kind of investment problems your genes predispose you to.

Parents could use information gleaned from their children’s DNA to figure out what kind of financial lessons to give their offspring, and to in part determine which of their children should have power of attorney over them if they become medically incapable of making financial decisions.

6 Reasons You're A Bad Investor

BY  James Early
Published in Investing on 5 January 2012

These mental traps may be killing your portfolio.

Made a New Year's resolution? You won't keep it.

Or at least there's a 78% chance you won't, according to a study reported in The Guardian a few years back.

But you knew the odds were against you, as years of failure have taught most of us already. Yet we continue to make resolutions... and continue to fail by allowing our brains to work against us. Fortunately, for you, people fail just as often -- if not more so -- with their investing.

This gives you a great opportunity to help improve your profits in the market: by noticing and controlling the psychological failings in your own investing. Indeed, these mental traps may be killing your portfolio!

1. Framing errors

"Which do you enjoy more: peas or carrots?" assumes that you enjoy either peas or carrots. You probably do, but together, our mental questions and perspectives often limit our thinking.

Erroneously comparing shares of different risks -- such as comparing the upside of a penny share to a stalwart such as National Grid (LSE: NG) -- and evaluating shares on short-term criteria (if you're a long-term investor) are classic mistakes. Fight it by taking the broadest, most rational view of your agenda, and question all your assumptions.

2. Confirmation bias

Isn't it splendid to see a positive article on a share we already own? It makes us feel quite smart. We all revel in support for our own ideas, and prefer to conveniently forget about conflicting evidence.

Indeed, before the financial crash, many of us remained tethered to old views about bank shares, despite the changing facts. Even HSBC (LSE: HSBA) -- one of the better banks -- saw its shares more than halve. The remedy is to forcibly seek out contrary views.

3. Consistency bias

You've convinced your wife that a share is a good buy. You've told your neighbours, and your workmates know as well. If you're like me, you've written about it on the internet, too. And then you find a bit of incriminating evidence that you missed. What do you do?

Rationally, we all know what's best -- but if we're honest, we have to acknowledge the strong pull to appear consistent. In life, how many times do thought leaders in a field actually admit to a mistaken idea? As with oppressive dictatorships, it's usually only by the previous generation dying off that change really happens.

Consistency bias is incredibly powerful and, incidentally, I'm sticking to what I've said on the topic, no matter what.

4. Recency bias

Your football team has lost two consecutive matches. Heads need to roll. Because recent events generate stronger, more 'real' feelings to us, we weight them more in our mind, even if they don't deserve it.

Momentum investors thrive on recency bias, but fundamental sorts -- and if you're reading this, odds are, you're probably a fundamental investor -- would do well to turn the volume down on the latest news. The media doesn't make it easy, though.

5. Herd instinct

We're drawn to the 'safety' in numbers, even if that safety doesn't exist. Ditto for City analysts, who often find it safest to predict roughly the same thing everyone else is predicting, with a few tweaks made for the sake of appearance. We at The Motley Fool aim to help you here, as we tend to be a bit quirky for City work in the first place.

6. Survivorship bias

For every long-term corporate winner -- be it a utility such as Vodafone (LSE: VOD) or something more industrial such as BHP Billiton (LSE: BLT) -- often hundreds of losers have fought and lost the battle for dominance.

We don't hear much about the losers, but focusing on the winners gives us a false picture of the competitive fire through which they, and their many fallen peers, almost certainly passed en route.

Cognitive biases

These are just a sample of the psychological traps we can fall into, and I'd invite you to Google 'cognitive biases' for many more. You'll notice a common theme: they're mental shortcuts -- heuristics, as we say -- that actually serve the caveman rather well. Less so the investing man.

And probably the forgetful New Year's man as well.

Trying to sidestep these mental biases is less sexy than chasing the next big penny share. It's a methodical, slow and boring process, which rarely shows an immediate benefit. Yet in my view, slow and steady is what successful fundamental investing tends to look like. 

Attention! The Fool's latest wealth report -- Ten Steps To Making A Million -- is still free for all private investors. Download your copy, with no further obligation!

http://www.fool.co.uk/news/investing/2012/01/05/6-reasons-youre-a-bad-investor.aspx?source=ufwflwlnk0000001

Market Volatility: Know your psychological biases

The more you know about your psychological biases, the better you can function in the volatile stock market.

Everyone has opinions and psychological biases.  However, people may not know their own biases. 

The more you know about your psychological biases, the better you can function in the volatile stock market.

The entire market may be influenced by psychological reasons, not by fundamental reasons alone. 

From an investment perspective, the bottom line is that the market will continue to fluctuate and give you solid opportunities every so often.

Value in the long run is determined by fundamentals, while short-term gyrations reflect market participants' psychological weaknesses, such as herding.  

Knowledge is the best antidote to making wrong decisions.

If you are a long-term investor, the rational thing to do is to make decisions based on long-term fundamentals of the business.

Savers' Impatience Hinders Retirement Goals

Too many savers choose immediate gratification instead of taking advantage of larger long-term payoffs.

Few would argue that we have a retirement crisis in America. What people might debate is how we solve the problem.

Slowly but surely, however, researchers are producing work that offers much-needed insight into how we can reduce the severity of the problem. Case in point: A working paper just published by the National Bureau of Economic Research, on two explanations for why consumers have trouble with financial decisions.

"One is that people are financially illiterate since they lack understanding of simple economic concepts and cannot carry out computations, such as computing compound interest, which could cause them to make suboptimal financial decisions," wrote Olivia Mitchell, the director of the Pension Research Council, and Justine Hastings, an economics professor at Yale University, in their paper, "How Financial Literacy and Impatience Shape Retirement Wealth and Investment Behaviors."

"A second is that impatience or present-bias might explain suboptimal financial decisions. That is, some people persistently choose immediate gratification instead of taking advantage of larger long-term payoffs."

In other words, people generally don't much know, if anything, about money. And two, consumers — even when they are financially literate — sometimes can't help themselves from making bad decisions. It's the way we are wired. The lizard part of our brain overrules the more rational part when it comes to things financial. The lizard part of the brain says that the joy of spending (or not saving) today is greater than the pleasure of having a nest egg later on.

"Impatience or present bias seems to be an inability to plan for long-term consequences," said Stephen P. Utkus, a principal with the Vanguard Center for Retirement Research. "It may be a learned trait from family and peers, or it may be inherited. There is some evidence from neuroeconomics that impatience may be related to certain brain structures.

Read more here.

Knowing about the psychological biases is not enough. You must also have a strategy for overcoming them.

Battling Your Biases

Remember the day-trader cartoon in Chapter 1? The roller coaster called "The Day Trader" represents the modern investment environment. The roller coaster has dramatic highs and lows. As a modern-day investor, you can experience strong emotional highs and lows. This emotional roller coaster has a tendency to enhance your natural psychological biases. Ultimately, this can lead to bad investment decisions.

The previous chapter began the discussion of how to overcome your psychological biases. It introduced two strategies of exerting self-control: rules of thumb and envi­ronment control. This chapter proposes strategies for controlling your environment and gives you specific rules of thumb that focus you on investing for long-term wealth and on avoiding short-term pitfalls caused by decisions based on emotions.

The first strategy was proposed in Chapter 1: Understand the psychological biases. We have discussed many biases in this book. You may not remember each bias and how it affects you (due to cognitive dissonance and other memory biases—see Chapter 10), so reviewing them here should be beneficial. In fact, to help you make wise investments long after reading this book, you should re-familiarize yourself with these biases next month, next year, and every year.

STRATEGY 1: UNDERSTAND YOUR PSYCHOLOGICAL BIASES

In this book, there are three categories of psychological biases: not thinking clearly, letting emotions rule, and functioning of the brain. Let's review the biases in each category.

(a)  Not Thinking Clearly

Your past experiences can lead to specific behaviors that harm your wealth. For example, you are prone to attribute past investment success to your skill at investing. This leads to the psychological bias of overconfidence. Overconfidence causes you to trade too much and to take too much risk. As a consequence, you pay too much in commissions, pay too much in taxes, and are susceptible to big losses.

The attachment bias causes you to become emotionally attached to a security. You are emotionally attached to your parents, siblings, children, and close friends. This attachment causes you to focus on their good traits and deeds. You also tend to discount or ignore their bad traits and deeds. When you become emotionally attached to a stock, you also fail to recognize bad news about the company.

When taking an action is in your best interest, the endowment bias and status quo bias cause you to do nothing. When securities are given to you, you tend to keep them instead of changing them to an investment that meets your needs. You also procrastinate on making important decisions, like contributing to your 401(k) plan.

In the future, you should review these psychological biases.

(b)  Letting Emotions Rule

Emotions get in the way of making good investment decisions. For example, your desire to feel good about yourself—seeking pride— causes you to sell your winners too soon. Trying to avoid regret causes you to hold your losers too long. The consequences are that you sell the stocks that perform well and keep the stocks that perform poorly. This hurts your return and causes you to pay higher taxes.

When you are on a winning streak, you may feel like you are playing with the house's money. The feeling of betting with someone else's money causes you to take too much risk. On the other hand, losing causes emotional pain. The feeling of being snake bit causes you to want to avoid this emotional pain in the future. To do this, you avoid taking risks entirely by not owning any stocks. However, a diversified portfolio of stocks should be a part of everyone's total investment portfolio. Experiencing a loss also causes you to want to get even. Unfortunately, this desire to get even clouds your judgment and induces you to take risks you would not ordinarily take.

And finally, your need for social validation causes you to bring your investing interests into your social life. You like to talk about investing. You like to listen to others talk about investing. Over time, you begin to misinterpret other people's opinions as investment fact. On an individual level, this leads to investment decisions based on rumor and emotions. On a societal level, this leads to price bubbles in our stock market.

(c) Functioning of the Brain

The manner in which the human brain functions can cause you to think in ways that induce problems. For example, people use mental accounting to compartmentalize individual investments and categorize costs and benefits. While mental accounting can help you exert self-control to not spend money you are saving, it also keeps you from properly diversifying. The consequence is that you assume more risk than necessary to achieve your desired return.

To avoid regret about previous decisions that did not turn out well, the brain filters the information you receive. This process, called cognitive dissonance, adjusts your memory about the information and changes how you recall your previous decision. Obviously, this will reduce your ability to properly evaluate and monitor your investment choices.

The brain uses shortcuts to reduce the complexity of analyzing information. These shortcuts allow the brain to generate an estimate of the answer before fully digesting all the available information. For example, the brain makes the assumption that things that share similar qualities are quite alike. Representativeness is judgment based on stereotypes. Furthermore, people prefer things that have some familiarity to them. However, these shortcuts also make it hard for you to correctly analyze new information, possibly leading to inaccurate conclusions. Consequently, you put too much faith in stocks of companies that are familiar to you or represent qualities you desire.

This review of the psychological biases should help you with the first strategy of understanding your psychological biases. However, as Figure 15.1 suggests, knowing about the biases is not enough. You must also have a strategy for overcoming them.

"Y

THE EFFECTS OF YOUR PSYCHOLOGICAL BIASES (CONTINUED).
Psychological	Effect on		Table
Bias	Investment Behavior	Consequence	15.1
Get Even	Take too much risk	Susceptible to big
	trying to break even	losses
Social Validation	Feel that it must be	Participate in a price
	good if others are in-	bubble which ulti-
	vesting in the security	mately causes you to buy high and sell low
Mental	Fail to diversify	Not receiving the
Accounting		highest return possible for the level of risk taken
Cognitive	Ignore information that	Reduces your ability to
Dissonance	conflicts with prior	evaluate and monitor
	beliefs and decisions	your investment choices
Representativeness	Think things that seem	Purchase overpriced
	similar must be alike.	stocks
	So a good company must
	be a goodinvestment.
Familiarity	Think companies that	Failure to diversify
	you know seem better	and put too much
	and safer	faith in the company in which you work

STRATEGY 2: KNOW WHY YOU ARE INVESTING

You should be aware of the reasons you are investing. Most investors largely overlook this simple step of the investing process, having only some vague notion of their investment goals: "I want a lot of money so that I can travel abroad when I retire." "I want to make the money to send my kids to college." Sometimes people think of vague goals in a negative form: "I don't want to be poor when I retire." These vague notions do little to give you investment direction. Nor do they help you avoid the psychological biases that inhibit good decision making. It is time to get specific. Instead of a vague notion of wanting to travel after retirement, be specific. Try

A minimum of $75,000 of income per year in retirement would allow me to make two international trips a year. Since I will receive $20,000 a year in Social Security and retirement benefits, I will need $55,000 in investment income. Investment earnings from $800,000 would generate the desired income. I want to retire in 10 years.

Having specific goals gives you many advantages. For example, by keeping your eye on the reason for the investing, you will

■     Focus on the long term and look at the "big picture"

■     Be able to monitor and measure your progress

■     Be able to determine if your behavior matches your goals

For example, consider the employees of Miller Brewing Company who were hoping to retire early (discussed in Chapter 11). They had all their 401(k) money invested in the company stock, and the price of the stock fell nearly 60%. When you lose 60%, it takes a 150% return to recover the losses. It could easily take the Miller employees many years to recover the retirement assets. What are the conse quences for these employees? Early retirement will probably not be an option.

Investing in only one company is very risky. You can earn great returns or suffer great losses. If the Miller employees had simply compared the specific consequences of their strategy to their specific investment goals, they would have identified the problem. In this type of situation, which option do you think is better?

A.  Invest the assets in a diversified portfolio of stocks and bonds
that will allow a comfortable retirement in two years.

B.   Invest the assets in the company stock, which will either earn
a high return and allow a slightly more comfortable
retirement in two years, or suffer losses which will delay
retirement for seven years.

Whereas option A meets the goals, option B gambles five years of work for a chance to exceed the goal and is not much different than placing the money on the flip of a coin.

STRATEGY 3: HAVE QUANTITATIVE INVESTMENT CRITERIA

Having a set of quantitative investment criteria allows you to avoid investing on emotion, rumor, stories, and other psychological biases. It is not the intent of this book to recommend a specific investment strategy like value investing or growth investing. There are hundreds of books that describe how to follow a specific style of investing. Most of these books have quantitative criteria.

Here are some easy-to-follow investment criteria:

■    Positive earnings

■    Maximum P/E ratio of 50

■    Minimum sales growth of 15%

■    A minimum of five years of being traded publicly

If you are a value investor, then a P/E maximum of 20 may be more appropriate. A growth investor may set the P/E maximum at 80 and increase the sales growth minimum to 25%. You can also use criteria like profit margin and PEG ratio, or you can even look at whether the company is a market share leader in sales.

Just as it is important to have specific investing goals, it is important to write down specific investment criteria. Before buying a stock, compare the characteristics of the company to your criteria. If it doesn't meet your criteria, don't invest!

Consider the Klondike Investment Club of Buffalo, Wyoming, discussed in Chapter 7. The club's number one ranking stems in part from its making buy decisions only after an acceptable research report has been completed. Klondike's criteria have protected its members from falling prey to their psychological biases. On the other hand, the California Investors Club's lack of success is due partially to the lack of criteria. Its decision process leads to buy decisions that are ultimately controlled by emotion.

I am not suggesting that qualitative information is unimportant. Information on the quality of a company's management or the types of new products under development can be useful. If a stock meets your quantitative criteria, then you should next examine these quali tative factors.

STRATEGY 4: DIVERSIFY

The old adage in real estate is that there are three important criteria when buying property: location, location, location. The investment adage should be very similar: diversify, diversify, diversify.

It is not likely that you will diversify in a manner suggested by modern portfolio theory and discussed in Chapter 9. However, if you keep some simple diversification rules in mind, you can do well.

■   Diversify by owning many different types of stocks. You can be reasonably well diversified with 15 stocks that are from different industries and of different sizes. One diversified mutual fund would do it too. However, a portfoilio of 50 technology stocks is not a diversified portfolio, nor is one of five technology mutual funds.

■    Own very little of the company you work for. You already have your human capital invested in your employer—that is, your income is dependent on the company. So diversify your whole self by avoiding that company in your investments.

■    Invest in bonds, too. A diversified portfolio should also have some bonds or bond mutual funds in it.

Diversifying in this way helps you to avoid tragic losses that can truly affect your life. Additionally, diversification is a shield against the psychological biases of attachment and familiarity.

http://www.physcomments.org/THE-INVESTMENT-ENVIRONMENT/functioning-of-investment-choices-the-brain2.html

Bullbear Stock Investing Notes