The RATIONAL view versus the STORY view.

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.

Carefully examine the possible alternatives when you invest

Coping With the Inevitable: The Losers in Your Portfolio

Coping With the Inevitable: The Losers in Your Portfolio

By JAMES B. STEWART
However unnerving, there's this to be said about stock-market crashes and bear markets: They generate losses, which in turn lower your taxes. One of the few positive things I can say about the tech-stock collapse of 2000-02 is that I didn't pay capital-gains taxes for years.

If you've been avoiding looking at your account statements recently -- a state of denial I can well understand -- it's time to take a deep breath and tally your unrealized losses. (Most online accounts have a feature that displays that information, as do many paper reporting statements.) I did this recently, and though the results came as something of a shock, I was actually surprised at how many positions still showed gains or only minor declines. Of course, many of these positions were 10 years old or more.
It seems to help, at least psychologically, that for these purposes, the bigger the losses the better. If you have capital gains this year, as I do (the result of selling some of my energy positions last spring) you can use these losses to offset the gains. Most investors can deduct up to $3,000 in net losses against ordinary income ($1,500 if you're married and filing separately), provisions everyone should be sure to take advantage of. And excess losses can be carried forward to that happy day when once again you need to shield gains.
Obviously, you need to sell something to realize a loss. What should you sell? I simply start with the biggest losers. This year, two of those positions were General Electric and Valero Energy, not the financial stocks I'd begun buying this year and which I expected to show the biggest losses.
I had no trouble dispensing with both. GE has pretty much been a disappointment ever since Jack Welch stepped down. I don't blame his successor, Jeffrey Immelt; after all, Mr. Welch was the architect who added NBC (now NBC/Universal) to GE's portfolio and beefed up GE Capital. Media and financial are two sectors that have been crushed in the recent sell-off. While I believe GE Capital will weather the storm, I'm no longer interested in owning a television network or a Hollywood studio.
Part of my goal while selling is to maintain my overall exposure to the market; I'm not trying to time the market. I also want to avoid a common syndrome, which is to sell the biggest losers, then chase the best performing stocks. So I put the GE proceeds into shares of United Technologies, which is a genuine industrial cyclical compared to the hybrid GE. UTX is down over 35% this year, better than GE has fared, but still a steep decline. Not only are cyclicals out of favor in the midst of depression fears, but I believe they could benefit from proposed global infrastructure spending.
For Valero, I substituted Devon Energy and Chevron, two oil producers I've previously recommended for their exposure to Brazil's big offshore oil discovery. A closer alternative would have been another refiner, like Tesoro. But the refiners have shown a perverse ability to suffer from both low and high oil prices. I suppose there exists a golden mean where they manage to make money, but I've given up waiting for it. The refining business is just too competitive, which is great for consumers, but not shareholders. By buying Devon and Chevron, I'm gradually increasing my exposure to the energy sector now that oil prices are below $50 a barrel.
I find making these kinds of changes to be healthy, forcing you to concentrate on the investment rationale for your holdings. By moving from one stock to another in the same sector, you also avoid the problem of violating the "wash sale" rule. A wash sale typically occurs when you sell stock at a loss and buy the same thing within 30 days of the sale. Violate this rule, and you can't deduct the loss.
Of course you have to make these moves before Dec. 31 to reduce your 2008 taxes. I'm planning to continue realizing losses gradually over the remaining month. Supposedly there's a burst of this kind of selling right before the end of the year, depressing stocks, followed by the "January effect" rise once the selling is over. That seems plausible, but I've never seen any data to support it. Last year there certainly was no January effect. In any event, by maintaining your overall market position, you don't need to worry.
James B. Stewart, a columnist for SmartMoney magazine and SmartMoney.com, writes weekly about his personal investing strategy. Unlike Dow Jones reporters, he may have positions in the stocks he writes about. For his past columns, see: www.smartmoney.com/commonsense.

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