It is hard to understate the importance of emotions for investors in the stock market.
Investors usually make bad decisions when they allow their emotions to over-ride rational thinking.
I'm not saying you have to be a emotionless Vulcan to succeed in investing, however you do need to be self-aware about whether you are letting you emotions get the best of you.
The most common and dangerous emotions are fear and greed. In many cases, it is fear that is the stronger of the two.
One way to reduce the role of fear in your investing strategy is to know and stay within you tolerance for risk.
Greed may (and will) tempt you to take more risk than you are normally comfortable with in your portfolio. This is the case during low-return market environments.
When you take that extra risk in hopes of a better-than market return, it plants the seed of fear. Fear may lead you to may poor decisions, so many investors try to stay within their tolerance for risk.
Watch your risk tolerance or you'll step out of your comfort zone and into a pile of trouble.
If you've ever been involved in any type of personal or professional growth counseling, you are probably familiar with the phrase "stepping outside your comfort zone."
This is when you are encouraged to take a risk and try something that might seem challenging either emotionally or professionally.
Know Your Limits
While some risk-taking may lead to personal or professional growth (or not), it can be disaster in the market if you don't know where your limits are. Investing is all about taking risks; however, you know the risks are calculated relative to the potential payout. Every reasonable investor has a limit to their risk tolerance and the smart ones know where that limit is and don't stray past it.
Bad things Happen
Several things can happen when investors stray past their risk tolerance level and they're all bad. How do investors get themselves in trouble? Here are several ways:
- They make a bad decision and refuse to admit they were wrong, so the problem just gets worse.
- They invest more money than they can afford in a stock(s) that now don't seem like such a good idea.
- They bought on margin and shouldn't have and now they can't sleep.
- They bought a stock that someone talked them into even thought they didn't really understand the investment.
Whatever the reason when investors stray past their risk tolerance, they begin making decisions that are tainted by emotion, which are almost never good decisions.
How to Avoid this Mess
Investors can avoid these problems if they will simply know where their level of risk tolerance is. It is easy to find.
All you need to do is listen to that knot in your stomach to know if you are stepping over the line. Here are some practical tips:
- Never invest in anything you don't understand. I don't care if your neighbor thinks this is the hottest thing since Poptarts. If you don't understand it, let it pass.
- Make sure the money you invest is not needed to pay the mortgage. Investment funds come after you have covered the necessities.
- If you are not completely comfortable with margin investing and fully understand the risks, don't use it.
- If you buy a stinker and it is always going to be a stinker, take a small loss rather than letting it become a big loss. There is no shame in making a mistake, but it is foolish to let it become a disaster.
Stepping outside your "comfort zone" or risk tolerance can be a disaster. Like Clint Eastwood said in one of his movies (this applies to women too), "a man has to know his limitations."