In part 1 I wrote about the importance of having an investment strategy and I explained the reasoning behind my own investment strategy, and I gave a step-by-step guide on how my investment process was. In this part I will write more about what happens after the decision to purchase a stock has been made and the wild emotional ride that follows.
I state that, besides not having a well-defined investment strategy, the error most investors do when they decide to invest in the stock market is to not reflect upon the length of the holding period. What do I mean about the “holding period” and what is “the length of the holding period”? A holding period, in short, is the time from you buy the stock until you sell the stock. As for the second question I have no exact number of days, but I will try to explain my reasoning for why private investors tend to have a too short holding period. At the end you will find my checklist I use for my companies during the holding period. In part 1 you can find my checklist for the investment decision.
For long-term investors the focus should not be on reported earnings the next quarter, daily news in the financial press or the everyday market fluctuations, but on the long-term value creation of the company. Private investors tend to not focus on how the company develops in the long run and in return they receive returns, which on average, are below market returns.
To become a long-term investor, and to focus on the aspects which you can control, you must control your mindset and have discipline to follow your investment strategy. If not, you are bound to make the wrong short-term decisions that probably will hurt your long-term returns. By experience I know that the mindset is the hardest to improve for most investors and I have fallen in most of the behavioural pitfalls there is (and I’m pretty sure that I will do some of the same mistakes again). The field of behavioural economics tries to explain how humans make decisions and that people are irrational. I’ve listed two books which I’m currently reading from two psychologist that have won the Nobel Memorial Price in Economics on my book list. (list opp Kahneman og Thaler).
So, what are the common mistakes that investors do and how can you avoid them?
Anchoring: What investors tend to do is to anchor their decision to the price they purchased the stock (the anchoring effect). This fallacy of the mind misleads you from making good investment decisions. Have you heard the saying; “when in trouble, double”? This is an action that stems directly from your initial position being deep in the red and instead of closing the position you choose to add on your position in order to lower your average cost price.
Tips: View your initial cost price as a sunk cost. You can’t force the direction of the share price and hence it should not be part of your decision. Get rid of positions that makes you act irrational.
Fear: Investors overreact. Period. Emotions causes irrational behaviour and investors today has all the «help» in the world to overreact to news through their mobile phones and other electronic devices. Acting based on fear reduces your average holding period and destroy your potential stock returns!
Tips: Do not act based on headlines in the newspaper, forums or your neighbour telling you to get out of the stock market. It’s probably too late to act on the news and you miss out on the upside when the market is about to recover.
Greed: Investors doesn’t only overreact to bad news. Investors extrapolate the given data they have at hand into the future, which in turn may lead to biased estimates. This recency bias may lure you into taking on more risk than you should and may trick you into “get rich quick”-schemes, e.g. penny stocks or wildly overpriced stocks. If you are aware and recognise the greed in human nature you have come a long way.
Tips: Do not buy volatile penny stocks and don’t be lured into investments based on lofty prospects. Buy high quality companies with proven track record.
So, what do I do? In the holding period I try to act as rational as possible, keep the number of transactions to a minimum and focus on the long-term prospects of a company. In an ideal world the initial work you put into the initial investment process was enough for you to “forget” about your position and move on to the next one. I’ve come to realise that I cannot force myself to forget about the stocks in my portfolio, hence I try to add to my knowledge about the company, its’ industry etc. and make rational decision based on the new information. I ensure that I check off all the five objects in “The Holding Period Checklist” for every investment I make, and I keep an eye out for any red flags in my companies.
This concludes part 2 of the blog series and part 3 will be published next week. If you would like to get an update when the next part is uploaded, please subscribe below.