Investing involves making a number of decisions. It is worth following the basic rules, the operation of which has been tested on experienced investors. Here are five basic rules that can help us avoid investment failures.
You always need to have a strategy and an investment plan
The strategy and investment plan largely determine the future investment results. Of course, the strategy itself should be a consequence of a previous deeper analysis (of a given company, market environment, etc.), because depending on the conclusions that came from it, different scenarios of future decisions can be created, specifying the target sale price of the asset, the maximum acceptable risk, the investment horizon, as well as potential emergency scenarios in the event of a change in the base model of the strategy adopted by us.
In practice, it is very often the case that the investor in his strategy assumes only the sale of shares at a higher price than he bought them, because this is the purpose for which he invests. Of course, he is aware of the risk of capital loss, but he pushes this risk into the background, and only when the price falls below the purchase price groping for an idea for the best way out of this situation. The same is true for growth. The lack of a strategy, the lack of proper assessment of the situation usually causes the investor to get rid of shares prematurely, enjoying a small profit, and losing the chance to achieve above-average results.
Meanwhile, investing based on the investment strategy adopted at the beginning makes our later decisions much more thoughtful, and above all, usually end up with much better results. Importantly, the investor’s strategy should also include the possibility of changing the original strategy. This is because there are often situations that we did not assume before, such as extremely significant upward or downward deviations from the company’s financial results we assumed, significant contracts signed by the company that were unforeseen in any scenarios, or e.g. announced write-downs on assets, or extraordinary market-related events, such as those observed in the previous year, etc.
Therefore, it is very important to have a specific plan for each investment from the very beginning. Then, depending on the development of events, it is much easier to apply this plan, and above all, we are able to react relatively quickly and thoughtfully to the changing situation and circumstances.
Don’t be guided by emotions in your decisions
This is the principle that is most difficult to implement, and even the most experienced and experienced investors have a problem with its application. On the one hand, it is difficult to imagine that strong declines in share prices or their strong increases would not evoke emotions. It is also difficult to imagine that these emotions would not be evoked by the rapidly changing value of the portfolio under the influence of significant changes in share prices. It seems all the more unrealistic to get rid of these emotions in such cases where we first had a violent crash and then an extremely strong rebound of the markets.
Meanwhile, it is emotions, including the fear of further loss, fear of losing the profit already achieved and simply greed, that cause even the most educated and experienced investors to make cardinal investment mistakes, e.g. selling shares at the lows and buying them at the highs.
Of course, in investments, emotions cannot be completely removed, but you have to learn to control these emotions, and above all, learn to properly interpret the market environment, the moods of other investors and the messages coming into the market. Controlling and controlling emotions cannot be learned in one day. It is a continuous process that will continue throughout the entire period of the investor’s presence on the market. Every day, every experience teaches the investor something new, and these experiences should be supported by literature on the psychology of investing, very good educational materials on websites, or participation in webinars and training courses on the psychology of investing.
There are investors who have a lot of knowledge about financial analysis or technical analysis, but never achieve above-average results. The problem is their emotions. The ability to control emotions, especially in these difficult moments, i.e. in periods of panic, euphoria or long-term consolidation on the charts of owned companies, can have a significant impact on the results of our investments. Therefore, when investing in the market, it is worth devoting a lot of space to this issue.
Don’t get caught in the trap of virtual loss
An investor does not like to lose capital, which is obvious. In practice, no one likes to lose money, and even more so few people like to admit their own failure. And this is the reason for one of the biggest sins of a stock market investor, which leads to the loss of control over the losses incurred. When the price behaves differently from the original assumptions and, for example, falls sharply, then it is difficult for the investor to admit to himself that he misinterpreted the situation by making a wrong decision. This, in turn, entails a chain of further errors.
In the first phase, the person incurring the loss assumes that it is only a temporary loss, and the price will soon return to the positive. The situation worsens when the downward trend turns out to be a more permanent change. Then the investor, in turn, explains to himself that it is “only” a virtual loss and until he sells the shares, he has not actually lost money, because he still has a chance to sell them at a profit. Of course, this is true, but downward trends can often proceed with the force of a tsunami, leaving behind some time ashes, i.e. losses reaching levels of e.g. 90% or higher, and this happens even in the case of the largest companies. And then, in order to make up for this virtual loss, the value of such a position would have to increase by 900%. In many cases, this takes decades, and in many cases it is never possible to make up for it, although of course scenarios of 900% or higher growth are also possible and sometimes happen. Nevertheless, it is definitely better to admit your own mistake before the scale of the devastation of your wallet becomes too large, and you certainly need to unlearn the idea that a loss is just a virtual loss.
Of course, it is worth admitting to a mistake only if the loss goes beyond the maximum permissible loss framework adopted in our strategy. It should be remembered that each loss is an actual loss, while at the time of its realization it simply becomes an accounting loss. On the other hand, it is the investment strategy referred to in the first point that should determine the maximum level of permissible drawdown of capital on a given position and the moment of its closing. You don’t have to “marry” investments for years, but as a consequence of the mistakes made, this is often the case. What is worse, it is often a “marriage” in which we later last for years, in a sense against our own will.
Let profits grow, cut losses
This is a principle that is de facto a derivative of all three previous principles. It is a mixture of psychology, strategy and skilful position and portfolio management, but also a derivative of the belief that virtual losses are not a real loss. Failure to apply this rule means that investors very often allow their losses to grow irrationally, because they are still counting on a rebound in the exchange rate.
In the case of growth, it is most difficult for investors to survive downward corrections and tiring, sometimes multi-month consolidations occurring in uptrends. In the case of downward corrections, the investor fills himself with fear and anxiety that this is the end of the uptrend, getting rid of the profitable position prematurely and saving the profit that is left.
In the case of consolidation, especially when other companies are growing and when the market is growing, the investor cannot emotionally cope with the belief that he is losing the opportunity to make money on other companies, also often deciding to close a profitable position for this reason. And even more often, investors close profitable positions when, after reaching a bottom after a bear market and a very long consolidation, the price finally breaks up strongly at high turnover. Meanwhile, such a breakout often takes place in the first phase of later, longer uptrends. In this way, investors usually get rid of well-picked stocks at the very beginning of the trend.
When shares fall below the purchase price, their propensity to sell decreases significantly and often a short-term investment, e.g. speculative, turns into a long-term investment in anticipation of making up for losses. Plaintiff? Inability to come to terms with loss and irrational acceptance of an unlimited level of loss. This often ends with the sale of the shares at the bottom.
Probably many readers are well aware of these situations, and many have experienced them personally. In order to react appropriately in such cases, you must always have a clearly defined strategy of action, and be able to control your emotions. You also need to know for what purpose you have invested and how much you can lose on a given investment. If we also have a well-analyzed company, we should not experience such negative situations too often. It is worth noting that it is definitely easiest to apply this principle when we have a properly diversified portfolio. It is certainly more difficult when the portfolio is based only on one or two positions, which is obviously a wrong way of management. This is because then the emotions associated with a single position and dependence on its price changes make it much more difficult to make rational decisions.
Education above all else
Many investors, especially beginners, believe that investing is not that difficult at all, but they usually change their minds when their wrong decisions and lack of knowledge lead to the loss of a significant part of the invested capital. On the other hand, people who have been on the market for a long time, especially those entering the market in a good economic period, who have not yet experienced a strong bear market, believe that since they are doing quite well, learning is not so necessary at all. Then, however, the first potential bear market verifies their ability to invest.
Of course, such situations absolutely do not have to be the rule, because there is also a large group of investors who take their role very seriously, starting education even before entering the market. The facts, however, are that an investor must learn throughout his life. Certain analytical elements are timeless, of course, but markets as such change. Each new bull market, consolidation or bear market teaches many new things. The best results, on the other hand, are achieved by people who have approached their role as a stock market investor professionally from the beginning and systematically expanded their knowledge.
Currently, there are many websites on the market offering educational materials about investing, numerous open and closed training webinars are organized, as well as a whole range of excellent professional literature is available.