Your past stock wins and losses do not change the future risk of your investments

What does this mean?  Investors believe that if they made money on a stock then buying the stock again is less risky (House Money Effect) or if they lose money on a stock then buying the stock again is more risky (Snake Bite Effect), even if the underlying fundamentals and growth potential of the company does not change. 

Another position an investor may take is buy more of the stock when they already loss money because want to make up their loss. (Break Even effect).

I'm not saying that this is a correct or incorrect position.  I'm only saying that there is a incorrect risk evaluation due to past experience.

Are you taking on more risk with money you gained or feel like you need to take on more risk to break even?  Are you taking on less risk because you loss money?

Acknowledge that you are doing this.

Irrational Mistake

House Money Effect - When people have gained a profit, they segregate that profit and feel that profit is "house money" and not their money, when in fact, it is their money.  People will take more risky investments with "house money" than their own money.  They don't realize that this is already their money and the risk they take is on their money.

Snake Bite Effect - When people experience a loss, they feel that they should take less risk with the money they have left because they feel they will continue to be unlucky.  This may not be true, if the investment fundamentals and growth potential has not changed. 

Break Even Effect - Sometimes when people experience a loss, they want to "make it up" by assuming more risky investments.  However, they don't realize they are taking on more risky investments to "break even".  This is a more powerful effect than the Snake Bite Effect and can be seen in bond traders who need to close out all positions at the end of the day.  They will take riskier position in the afternoon if they experienced losses in the morning.

Good companies do not always make good investments

A caveat of this is that past performance is not representative of future performance.  Look for value companies.

Most investors consider a good company a growth company with strong earnings, high sales growth and good management.  Is this good company a good investment?  Most research indicates No.  When growth and value company stock performance is compared, value company's stock prices have a higher return.

Why is that?  I believe there are two main reasons:

1.  Growth companies are followed closely by inventors and advisers so their stock price already takes into account the growth potential, so the upside is limited because the bar is already set very high.  The downside is larger due to this fact.

2. As these good companies grow, more competition enters the market to take away market share and the total available market shrinks.  Then, the fast growth of the past slows down and the stock returns to the mean of the market.

A good example is Cisco Systems.  From 1992 to 2000, the stock price, adjusted for splits, went from $0.05 to $77. A return of 15,300%!!  If you invested in the early to mid 1990s you make a killing if you sold by 2000. 

Since 2000, the stock price dropped from $77 to hover around $25-30 for the past 6 years.  Management did not change much and they are still considered a well run company but as an investment, this company is a dog.

Good companies cannot be good investments forever and bad companies, if they stay in business cannot be bad forever.  Search out the value companies that few investors follows and are in a turnaround.

Irrational Mistake

Representativeness - Making a judgement of a stock based on stereotypes; i.e. good companies and good past performance = good future investment.

Why do we do this?

Research indicates that our brain makes shortcuts to analyze complex information.  It is very easy to equate a good growth company with great past return to a good future growth company.  Unfortunately this shortcut creates bad investments.

Set buy and sell rules for your stocks

Roller coasters are fun for vacations but not for stock investing.  How do you stop making yourself stressed about the ups and downs of the market and take you emotions out of buying and selling stock?

When you initially buy a stock, determine right then and there how much you believe you will make in this stock and how much are you willing to lose.  Write these limits down and then set a stop limit on the loss.  For example, I am buying TiVo at 10 per share.  I am willing to lose 20% and I believe I can gain 25%.  Set your stop loss at $8 per share.  On the upside, when your stock reaches $12.50 (25%), relook at the stock again as a new buy.  "At $12.50, do you think TiVo is worth it and will continue to go up."  If not, sell it, if so, keep it.

Irrational Mistake

Avoiding Regret - Trying to delay any mental pain from a bad investment decision.  When your stock goes down, you want to avoid the pain of regret by selling the stock, so you may say, "It will go back up, so I will keep it" even if the stock price has dropped in half and management has no good news.

Why do people watch stocks all the way down?
 
In stock investing, regret is only emotionally felt if you sell the stock after a loss and thus mentally say to yourself you made a bad investment.   If you keep the stock, even if it has dropped to half it's value, you still have emotional hope it will go back up and can delay the pain of regret

Seeking Pride - The opposite of avoiding regret is seeking pride.  Seeking pride creates an emotional joy by proving to yourself that you made a good decision.  In stock investing, pride is created when you sell your winning stocks and can tell everyone how much of a stock investing genius you are.  The question is, did you sell to early?  When your stock doubled, did you re-analyze the company and stock again as a new buy?  If you sold Google when it doubled from the IPO price you would have done very well.   However, if you had relooked at Google and decided to hold on, you could have quadrupled your money.

Why do people sell too soon?

People rather sell winners than losers, even if the final payout is the same.   Because they rather sell winners, people may prematurely sell a stock and feel pride rather than sell a losing stock and feel regret, even if the final payout is the same and it is more tax efficient to sell the losing stock.

Don't panic due to the herd mentality of the market

Many irrational investors will sell now because their stock prices are going down, but if the underlying company and prospects has not changed since you purchased the stock, why sell now and take a loss?

Before selling your stock, you need to know where you are going to put the cash.  You need to find another financial vehicle that will gain a better return than the return on the stock you want to sell.  If you cannot find a better return, then why are you selling?

Irrational Mistake

Herding - Moving with the "market herd" because it is easier than doing a formal analysis of your holdings.  If everyone is doing it, it must be right...right?

Why do people follow the herd? 

1.  Misery loves company - If I sell and lose money when everyone else is losing money, so it does not feel so bad.

2.  If I make a mistake in selling, I can blame it on the market and not myself.  No feeling of regret.