While number crunchers and quantitative analysts can and do make a lot of money in the stock market, the most successful investors also use psychology as a tool to enhance returns. We'll provide some tips that can help you improve your investing mindset, set your thinking straight and start thinking like a stock market high-roller.
Tutorial: Major Investment Industries
Tip No.1: Avoid Panic
Panic is an emotion that causes us to make irrational decisions - to sell a stock when it should be held, or to buy a stock when perhaps it should be sold.
Of course, our basic instinct to panic can't be eliminated altogether, so the key is to control it. Jim Cramer attributes some of his success to the fact that he has always believed that he was just a paycheck away from the unemployment line. But rather than let this panic eat away at him, he harnessed it. He used the emotion to drive him to conduct more thorough research and to get a leg up on the competition. Anyone can use this same strategy and resolve to become better investors.
Finally, try to take bad market news in stride and thoroughly analyze a situation before acting on it. By delaying an investment decision by even a few minutes, your thought process can become infinitely clearer.
Tip No.2: Consider Near Term Catalysts
While stock market gurus such as Peter Lynch and Warren Buffett have encouraged investors to focus on the longer term, there is something to be said for timing a purchase or a sale around a potential near-term catalyst.
For example, a long-term investor who bought shares of General Motors (NYSE:GM) in early 2005 because the stock looked "cheap" saw the investment lose 50% of its value within a year. Had that same investor heeded the near-term risks associated with the rising cost of fuel and waited until the stock leveled off in the spring of 2006 before buying in, they would have been up about 30% on the investment by Christmas.
Invest for the long haul, but consider the possibility that certain events could have a positive or negative impact your investment; use that information to assess when to buy.
Tip No. 3: Have a Fallback Position
Investors should always have a fallback position in mind, whether it's setting a mental stop loss at a price 10% or 15% below their purchase, or identifying a hedge that can be used at a future date against a particular position. This doesn't mean that you need to act on these thoughts, but you do need to identify these fallback positions in case they're needed.
For example if fuel prices were expected to rise and you owned stock in an auto company, you might want to think about hedging your risk by buying shares in a domestic oil company. Or, if a decline in domestic consumer spending was anticipated, you might want to consider swapping your shares in a U.S.-based fast food chain for shares in a company that garners the majority of its revenue from overseas markets. Again, the point is to always have a way out of a position, or a way to mitigate your risk.
Tip No.4: Hone Qualitative Skills
The most successful investors make their money not by crunching the numbers found in annual reports, but by inferring and deducing things from press releases, management's public comments and other shareholder correspondence.
For example, in early 2002, Ciena Corp's (Nasdaq:CIEN) chief executive, Gary Smith, repeatedly used the word "difficult" when referring to the environment for telecommunications companies during an investor conference call. Despite Smith's otherwise upbeat commentary, those that were able to read into his frequent use of that adjective as well as his tone of voice when he used the word were able to avoid the almost 50% selloff in the stock that occurred in the months after the call.
Along those same lines, those that were able to read into and act upon the positive aspects of Bob Nardelli's resignation from Home Depot (NYSE:HD) in early 2007, or Philip Purcell's resignation from Morgan Stanley (NYSE:MS) in 2005 could have made a mint. Again the idea is to play detective and be willing to make assumptions based upon certain idiosyncrasies or other factors that aren't often analyzed in Wall Street research reports or found in Securities and Exchange Commission (SEC) filings.
Tip No.5: Know When to Swim With the Tide
As the dotcom bubble showed, sometimes it pays to go against the prevailing trend. However, in most situations, the average investor should not necessarily swim against the tide. In other words, if a stock is falling, it's often better to wait until it levels off or buying pressure resumes before jumping in.
As evidence that patience pays off, consider what happened to companies, such as CMGI (Nasdaq:CMGI) and JDS Uniphase (Nasdaq:JDSU). Just a few years back, a number of contrarians and bargain hunters tried to buck the downward trend in these stocks, arguing that they were a "buy", despite of the masses of people who were selling these stocks and their precipitous fall from $100 to the single digits. The fact is that only those who were patient and waited until these stocks finally bottomed made any money.
In many situations we have been told to "think outside the box" or "go against the grain", making the concept of following the herd very difficult for some investors to grasp. In a way, it also goes against human nature in that if we see a stock getting pummeled, we want to get out before it goes down even further, even if it's not in our best interest.
In order to avoid this instinct to buy when everyone else is selling or to sell when everyone else is buying, the investor must focus on the fact that there are countless opportunities to be had in the stock market at any given point in time. Investors should also keep in mind that recent history suggests that jumping the gun ahead of the crowd is more often than not a losing cause.
So how can you figure out whether to go with the crowd or not? The short answer is to do your homework and confirm the herd's position. Maybe you should go take a look and find out if there is a reason why a company's stock is so out of favor with the market. More often than not, a slump in a stock's price is probably justified by some underlying fundamental reason.
Tip No.6: Seize Opportunity
Patience and thorough analysis is important, but once the analytical process is complete, go for it! Inactivity or paralysis is just as deadly as is acting in haste. Just think about the people who are still kicking themselves for missing the meteoric rise in companies, such as Microsoft (Nasdaq:MSFT) or Google (Nasdaq:GOOG).
Make sure that you don't act like a deer in headlights: stick to a formal research process. In other words, before a purchase, resolve yourself to reviewing all of the financials, comparing the company to its competitors and reading Wall Street research on the company. Then, after the homework process is complete and you have a fallback plan, commit to taking action.
It helps to be a "numbers person," but an investor's ability to extrapolate ideas, infer things from shareholder communications and to control his or her emotions is of far greater value.