Building Wealth Managing Editor's note: There's a common investing phenomenon that trips up educated and ignorant people alike. It's very human. And if you're not aware of it, you'll lose thousands of dollars before you know it. Here's how to combat it...
Don't fall for these headlines...
The New York Times reported that "trust your gut" could be profitable advice on Wall Street... while the Financial Times described "gut feelings" as key to financial trading success.
A 2016 study out of the University of Cambridge showed that better traders have better instincts... or a stronger mind-gut connection.
Researchers ran heartbeat detection tests on their subjects. The idea is that the more accurately you can detect changes in your body, the better able you are to read complex and subtle market changes to make better trade decisions.
They gathered successful high-frequency traders – folks who held their trading positions for seconds or minutes, or a few hours at most – and compared them with similar undergraduate students as a control group. Sure enough, the traders scored far higher on the tests. Even more telling, the longer that someone had been a trader, the better his score.
Successful high-frequency traders may have a sort of "sixth sense" that they use to take in information and make snap decisions. For a certain group of investors, "trust your gut" may make them money.
However, the vast majority of us don't have this sixth sense. Instead, most people make terrible investing decisions when they listen to their "gut."
The biggest trap we fall into is something called "loss aversion."
If you remember my friend Dr. Sue, she's a good example of loss aversion. Instead of cutting her losses early, Sue watched as her entire portfolio tanked. She was so afraid to make a mistake, she just kept watching her losses get greater and greater.
The losses highlight one of the most common mistakes (and among the hardest lessons to learn) of investing.
Loss aversion is a well-known phenomenon. It's been studied and reported in financial and economic literature. Yet it trips up educated and ignorant people alike. It's very human. And if you're not aware of it, you'll lose thousands of dollars before you know it.
Loss aversion goes hand in hand with something else called the disposition effect.
The disposition effect basically means people hate losing far more than they like winning. It's the basic principle behind why people can lose their shorts in Vegas – they're more likely to take a gamble when they've been losing.
Dr. Sue was gambling in a sense with her portfolio. Instead of cutting her losses, she kept "gambling" on the chance they would bounce back. So her losses kept adding up.
This kind of behavior stems from fear – fear of losing money and of making mistakes. And fear comes from a tiny part of our brain called the amygdala.
Here's my secret: you don't need a sixth sense to figure out how to be a good trader. What you need are the tools I've already given you here in Retirement Millionaire Daily.
Secret No. 1. Control your fear.
Your amygdala senses threats, and your brain releases chemicals that trigger the "fight or flight" response... You get sick to your stomach, your pupils dilate, and you want to run and hide. Learning to calm your amygdala helps you evaluate things more logically, without falling prey to fear.
Meditation is my favorite way to reduce the activity in the brain's amygdala. The amygdala is also a contributor to anxiety disorders and stress. Quieting this brain region bolsters more positive feelings.
In a 2011 study from the brain research journal NeuroImage, beginning meditators showed reduced activity levels in their amygdalae when faced with fear-inducing images.
And if you remember, another study from the National Bureau of Economic Research discovered that traders with happier, more positive moods (and thus quieter amygdalae) had better performances in their portfolios.
That's why this month I want to share her story and teach you how to avoid the greatest trap there is in investing. It takes practice and discipline to protect yourself from loss aversion. But once you learn a few techniques, managing losses will be easy.
Secret No. 2. Use stop losses.
As we discussed in our issue "Two Easy Ways to Avoid Disaster in Your Portfolio," you need stop losses to best protect your investments. They take all the emotion out of your choices – replacing it instead with, when your stock hits a stop, you sell. No questions or hesitations.
There are two types of stop losses: hard stops and trailing stops.
Hard stops use a set price or percentage below the purchase price. If the stock falls to that amount at any time, you sell.
Let's say you purchase Stock X at $10 and set a 20% hard stop at $8. No matter what the stock price rose to for Stock X, once it fell to $8, you would sell.
Trailing stops use a percentage below the purchase price, but they don't stay the same. As the price rises, the trailing stop follows it.
For a trailing stop, let's say you would initially set it at 20% below your purchase price. So for Stock X, you'd start out at $8, the same as a hard stop.
Picking the right kind of stop can be tricky. Generally, we recommend hard stops for income-generating investments and trailing stops for growth investing.
Secret No. 3. Spread out your wealth.
Asset allocation means how you divvy up your capital among several categories of assets. Changes in the market get smoothed out by the diversified nature of your portfolio... leaving you to sleep well at night.
The key is doing it from the start and sticking to it.
First, you should set aside some cash for emergencies... Then, start with a simple allocation: Decide between stocks and bonds. If you have a longer-term view and a high tolerance for risk, you might make your allocation 80% stocks and 20% bonds. If you are closer to retirement and don't like volatile returns, you could do 30% stocks and 70% bonds.
Most of us fall somewhere in between those extremes. When someone is starting off, I suggest using a "middle of the fairway" asset-allocation plan: 60% stocks and 40% bonds. It ensures you will harness the proven wealth-building power of stocks... while also using the conservative, income-producing power of bonds.
The key is to find a balance that best suits your risk tolerance. And remember, don't sink all of your 401(k) into one company or one sector – if it drops, you'll lose everything.
You might never develop that sixth sense for investing, but if you follow these three steps, you'll be well on your way to becoming a successful trader.
But even with these steps, it's not easy to take the emotion out of knowing when to sell. That's why I recommend you set some time aside in the evening tomorrow, March 28.
You'll learn about a small group of our readers who actually knew that the crash was coming...
And many were able to sell their stocks and lock in profits weeks before the market bottomed.
So mark your calendars... On that night, you'll learn a way of timing the markets that is so precise, it would have alerted you to sell your stocks weeks before the crash.
Here's to our health, wealth, and a great retirement,
Dr. David Eifrig and the Health & Wealth Bulletin Research Team
May 27, 2020