An Introduction to Emotional Risks in Stock Investments - dummies

An Introduction to Emotional Risks in Stock Investments

By Paul Mladjenovic

What does emotional risk have to do with stock investments? Emotions are important risk considerations because investors are human beings. Logic and discipline are critical factors in investment success, but even the best investor can let emotions take over the reins of money management and cause loss.

For stock investing, you’re likely to be sidetracked by three main emotions: greed, fear, and love. You need to understand your emotions and what kinds of risk they can expose you to.

The price for greed

In 1998–2000, millions of investors threw caution to the wind and chased highly dubious, risky dot-com stocks. The dollar signs popped up in their eyes when they saw that easy street was lined with dot-com stocks that were doubling and tripling in a very short time. Who cares about price/earnings (P/E) ratios when you can just buy stock, make a fortune, and get out with millions?

Unfortunately, the lure of the easy buck can easily turn healthy attitudes about growing wealth into unhealthy greed that blinds investors and discards common sense. Avoid the temptation to invest for short-term gains in dubious hot stocks instead of doing your homework and buying stocks of solid companies with strong fundamentals and a long-term focus.

The role of fear

Greed can be a problem, but fear is the other extreme. People who are fearful of loss frequently avoid suitable investments and end up settling for a low rate of return. If you have to succumb to one of these emotions, at least fear exposes you to less loss.

Also, keep in mind that fear is frequently a symptom of lack of knowledge about what’s going on. If you see your stocks falling and don’t understand why, fear will take over, and you may act irrationally. When stock investors are affected by fear, they tend to sell their stocks and head for the exits and the lifeboats.

When an investor sees his stock go down 20 percent, what goes through his head? Experienced, knowledgeable investors realize that no bull market goes straight up. Even the strongest bull goes up in a zigzag fashion. Conversely, even bear markets don’t go straight down; they zigzag down.

Out of fear, inexperienced investors sell good stocks when they see them go down temporarily (the correction), whereas experienced investors see that temporary downward move as a good buying opportunity to add to their positions.

Love in all the wrong places

Stocks are dispassionate, inanimate vehicles, but people can look for love in the strangest places. Emotional risk occurs when investors fall in love with a stock and refuse to sell, even when the stock is plummeting and shows all the symptoms of getting worse. Emotional risk also occurs when investors are drawn to bad investment choices just because they sound good, are popular, or are pushed by family or friends.

Love and attachment are great in relationships with people but can be horrible with investments. To deal with this emotion, investors have to deploy techniques that take the emotion out. For example, you can use brokerage orders (such as trailing stops and limit orders), which can automatically trigger buy and sell transactions and leave out some of the agonizing. Hey, disciplined investing may just become your new passion!