An investor must have strict stop-loss (the level of stock, ideally a percentage points, lower than the bought price) and targets for every stock purchase

Whenever we begin our investment journey to stocks, there’s a lot of research and analysis done over the available instruments. Rules are placed and filters are ensured to distill the list of potential winners to the defined parameters. While this is important to derive an investment philosophy and investment policy that governs how to invest into the future, equally or even more important is our mental condition towards this thesis.

Very rarely do investors prepare themselves to the investment journey they set upon. This is mostly true with equities as most of the investors begin their equity expedition in times of a bull market or at least when they’re relatively sanguine. Volatility in equity markets is not a bug but a feature and most investors try avoiding this. Also, a flaw in the approach of many investors is that they try to understand or estimate the risk of an investment i.e., risk associated with each asset class and accordingly try to respond to it.

However, it’s critical to understand the risk appetite or tolerance of the investors themselves than that of the instrument or product. While we consider the risk profile of an investment, we tend to consider how it behaves on an average, ignoring the fact that the extremes make up for the average. So, we need to be prepared to mock our behavior when the asset behaves at the extremes, do we’ve the capacity to internalize such price movements in an asset. Only once that matches, should one consider exploring, also to the proportion of exposure. This is why asset allocation plays such a critical function in wealth creation.

How we respond to the market extremes, for instance, at highs to control our urge or succumb to FOMO (Fear Of Missing Out) so that we don’t deviate from our investment objective thus trespassing the redlines of risk. Economic historian once put this in a much humorous way, “there’s nothing so disturbing to one’s wellbeing and judgement as to see a friend get rich”. Similarly, how we behave during the market bottoms or dips, trying to limit our position size or calls of exit. This simulation is vital in safeguarding our initial investment plan.

One can’t keep digging out the seed to check if it’s germinating or not. One must be sure or put efforts in identifying the correct seed and then pull in the right conditions like good soil, adequate sunlight, enough water and other desired levels of enrichments (like manure, etc.) to place the seed and allow it to get nurtured. Now once we have all these in place, we just allow time to let the seed germinate, develop the roots to its bottom simultaneously pulling out tender shoots at the top. Over time it developes into a small plant and with enough space and time matures into a tree.

Taking this analogy, to investing, one needs to give time to get the benefits of compounding to work. Numerous studies have shown how the magic of compounding worked better when undisturbed and how investors became rich just by not checking their investment accounts. Why investor behavior trumps all other shortcomings in investing is because irrespective of the decision made, the constant itch to check if the decision is correct puts us in trouble.

So, how do we overcome psychological biases to make better and rational investment decision? Adhering to the initial investment framework. If one has already detailed on their investment style, they should stick to it irrespective of the markets. Having strict stop-loss (the level of stock, ideally a percentage points, lower than the bought price) and targets for every stock purchase. A clear plan to act when the target price has reached i.e., exit, reduce, add, etc. and enhancing the stop-loss i.e., trailing stop-loss in case of retention of the stock. Position sizing, how much proportion to allocate to each stock initially and a clear path to reduce losers while adding on to winners. Most importantly sticking to the circle of competence i.e., considering those stocks/sectors that one understands better.

These ideas sound rational while they address the various biases that we’ve been built with. Once we find an equilibrium to our rational thoughts with our emotions, the investing magic begins to unravel.

(The author is a SEBI registered Research Analyst and could be reached at [email protected])