I’ve devoted two other posts in the past to the mindset needed to be a successful stock investor, this one and this one, but if you’re not into investing or specifically stock investing, those posts also apply to managing one’s money in general. But since this is a stock investing blog, I want to focus specifically on the one key trait that one absolutely needs to have in order to become a successful stock investor.
I mentioned several personality traits in the two posts mentioned, but with the passage of time and the gaining of more experience, I’m able to better wrap all those ideas up into one key trait: the ability to manage your emotions.
Although I believe that nobody has ever fully mastered their emotions (aside from someone like Jesus!), you can learn to control them to the point where they don’t start to overwhelm you and tempt you to make irrational or stupid decisions when something scary happens, like when a particular stock’s price or the overall market takes a dip or an outright plunge.
Let me use an example: suppose that you’ve managed to save up $1,000 to buy a stock, maybe your first-ever stock. (I would recommend buying at least two stocks with this amount as a beginner, but let’s say just one stock for this example.) You’ve also searched resources like The Motley Fool or Seeking Alpha or Cabot Wealth Management and narrowed things down to a short-list of favorites. Next, you’ve maybe analyzed some numbers (if you’ve learned how the basics about income statements and balance sheets) plus learned more about the industries in which your companies of interest operate and their level of dominance in those industries. Maybe you’ve also consulted a friend or relative who is a successful investor and/or consulted a professional about your picks. You’ve also been watching the stock prices of the companies on your short-list and the overall market. Finally, you’ve narrowed your choices down to one favorite stock and now you’re waiting for an opportunity to make the purchase.
One day, you notice that a dip has happened and the price is right, so you deploy the money by buying $1,000 worth of shares. You have just become a part-owner of the company by becoming a shareholder.
You have also now officially entered the most difficult phase of stock investing: the period right after you buy it.
Some people believe that the hardest part of being a stock investor is finding great companies to invest in. What one learns after not much research is that there are in fact hundreds of great companies to invest in.
Others believe that the hardest part is knowing when to buy or when to sell. True, these can both be difficult and can even cause one to lose sleep if one thinks about either too much.
But I believe that the hardest part of stock investing is what a person does or doesn’t do in the first hours and days after buying shares in a stock, and this the direct result of how a person handles their emotions. I’m convinced that how a person reacts during this phase determines whether owning that stock will result in ultimate failure (losing money) or success (earning money), plus the degree of either.
A person will react in one of two ways during this first phase of owning a stock simply because the price will either rise or fall, and oddly enough either situation can produce its own dilemmas.
If the stock price rises
Naturally, every single investor who buys a stock wants the price to rise, but different personalities will have a different reaction to the rise in price.
The day-trader wants to get out before the end of the trading day before the price has a chance to fall because they’ve often leveraged to be able to put a large amount of money into one purchase. The new or more risk-aversive investor might want to get out after a rise of only a few percent. Some investors are not content unless they sense that the price could double within several months or a year. Yet others are fine with a slow, generally steady rise in price because they aren’t planning to sell any shares for several years.
The level of anxiety or stress caused by an increase in the price of a stock seems to increase with a shorter time frame and/or lower level of investing knowledge and experience. So the day-trader and short-term investor will more cautiously watch the price, looking for the soonest possible time to sell before there’s a chance of a loss. A new or less experienced investor will be more anxious if they haven’t learned about the natural rhythms of the stock market, which are similar to the oceans and the weather – ranging from calm to violent in nature and about as unpredictable.
An investor with a longer time-frame however, and I’m referring to years and not just months, pays little attention to the daily and literally moment-by-moment fluctuations in a stock’s price because they know or have learned that time smooths out all bumps and shakes out the short-term investors. This results, in the case of a quality stock (not a penny or micro-cap stock), a price curve that trends upward over the course of several years even if it goes through periods where several months are even a year or two are flat or even in a downward direction.
If the stock price falls
Naturally, every single investor who buys a stock doesn’t want the price to fall, but as with a rising price, different personalities will have a different reaction to the fall in a stock’s price.
To the day-trader, this is the absolute worst-case scenario since they’ve put most or all of their ‘skin’ into just one stock – often several thousand dollars’ worth, with more experienced ones putting in tens of thousands of dollars. However, seeing how day-trading has been found to be the most addictive form of gambling (source: The Motley Fool), their success is akin to your typical gambler playing slot machines: almost always a loss.
To the new or more risk-aversive investor, a price drop is often a cause of anxiety or even panic depending upon the speed and severity of the drop. IT IS AT THIS POINT WHERE MOST NOVICE STOCK INVESTORS LOSE HEART AND SELL AT A LOSS and therefore a key reason why most investors never build the ‘thick skin’ needed to succeed as stock investors.
*** IF YOU CAN HOLD ON DURING THIS PHASE IF THE STOCK PRICE DROPS and keep your anxiety and fears in check and wait out the storm, it is more likely than not that the company’s stock price will recover. *** However, this might take weeks or even months.
In the meantime, DO YOU HAVE WHAT IT TAKES to keep your emotions in check and to stick with your initial investment thesis? If you had put a good amount of effort into finding which stock to invest in, it’s a whole lot easier to believe in it during a price drop and to hold on until it recovers and becomes profitable. Knowledge reassures and builds confidence. But if you bought based upon a hunch or another person’s suggestion with little to no research effort on your part (LIKE ALMOST ALL NOVICE STOCK INVESTORS), then you’re much more likely to be looking for the lifeboat as soon as the first wave crashes in, thereby selling at a loss.
If you do manage to hang on for dear life
… then you have done what very few stock investors have ever managed to successfully do and it is these few who comprise the very small ranks of successful investors. Holding on through the storm by believing in why you bought the company in the first place to me is akin to bracing for your first hit as a football player or opening your mouth to make your very first speech. The wall of fear may be very high but it is also very thin, and often all you need to do cause that wall to crumble is stand up, resist it, then take a poke at it. The resulting victory causes your confidence to grow by leaps and bounds. Your next chance to get the ball or make the next presentation now seems more exciting instead of scary.
Here’s another consideration: if the price of the stock drops, have you actually lost any money? Only if you sell it! Until you place that sell order or click the sell button, your loss is only theoretical, not actual!
If you can keep these key points in mind and hold on for days, weeks, months, even a year or more for the price to return to where you bought it at and then start generating a return of 10%, 20%, 30%, 50%, even more, then what will your confidence level be like if the next stock you buy starts off on a bad note? I would imagine that, like me, the resilience you built up during your first big test will help you get through this one a whole lot easier!
The Final Word
The scenarios that I’ve just described – of not just holding on when a stock price falls, but resisting the temptation to sell with only a small gain if the price rises – are ones that I’ve had to go through several times in my own investing career thus far. BUT CONTINUING TO HOLD ONTO THE STOCKS THAT I BELIEVE IN – that is, managing my emotions and holding onto my investing thesis with each stock purchase – is why right now most of my stocks have solid returns with a growing number of them also multiplying in value, i.e. worth two, three, four, and more times than what I bought them for.
Doing this also builds the mindset required to become a long-term stock investor (holding a stock for at least three years), which statistics have shown beats the returns on all other forms of investing, whether bonds, mutual funds, ETF’s, real estate, or precious metals as the length of time increases.
So my hope is that you’ll have the guts to win your first challenge after buying your first stock, or at least win the next challenge if all you’ve ever done to this point is sell out of fear or earn only marginal returns. I’ve been there, done that – done all the wrong things in the past – and I can tell you that learning to hold on even when things look and feel terrible is the best lesson you’ll ever learn, not just in stock investing but also in life.
If you’re a brand-new stock investor – or still thinking about it – then I highly recommend the free e-book, Should You Consider Stock Investing? It could become one of the most beneficial 30-minute reads of your life.
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To new beginnings!