Controlling Your Emotions During Tough Markets

All year, investors have been fleeing the stock market for the perceived safety of the bond market, letting fear take control of their investing and financial future. But if you can learn to control your emotions, today’s equity markets offer enormous opportunity.

Your biggest enemy for successful trading is not the “market,” other traders or investors, the economy, or any outside force. You face your biggest danger in the mirror every morning, because your biggest danger is you — your emotions and the human frailties that can easily lead to your financial ruin.

How many times have you read that the average investor has an uncanny knack to buy at the top and sell at the bottom? It’s true — and it’s sad. People tend to chase bubble fads and the latest “hot” investment. And when they do, they invariably get burned.

More of us need to be like Warren Buffett and train ourselves to “be greedy when others are fearful, and be fearful when others are greedy.”

Greed, Fear, and the Herd

Greed and fear are the two primary driving forces behind most investor decisions. Because though much has been written about markets being rational and investors making rational decisions based on earnings reports, price-to-earnings ratios, or technical analysis, the fact is that markets are not rational, as witnessed by the stock market’s recent wild gyrations.

We’ve seen incredible global volatility, a flash crash, strong short-term rallies and declines — and there’s no rational reason for any of this in terms of corporate profits, economic reports, or political events. The explanation for what’s happening in these crazy times is very simply that greed and fear are driving today’s markets in very powerful and extreme ways.

Greed is simple to understand. People want to make money. But fear is a little more complex in that there are really two types of fear: fear of loss, which we all understand, but also fear of being left behind.

I believe a key to investment success is learning to control your greed and your fear.

You can control both of those emotions by following these rules:

• Do not overtrade. In the search for better results or to limit loss, investors tend to overtrade and so wind up paying too much in commissions or getting whipsawed by short-term market gyrations.
• Do not take on too much risk. Greed causes investors to take on too much risk, either through options, leverage, investing in risky companies, or by taking positions that are too large.
• Do not look back. Successful traders don’t go back and look at trades they have sold to see how they “would’ve done.” When a trade is over, it’s over. They don’t do a postmortem to see if they were “right” or “wrong” about the market.
• Do not sell your winners too soon. When you sell too soon, you miss out on further gains.
• Do not hang on to losers too long. Most investors find it’s hard to admit they were “wrong,” and so lose more than they should or could. Ego plays a big role here. People want to be right. But “Hang on, it’ll come back” is not an investment strategy. Just ask anyone who still owns some of the darlings of the dot.com boom and bust.
• Keep your ego out of your trading. Pride in a good trade is as harmful as shame or anger or grief over a bad trade. Some trades will go well. Some trades won’t go well. It has nothing to do with the investor’s intellect or self worth.
• Find a good plan and stick with it. A great batter in baseball only succeeds four out of 10 times at the plate. Investing is a marathon, not a sprint.

To be successful, you must use a trading system that suits you. It must fit your personality, your lifestyle, and your goals. A day trader, for example, is a totally different animal than a buy-and-hold investor.

Once you recognize who you are, you must apply discipline to your trading activities by having a written plan that you stick to unrelentingly. You must learn your market inside and out and become a specialist, not try to be an expert in all things. Today’s markets are much too fast complex for anyone to be a generalist. Be a one-trick pony, and make it a very good trick.

I can tell you from personal, painful experience that if you violate the above rules, your chances for investing success are slim at best.

I’ve made all of the mistakes I mentioned at one time or another — and, almost invariably, it’s cost me money. The “trading gods” just seem to know when you violate the rules, and then smack you down for your transgression.

When I look around at people I know and have worked with who’ve made these mistakes, they, too, have usually lost money.

I know one guy who has lost money for three years running who spends his weekends watching the talking heads on financial television. By Sunday evening, he’s so confused that he doesn’t know where to turn. Recently, I watched one of the weekend talk shows for a few minutes at SeaTac International Airport between flights — and I could almost feel the paralysis start to set in.

I know a woman who skips from advisor to advisor, managing to lose money with each one of them — and she can’t figure out why. I know more people than I care to count who trade by the seat of their pants or on a hunch or based on a tip that they read or heard about in the financial media. Frankly, they’d have about the same odds of winning and a lot more fun if they went to Las Vegas instead.

The bottom line is this: Trading and investing in our current climate is tough. Like the old saying goes, “Trading isn’t rocket science, it’s harder.”

You can be like the herd, the “sheepies” who have fled to the bond market and are in the process of creating another bubble there. Or you can be different, a contrarian, and deploy a professional, unemotional trading plan that can take advantage of today’s unique opportunities.

The choice is yours.

[Ed. Note: John Nyaradi is the publisher of Wall Street Sector Selector, an online newsletter specializing in exchange-traded funds (ETFs), and the author of Super Sectors, How to Outsmart the Market Using Sector Rotation and ETFs.]