The ability to control your emotions is an important skill for investing (and life). Human begins are emotional animals. That’s a fact. That fact shows itself in the stock market every year.
Stocks become overbought or oversold all the time. Basically what that means is that when humans react to news, they tend to over-react, both positively and negatively. They see a company that has grown at 20% for 6 straight quarters and bid up the stock price to astronomical triple digit P/Es and untenable valuations. They see a company whose revenue remains flat (or god forbid goes down) for a quarter or two and all the sudden the sky is falling. It can’t be sold quick enough. In reality what should happen is almost always more muted than what does happen.
Why is that? Emotion. People see the price going down and see their hard earned money “disappearing” and panic and sell before more if it is “gone”. Or they see the value of their account growing at a fantastic rate and think the good times will keep on rolling. Overreaction to the downside can be explained by loss aversion – losses hurting more than gains feeling good. Loss aversion is a well studied and documented psychological phenomenon. Overreaction to the high side isn’t as easily scientifically explained, except perhaps via recency bias (overweighting recent events compared to historical expectations) . My personal take on it is a combination of recency bias and what I’ll call free roll theory. Once someone is in the green, especially far in the green, anything that happens after is gravy, so they are reluctant to sell, even at extravagant valuations.
So, how do we avoid emotion in investing? One way I like to use is something called a dividend re-invesment plan (DRIP). DRIP investing is a form of dollar-cost-averaging. That is, investing the same amount of money in a stock at regular intervals, generally monthly. A DRIP program takes it a step further and also automatically reinvests any paid dividends. Dollar-cost-averaging helps remove the emotion from investing because you are creating a plan. You are going to invest X dollars on the 1st day of every month. It doesn’t matter if the stock was up or down the previous month. Your X dollars are still going to be buying more shares of the company of your choice the first day of every month.
One awesome side effect of this, is it makes it so you are agnostic about the direction of the stock price. If the stock price goes down, fine. You get to buy more shares for your X dollars. Your income stream grows even more than it would have. If the stock price goes up, fine. You are making money. The short term gyrations of Mr. Market matter a lot less. It is truly a great way for you to build up an ownership stake in a company while at the same time not having to stress about what happens in the stock market on a daily basis. The reason for this is summed up perfectly in this quote:
“In the short run, the market is a voting machine. In the long run, it is a weighing machine.”
Benjamin Graham
To paraphrase Ben Graham: In the short term emotion controls stock price. Over time, the price of a stock will reflect the value of the business.
Many companies allow you to establish DRIPs through ComputerShare where you can invest as little as $50 monthly for low to no fees. It is set up so the money is withdrawn from your bank account automatically, so once you’ve set it up, there’s no more work for you to do. Alternatively if the company you want to create a drip for is not available on ComputerShare, you can build your own DRIP and still avoid fees using Robinhood. It’s a little more involved, but there is really no excuse for you to not create one if you have the desire to do so.
The stock market can be an extremely volatile place. You will find at least a 10% swing from high to low for almost every year on record. Committing to a dollar-cost-averaging approach is a great way to take some of the emotion out of investing.