FGHIs of investing

Question: They say you should take emotions out of the equation when investing in stocks. Can you expound on this?—asked at “Ask a friend, ask Efren” free service available at www.personalfinance.ph, Facebook and SMS.

Answer: I have to give credit where credit is due. Jesse Livermore, touted as the world’s greatest stock trader, came up with the rule on getting emotions out of investing in stocks. How good was Jesse?

Livermore made $1 million in one day in 1907. During the stock market crash of the United States in 1929, Jesse made $100 million. Now that is brilliance!

Anyway, Jesse said that the stock market investor should avoid the FGHI’s.

The “F” stands for fear as he knew that humans are by nature risk averse. But being too risk averse will prevent a person from enjoying the benefits of potentially inflation-busting returns.

The “G” stands for greed. By nature, humans tend to repeat what is pleasurable. And chalking up wins from investing is pleasurable indeed as the brain releases dopamine with each gain. However, chasing after gains can give the investor the false impression that he is invincible and blind him to the risks that go hand in hand with investing. In fact, there is no investment in the world that is fully guaranteed. And, the guarantee is only as good as the guarantor.

The “H” stands for hope. When an investor recognizes that he made a bad investment, risk aversion again kicks in. There is resistance to accept and realize the loss by selling the investment. This behavior also gives rise to the disposition effect that states that people hold on to losers too long and sell the winners too soon. And why is selling the winners too soon a product of risk aversion? It is because there is the fear that if profits are not cashed in right away, they may be lost eventually when the holding period is extended.

The “I” stands for ignorance. There is ignorance if the investor allows his brain to just follow simple rules of thumb, educated guesses, intuitive judgments and plain common sense. All of these are called heuristics. Since it is to the body’s advantage for the brain not to overthink things, the brain resorts to heuristics so that decisions can be made fast and effortlessly. In investing, such behavior is manifested in relying simply on tips without really digging into the fundamentals behind such tips. And tips abound nowadays due to the power of technology, particularly in social media.

So, even if you have mastered the ABCs of investing, remember that you also have to avoid the FGHIs.

Here’s to your emotionless but profitable investing in the stock market.