Investing involves making a number of decisions. It is worth following the basic rules, the operation of which has been tested on experienced investors. Here are five basic rules that can help us avoid investment failures. Investing requires commitment, time, knowledge, and the ability to deal with emotions. No one is born with such a set of skills. They must be acquired, primarily as a result of active education, because it is education and then the accumulated market experience that are the overriding carrier of potential future investment successes.
Rule 1 – You always need to have a strategy and an investment plan
The strategy and investment plan largely determine the future investment results. Of course, the strategy itself should be a consequence of a previous deeper analysis (of a given company, market environment, etc.), because depending on the conclusions that came from it, different scenarios of future decisions can be created, specifying the target sale price of the asset, the maximum acceptable risk, the investment horizon, as well as potential emergency scenarios in the event of a change in the base model of the strategy adopted by us.
In practice, it is very often the case that the investor in his strategy assumes only the sale of shares at a higher price than he bought them, because this is the purpose for which he invests. Of course, he is aware of the risk of capital loss, but he pushes this risk into the background, and only when the price falls below the purchase price groping for an idea for the best way out of this situation. The same is true for growth. The lack of a strategy, the lack of proper assessment of the situation usually causes the investor to get rid of shares prematurely, enjoying a small profit, and losing the chance to achieve above-average results.
Meanwhile, investing based on the investment strategy adopted at the beginning makes our later decisions much more thoughtful, and above all, usually end up with much better results. Importantly, the investor’s strategy should also include the possibility of changing the original strategy. This is because there are often situations that we did not assume before, such as extremely significant upward or downward deviations from the company’s financial results we assumed, significant contracts signed by the company that were unforeseen in any scenarios, or e.g. announced write-downs on assets, or extraordinary market-related events, such as those observed in the previous year, etc.
Therefore, it is very important to have a specific plan for each investment from the very beginning. Then, depending on the development of events, it is much easier to apply this plan, and above all, we are able to react relatively quickly and thoughtfully to the changing situation and circumstances.
Rule 2 – Don’t be guided by emotions in your decisions
This is the principle that is most difficult to implement, and even the most experienced and experienced investors have a problem with its application. On the one hand, it is difficult to imagine that strong declines in share prices or their strong increases would not evoke emotions. It is also difficult to imagine that these emotions would not be evoked by the rapidly changing value of the portfolio under the influence of significant changes in share prices. It seems all the more unrealistic to get rid of these emotions in such cases where we first had a violent crash and then an extremely strong rebound of the markets.
Meanwhile, it is emotions, including the fear of further loss, fear of losing the profit already achieved and simply greed, that cause even the most educated and experienced investors to make cardinal investment mistakes, e.g. selling shares at the lows and buying them at the highs.
Of course, in investments, emotions cannot be completely removed, but you have to learn to control these emotions, and above all, learn to properly interpret the market environment, the moods of other investors and the messages coming into the market. Controlling and controlling emotions cannot be learned in one day. It is a continuous process that will continue throughout the entire period of the investor’s presence on the market. Every day, every experience teaches the investor something new, and these experiences should be supported by literature on the psychology of investing, very good educational materials on websites, or participation in webinars and training courses on the psychology of investing.
There are investors who have a lot of knowledge about financial analysis or technical analysis, but never achieve above-average results. The problem is their emotions. The ability to control emotions, especially in these difficult moments, i.e. in periods of panic, euphoria or long-term consolidation on the charts of owned companies, can have a significant impact on the results of our investments. Therefore, when investing in the market, it is worth devoting a lot of space to this issue.
Rule 3 – Don’t get caught in the trap of virtual loss
An investor does not like to lose capital, which is obvious. In practice, no one likes to lose money, and even more so few people like to admit their own failure. And this is the reason for one of the biggest sins of a stock market investor, which leads to the loss of control over the losses incurred. When the price behaves differently from the original assumptions and, for example, falls sharply, then it is difficult for the investor to admit to himself that he misinterpreted the situation by making a wrong decision. This, in turn, entails a chain of further errors.
In the first phase, the person incurring the loss assumes that it is only a temporary loss, and the price will soon return to the positive. The situation worsens when the downward trend turns out to be a more permanent change. Then the investor, in turn, explains to himself that it is “only” a virtual loss and until he sells the shares, he has not actually lost money, because he still has a chance to sell them at a profit. Of course, this is true, but downward trends can often proceed with the force of a tsunami, leaving behind some time ashes, i.e. losses reaching levels of e.g. 90% or higher, and this happens even in the case of the largest companies. And then, in order to make up for this virtual loss, the value of such a position would have to increase by 900%. In many cases, this takes decades, and in many cases it is never possible to make up for it, although of course scenarios of 900% or higher growth are also possible and sometimes happen. Nevertheless, it is definitely better to admit your own mistake before the scale of the devastation of your wallet becomes too large, and you certainly need to unlearn the idea that a loss is just a virtual loss.
Of course, it is worth admitting to a mistake only if the loss goes beyond the maximum permissible loss framework adopted in our strategy. It should be remembered that each loss is an actual loss, while at the time of its realization it simply becomes an accounting loss. On the other hand, it is the investment strategy referred to in the first point that should determine the maximum level of permissible drawdown of capital on a given position and the moment of its closing. You don’t have to “marry” investments for years, but as a consequence of the mistakes made, this is often the case. What is worse, it is often a “marriage” in which we later last for years, in a sense against our own will.