Sunday, September 24, 2006

Managing greed and psychology

In investing, managing greed is as important as managing how you allocate your capital.

Personally, I have my share of greediness which causes me a lower return on my capital. A simple illustration as follows.

A value investor has bought AAA at $2. Before he got it, he had in mind that the stock is worth $4 in time. So after a year, the stock rises to $4. But he did not sell it, the greed behaviour of human had taken over the logical value thoughts. Then the stock went up to $4.5, he still being greedy thinks it'll goes up more. Yes, he was right, it went up to $5, then $5.2, then $6 And he was still holding to it. Then the stock came tumbling down, from $6to $5. Then for a few days, it hovers around $5, he still did not sells, thinking that it's just a market correction, hoping for it to rise. Then again, the market crashes, it went to $4.5, then $4, then finally, $3.5 and here, it bottoms out. He finally sold off at $3.5 and still made a pile but his initial target was not met because of greed.

In another scenario, this is about managing psychology or so-called "lost" profits. In the same case, the investor got AAA at $2 with a target of $4. When it hit $4, he sold it off. Then the stock was driven way up to $8 because of speculative forces. This investor feels he had taken the wrong strategy because of what happened, attributed to lunatic speculation forces. This is an important junction where the investor's initial discipline on his faith in value strategy is finally tested. If he were to hop onto the other lane, he has lost his discipline in the hope of searching for a hopeful result. If he stay on the same lane, whatever future investment he does, he will most always have a certain result. And he may have missed the peak, but more importantly, he missed the wreak that followed.

In investing, it is important to know the pitfall of greed and how psychology affects your feelings. Psychology is to do with feelings, not facts. Facts will correct everything that deviates from it. Feelings are something that causes the result to deviates from the facts.

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