Rules for Avoiding Behavioral TrapsDave:I don’t feel secure enough to trade again soon. I just want to learn
the right longer-term strategy. How can I get over these behavioral traps
and be a successful long-term investor?
IC:Dave, I’m glad you are not trading, since trading is right for only a
very small fraction of my clients.
To be a successful long-term investor, you must set up rules and in-
centives to keep your investments on track—this is called precommit-
ment.^24 Set an asset allocation rule and then stick to it. If you have
enough knowledge, you can do this yourself or else with an investment
advisor. Don’t try to second-guess your rule. Remember that the basic
factors generating returns change far less than we think as we watch the
day-to-day ups and downs of the market. A disciplined investment
strategy is almost always a winning strategy.
If you wish, you don’t have to eliminate your trading altogether. If
you do buy stocks for a short-term trade, set up a stop-loss order to min-
imize your losses. You don’t want to let your losses mount, rationalizing
that the stock will eventually come back. Also, don’t tell your friends
about your trades. Living up to their expectations will make you even
more reluctant to take a loss and admit that you were wrong.
Dave:I’ll have to admit that I sometimes enjoyed trading.
IC:If you really enjoy trading, set up a small trading account that is com-
pletely separate from the rest of your portfolio. All brokerage costs and
all taxes must be paid from this account. Consider that the money you
put into this trading account may be completely lost because it very well
may be. And you should never consider exceeding the rigid limit you
place on how much money you put into that account.
If that doesn’t work, or if you feel nervous about the market or have
a compulsion to trade, call me, I can help. And according to news re-
ports, there are some reformed traders who are establishing Traders’
Anonymous (TA) programs designed to help people who cannot resist
the temptations of trading too frequently.^25 Maybe you should look into
those.CHAPTER 19 Behavioral Finance and the Psychology of Investing 331
(^24) Hersh Shefrin and Richard Thaler, “An Economic Theory of Self-Control,” Journal of Political Econ-
omy, vol. 89, no. 21 (1981), pp. 392–406.
(^25) See Paul Sloan, “Can’t Stop Checking Your Stock Quotes,” U.S. News & World Report, July 10, 2000.