To reduce the risk of falling prey to emotional behavior that will hurt our performance we need an investment plan and some guidelines to follow. Planning protects us from unpredicted future events and just like everything else in life investing requires proper planning. The 7Ps from the old British Army adage describe why we need a plan: Proper Planning and Preparation Prevents Piss Poor Performance.
Since it is easy to make emotional mistakes we want to design a long-term plan when we are in rational, non-emotional state of mind. This should be done when there is little activity going on in the market. Once we have created our plan we need to make a commitment to it, write it down, and review it periodically to make sure it is always in the back of our mind.
Warren Buffett shares his practice We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.
Two practical investment plans Remove emotions from investing
1 Keep a wish list of stocks
Create a list of companies that you really want to own. Pick the best companies you can think of, with strong balance sheet and lots of growth potential. Then write down a price you would be willing to pay for the company. Make sure that your target price is far below the current price or this exercise wont work. I am talking about at least 25% off the current price and preferably 50% or more.
The second step of this plan is to automate the process. The legendary investor and mutual fund pioneer Sir John Templeton used this strategy to the fullest. He understood that emotional events like sharp selloffs could cripple the mind of even the savviest investor and that if he one day found the market or a stock down 50% he wouldnt have the discipline to execute the buy at the time. So he kept a wish list of stocks he wanted and made the buy decision beforehand. He would call his brokers and place buy orders, which were far below the current market price, and would be executed if the market would tumble in the future. This is as simple but highly effective strategy Mr. Templeton used to remove emotions from the situation.
This strategy can be implemented on individual stocks and whole indexes. Most online trading platform and brokers are capable of carrying out this simple function.
2 Dollar cost averaging (DCA)
Dollar cost averaging is a simple and effective approach that takes emotions out of investing. Dollar cost averaging is a technique of systematically purchasing a fixed dollar amount of equities on a predetermined schedule regardless of the share price. Fewer shares are purchased when the price is high and more shares are bought when the price is low.
To make Dollar cost averaging more effective setup a plan and following these three steps.
A. Decide how much you want to invest each month. Only commit funds that you can consistently invest every month.
B. Choose an investment. This can be an index fund or a set of stocks. Select an investment that is in an early stage of a cycle and that you want to hold on to for many years to come.
C. Automate the process to completely remove your emotions from the process. Setup weekly, bi-weekly, or monthly purchases of your selected investment through your broker with an automatic withdrawal plan.
This particular strategy works well for cycle investing. We will consistently buy into a bull market cycle during the initial phases at lower prices. ETFs are good investment vehicles for this approach. Many successful investors use this strategy and some use it without being conscious about it.
Your advantage over the pros!
You actually have a significant advantage over the professional fund managers. Why? You have the luxury of developing a sound strategy with a long term horizon. And you have the luxury of finding an attractive and undervalued investment and wait for it to rise in value. You also have the luxury to go against the crowd and invest in what you believe in.
Fund managers do not have this luxury. They are short term focused and have quarterly benchmarks to meet. They dont have time to wait for undervalued investments that within time will give good results. They do not have the appetite to go against bubbles that are forming as it may require sitting out of the market for an extended period of time. Most fund managers are paid for asset under management so the easiest way of not getting fired is to deliver performance close to the benchmark. Jim Rogers noted that no fund manager has ever gotten fired for doing what everyone else is doing and losing money. People get fired for doing something different and losing money.
Professional fund managers essentially do not have to luxury of investing in an undervalued stock and waiting for it to grow or going against the mainstream. It is this shortsightedness that leads to erratically behavior and amplify crowd behavior in the market. It is perhaps for these reasons that the vast majority of fund managers underperform the S&P500 market index.