Most Common Investing Mistakes – Part 6 (Emotions)

I mentioned in another post why retail investors are called the dumb money that emotion is one of the three reasons why individual investors are preyed upon by Wall Street.

If an investor acts while under an emotional state, it virtually guarantees that they will take actions that will be detrimental to their investing success.

There is an inverse correlation between emotions and investment success. The more emotional you are, the less likely you will succeed in investing. Conversely, the less emotional you are, the more likely you will succeed in investing.

Here are some common emotions that investors go through and the resulting consequences:

Greed: This is by far the emotion that is most harmful to investors over their investing life. It’s also the most difficult emotion to keep in check as investors cannot resist the temptation of quick financial gains.

Example:

In every bull market, investors will jump on the bandwagon as they see others around them make money. Because they see so many people take part in this, they feel secure in being part of a large group.

It’s not surprising to find out that at the height of all bull markets, and therefore at the level where stocks are the most expensive and at risk of falling dramatically, the average investor will almost be fully invested in equities. Greed blinds investors of the dangers lurking around the corner.

Fear: The twin brother of greed, fear is easily the second most harmful emotion for investors as it wreaks havoc in all portfolios on its path. It misguides us to focus solely on the short-term setbacks and masks the unbelievable opportunities that are right under our nose.

Example:

In every bear market, investors will sell their stocks or equity mutual funds out of fear as they watch their portfolio drop in value. Unfortunately, their timing couldn’t be worse as they usually sell near the bottom of the market, essentially locking in their heavy losses.

As the stock market recovers, investors still shell-shocked usually miss the rally as they stay in cash or money market funds in order to sleep better at night. Fear can paralyze an investor to the point where they act out of desperation and panic instead of seizing the opportunity.

Hope: In our everyday life, having hope is good. It lifts our spirit when things look bleak; it gives us the courage to fight when we feel like giving up. Unfortunately, when it comes to investing, it’s best to check hope at the door. Hope can blind us from making rational decisions by making us overtly and unrealistically optimistic.

Example:

Have you ever noticed how infomercials always show how buying their products can lead us to drive a fancy car, own a luxury home, live a great lifestyle, etc. Infomercials are usually run late at night as people who are still up at that time are often at a difficult juncture in their life and need a large dose of hope.

When investors have high hopes of accumulating great wealth or having financial freedom or early retirement, they tend to only see the positive side of their investment decisions. This can be very dangerous as it leaves them in a vulnerable state and liable to be victims of all the scams out there that promote get-rich-quick schemes.

Anguish: The loss of money can be an unbearable source of stress and anguish. Seeing our portfolio dissolved in half can be a tremendously painful experience. This is even magnified for investors close to their retirement years.

Example:

Unfortunately, feeling bad doesn’t help us in resolving our problems. The sooner we get out of that feeling of anguish, the sooner we can get back on track. The more you focus on something, the more it expands. If your focus is constantly on how devastated you are because of your financial loss, your anguish will not leave you and your financial situation will also not change.

You need to redirect your focus to what you DO want to expand, which is the size of your portfolio. During a market downturn, a good strategy is to rebalance your asset mix by increasing your equity position and reducing your fixed income/cash component. This simple action allows you to buy additional stocks at cheap prices, which will accelerate the growth of your portfolio.

Exuberance: Alan Greenspan, the former Federal Reserve Chief, is famous for describing investor bullish sentiment in the late 1990 as “irrational exuberance”. Exuberance is what you get when you mix envy, greed, overconfidence and sprinkle some herd-like mentality. Investors under this state do not see any dangers; they cannot even fathom the thought of something being too good to be true. They are usually the last to join the party not knowing that the party ended just as they walked through the door.

Example:

At the height of any bubble, exuberance is easily noticeable. It’s when everyone seems to be in the “game”; everyone seems to be talking about and playing the “game”, from the cab driver to the local barber to the convenience store clerk.

The behavior of exuberant investors hasn’t changed over the past century; the only thing that changes over time is the game itself. The game can take on different forms; during the past decade, it has taken the forms of the internet mania, real estate boom and oil price surge.

Indifference: This emotion is sometimes difficult to identify in victims. They don’t seem to be upset or traumatized that they lost money but there’s a sense of avoidance or unawareness in them, a sense that they don’t care anymore.

Example:

After the dot com crash, many investors lost a big part of their life savings. They were so dismayed that they just stopped looking at their statements. Looking at the Book Value column and Market Value column on their statements was just too painful. Unfortunately, it appears many investors are in the same position after the recent recession, which explains why so many of them have left their money in cash or money market funds even as the market has recovered significantly since the lows of March 2009.

Being indifferent is a dangerous place to be. For all problems that we have in life, the first step is always to recognize and admit we have a problem. Indifference doesn’t hurt, which is why it’s so dangerous. It doesn’t force us to admit we made mistakes and therefore, we cannot take the next step towards fixing the problem.

In a way, it’s better for an investor to be upset because this anger can serve as a wake-up call to start learning more about investing and take their financial destiny into their own hands.

The bottom line is this. You need to always be aware of the different faces of emotion that you go through as an investor during various market cycles so that you can take the appropriate steps and move in the right direction instead of letting your emotions dictate your decisions.

The different feelings we have as we go through the many stages and events in our life shape who we are. Emotions make us humans. But when it comes to investing, being emotional is equivalent to being blindfolded. It’s best to invest with your head and not with your heart.

Somehow, I think Mr. Spock would make an excellent investor.

Related posts:

Most Common Investing Mistakes - Part 5 (Keeping Losers, Selling Winners)
Most Common Investing Mistakes - Part 4 (Relying on Other People's Opinion)
Most Common Investing Mistakes - Part 3 (Focusing on Price Instead of Value)
Most Common Investing Mistakes - Part 2 (Following the Crowd)
Most Common Investing Mistakes - Part 1 (Overconfidence)

Most Common Investing Mistakes – Part 5 (Keeping Losers, Selling Winners)

The average investor often makes the mistake of holding on to their losers too long and selling their winners too soon. Let’s break this down to analyze each activity separately.

Investors hanging on to losers for too long

Investors tend to hold on to their losing investments for three reasons:

1) They view a paper loss as temporary and are still hoping for a turnaround.
2) They can’t stand the pain of locking in their loss.
3) They don’t want to admit they’ve made a mistake.

As investors see the price of their stocks decrease in value, they find it difficult to lock in the loss. There’s a voice in their head saying: “Hey, it’s okay. It’ll go back up some day. The stock price was high once so there’s no reason why it can’t get back there. I just need to ride it out.”

That’s only investor psychology at work. If we remove the psychology aspect as well as the emotional trauma of a financial loss, the picture would be very different and much clearer.

Let’s say you bought $10,000 worth of ABC Company at $50 per share and a year later, the stock price has dropped to $25. If you are a rational investor, you need to ask yourself the following question:

Has the stock price taken a nose dive because the fundamentals of the company have changed? In other words, has something at the core of the company or its industry changed so dramatically that it resulted in lowering the real value of the company (i.e. new competitors entering the market, an unfavorable shift in consumer behavior, negative demographic trends, etc.)?

If the answer is no (company still has a wide economic moat, consistent free cash flow, a strong brand, etc.), then patience is your best defense. Just because other investors are liquidating their stocks out of fear in the middle of a bear market or some other market panic, there’s no reason for you to sell.

However, if the answer is yes the fundamentals of the company have changed, then it’s time to sell the stock. There’s no point in hoping for a turnaround when the probability is low. No matter how painful it is to your bottom line and ego to sell at a loss, you need to make a rational decision.

The math doesn’t look good either. If your stock has dropped in price by 50%, it means that you need to get a return of 100% just to break even.

Investors in that situation often still think of the original amount they invested in the company as opposed to the current value of their holdings. This is important because you always need to look at alternatives when considering investment options.

With your stock now worth $5,000, you should imagine that this $5,000 is now in cash and available for you to invest as you wish. You have two options:

1) Invest it in the same ABC Company (which means you do not sell).
2) Invest it in another company that can get you a better return on your investment.

There’s nothing wrong with holding on to a stock if you truly believe it has been knocked down in price unfairly. This happens quite often when strong companies are taken down along with the rest during a recession as investors liquidate all their stocks and mutual fund equities out of fear and panic. In fact, when this happens, it may actually be a good time for you to buy more shares of your company at very low prices.

However, don’t make the mistake of holding on to a loser just because you’re hoping it will go back up in value or because it would be too painful to sell at a loss.

Just ask anyone who owns Nortel shares how they felt as the stock sank to zero. Actually, you don’t have to ask anyone; I’m not proud to admit it but I made that mistake and hung on to my Nortel shares too long.

Yes, I was hopeful that it could go back up; yes, I didn’t want to admit I made a mistake; yes, I couldn’t stand the thought of losing my initial investment. And no, it never occurred to me that Nortel’s fundamentals were deteriorating at an alarming rate.

Now I’m only hanging on to these Nortel shares as a reminder of the heavy price I paid for my irrational hope and inability to swallow my pride. I learned my lesson; it’s one costly mistake I will not repeat again.

Investors selling their winners too soon

Hanging on to losers too long can be explained by investor psychology but selling winners too soon is a different beast.

So why do investors sell their winners too soon? The answer can be summed up in one word: fear.

When investors buy a stock and it goes up in price, they often fear that the price will go back down so they want to lock-in their profit. And if by any chance they’re on the fence, all they need is a little push from the mainstream media.

How often did we hear throughout 2009 from the “experts” that the market had gone up too fast too soon and had outpaced the economic recovery?

How often did we hear from these same “experts” that a market correction of at least 10% was imminent?

The average investor who listens to these “experts” will also likely take their advice to “lock in their profit” or “take some money off the table”.

Investors who sold their winners in the middle of 2009 have missed out on tremendous additional gains as the market has marched higher into 2010.

So what should an investor do when they’re in the fortunate position where their stocks are worth more than the price they bought them at? When should they sell to lock in their profit?

The answer is simple. Only sell your stocks when they are fairly valued or better yet, overvalued. Selling anytime sooner simply means sharing your profits with the person who acquired your shares.

It’s as if you bought a valuable antique painting at a garage sale for $20. If this painting is by a famous painter and is worth $2,000 at an auction, why would you sell it to someone for $200? The only reason you would do that would be because you didn’t know the true value of the painting.

When it comes to investing in stocks, it’s no different. You need to be able to determine the intrinsic value of a company. That’s the bottom line.

Don’t make the costly mistake of selling your winners too soon out of fear of losing your profit or by listening to the “experts”.

If you take the time to learn about investing and always focus on the value of a company instead of its stock price, you won’t have to forgo any capital gains and share your profits.

In conclusion, to be a successful investor you need to do the complete opposite of hanging on to losers and selling winners even if it won’t feel natural and will definitely put you at odds with the crowd.

Selling your losers in a rational way will help you redeploy your capital toward a better investment opportunity. Letting your winners run will improve your investment returns many fold.

Be rational and humble instead of hopeful and proud. Accept your mistakes and learn from them instead of pretending they didn’t happen in order to protect your ego.

Related Posts:

Most Common Investing Mistakes - Part 6 (Emotions)
Most Common Investing Mistakes - Part 4 (Relying on Other People's Opinion)
Most Common Investing Mistakes - Part 3 (Focusing on Price Instead of Value)
Most Common Investing Mistakes - Part 2 (Following the Crowd)
Most Common Investing Mistakes - Part 1 (Overconfidence)

Most Common Investing Mistakes – Part 4 (Relying on Other People’s Opinions)

Below is a piece of advice I was fortunate to be the recipient of that had a major impact on my investing results. I want to share this with you because I’m convinced you’ll benefit tremendously.

The more you rely on other people’s opinion, the less you know.
The more you know, the less you need to rely on other people’s opinions.

At first glance, it seems rather simple and straightforward, even obvious. But if you take the time to think about it for a moment, you will discover a powerful underlying message, a message that separates successful investors from the rest.

Below is a conversation I recently heard from friends of mine (the names have been changed):

Gary: “Sara, listen to this. My boss told me today he made a killing on the stock market. He put in $10,000 in this one stock and it went up by 20% the following week! He made $2,000 in one week! Man, he made it look so easy.”

Sara: “Whoa, that’s a lot of money! Did he tell you which stock he bought?”

Gary: “Huh…no, not really, wait hold on, he did mention the name of the company. I can probably look up the stock symbol. Do you think I should buy it?”

Sara: “That’s a no-brainer! Don’t wait or it’ll be too late. We got a get in on the action. Buy some shares first thing in the morning tomorrow. How much can you buy? I can transfer some money from my savings account.”

Unfortunately, this scenario occurs too often. It happened during the Internet mania and it’s happening now as more and more individual investors are taking investing decisions into their own hands after a harrowing market downturn. There’s a growing feeling of disenchantment toward financial advisors that is creating this new wave of DIY investors.

When investors are not taking cues from their co-workers, neighbours or even cab drivers, they follow recommendations given by “experts” on popular business shows on CNBC, BNN and even PBS (Nightly Business Report).

Now whether you are influenced by your co-worker and buy a commodity stock, are convinced by your father-in-law and buy a biotech start-up or listen to a “market strategist” on CNBC and buy a sector ETF, you are making an investment decision based on someone else’s opinion.

This can only mean one thing: you relied on someone else’s opinion because you were not an informed investor. If you consistently undertake actions without proper knowledge, there’s a high probability you will get burned sooner or later.

Similarly, if you don’t know much about renovations and hire just any contractor, there’s a possibility you could be taken for a ride (you might need to call Mike Holmes).

But if you know about renovations or at least do some research to find out about a contractor’s license, what permits you need, how much materials cost and get several quotes, the chance of a contractor taking advantage of you is much less.

When it comes to your personal finance and investment portfolio, it’s no different. The more you know the basics of different investment vehicles such as stocks, mutual funds, ETFs and bonds, the less likely your financial advisor can misguide you towards high-commission products for their own benefit.

The more you learn about investing, the more personal power you have. The power I’m referring to here is not the kind of power that people in Washington lusts for. I’m referring to the power that emerges from within as you learn, grow and take control over your financial destiny.

Indeed, knowledge is power. But knowledge can only be converted into power if you act upon it. Act upon your knowledge, not upon other people’s opinion and you will reap the financial rewards.

If you have limited investment knowledge, start with low-cost index funds or ETFs. As your knowledge bank grows, you can start buying stocks directly.

Here at The Smart Canadian Investor, our mission is to educate our readers and raise their level of investment knowledge every day. That’s why we created a Resource Center to house useful tools (i.e. Morningstar's online classroom), links and recommended books so that we can help individual investors succeed. We encourage you to take a tour today.

Most Common Investing Mistakes – Part 3 (Focusing on Price Instead of Value)

When people buy and sell items on eBay, they don’t just focus on price; they also look at the value of the items they’re buying and selling.

Those who are better at assessing value usually have the upper hand. They can buy items at a discount to market value and can turn around and sell the same item at a higher price for a profit.

This is also common in the real estate market. Investors who can accurately assess the value of a property can buy it, fix it and sell it at a profit.

As a real estate investor, I’ve done this over and over again. I was able to spot and buy houses that were selling at a large discount for various reasons (i.e. divorce, foreclosure, neglect, etc).

When it comes to investing, it’s no different. Investors who can assess the true value of a company stand to benefit.

The average investor tends to focus on the price of a stock instead of the value of the company. That’s because it’s the stock price that is quoted every day, not the company's intrinsic value. Amazingly, stocks are very often mispriced.

This can easily be observed during bear markets when the stock prices of companies fall well below their true value. Fear and uncertainty cause investors to flee the market causing an imbalance between sellers and buyers.

Investors can make outsized gains if they can learn to ignore all the sensational gloom and doom headlines that instill fear. If they can focus on the value of a company, they can buy great businesses at a discount.

Over the years, Warren Buffett has had several quotes attributed to him. This one in my view is by far the most important:

Price is what you pay, value is what you get.

A great book I recommend is The Five Rules for Successful Stock Investing by Morningstar. It shows you step by step how to evaluate companies and calculate their intrinsic value using the discount cash flow (DCF) method.

Related posts:

Most Common Investing Mistakes - Part 1 (Overconfidence)
Most Common Investing Mistakes - Part 2 (Following the Crowd)

Most Common Investing Mistakes – Part 2 (Following the Crowd)

According to Maslov, after physiological and safety needs are fulfilled, the third layer of human needs involve feelings of belongingness.

We generally need to feel a sense of belonging and acceptance and this need can be fulfilled by being part of a large social group such as a club, community center or sports team. The social setting can also be smaller and more intimate such as the one among family members, close friends and spouses.

Unfortunately, when it comes to investing, the need to belong to a larger group in order to feel safe often leads to disastrous investment decisions.

That’s how bubbles are formed and that’s why there will always be boom and bust cycles in the financial markets.

Bubbles are formed when a particular sector, industry or fad gains momentum as more and more investors are lured by the prospect of fast cash.

Investors feel a false sense of security because they see so many people around them do the same. If they see other people make a quick profit, they cannot resist and will jump in.

One of the most common types of bubble that repeats over and over again is the real estate bubble.

I remember reading a Business Weekly article in late 2006 that showed a disturbing trend: for every 5 houses purchased in the U.S., 2 were for investment purposes.

I was fairly certain at that point that the U.S real estate market was going to crash in the near future. Being a real estate investor myself, I knew speculation had to be rampant when 40% (2 out of 5) of the houses bought were being flipped. You don't get a clearer sign of a bubble than that.

Benjamin Graham once said, you are neither right not wrong because the street agrees with you. You are right because your investment decisions are based on rationale thinking.

It’s never easy to go against the flow; it feels unnatural. It even feels unsafe. But you have to ask yourself this very important question: what is your decision based on?

It makes no difference whether it’s one, ten or one thousand individuals who are taking part in an activity. It doesn’t mean they’re making the right decision.

If you look at virtually all facets of life, it’s always a very small minority that gets it right, not the majority.

How many people do you know are truly passionate about their work versus those who hate their job or have a job just to pay the bills?

How many people do you know are happily married and enjoy a loving relationship versus people who are married but live together like roommates (about 50% of all marriages end in divorce)?

How many people do you know are successful at losing weight and keeping it off versus people who get on a quick-fix diet and gain their weight back?

The list goes on and on. When it comes to investing, don’t follow the crowds blindly. Instead, learn, learn more and keep learning. Don’t ever stop learning. Learn a bit every week and pretty soon, you’d be amazed at the size of your knowledge bank.

In the end, independent thinking is the key. Independent thinking combined with knowledge, patience, and the right temperament is the winning formula.

Check out Morningstar's classroom. It's a really good starting point to learn about investing in stocks, funds, bonds, etc.

Related posts:

Most Common Investing Mistakes - Part 1 (Overconfidence)
Most Common Investing Mistakes - Part 3 (Focusing on Price Instead of Value)

Most Common Investing Mistakes – Part 1 (Overconfidence)

Overconfidence is best illustrated by this survey of car drivers where 80% of the respondents rated themselves as above-average drivers.

Of course, statistically it’s impossible for 8 persons out of 10 to be above-average. I’m sure you won’t be surprised to learn that a similar survey carried out among investors produced similar results.

Excessive trading

Studies in behavioral finance show that investors who are overconfident, tend to trade excessively. Because they had a few profitable trades, they extrapolate and think they can consistently beat the market.

For example, if they trade in and out of a stock and make a gain of $200 in one day, they will extrapolate and think they can make $50,000 annually in trading profit since there are 250 trading days in a year.

Overconfident investors typically think they have something unique. They think they have the magic trading system or something special that other traders don’t have. They usually act on gut feeling or by looking at charts.

Cannot make the distinction between skill and luck

Many investors who bought shares in Internet companies during the dot com mania thought they knew what they were doing. They buy a stock based on a hot tip at a cocktail party, the stock goes up in price by 10% the next week and suddenly, they see themselves as expert investors.

Somehow, luck never enters the picture for them. It’s as if I go to the casino and win 5 black jack hands in a row; it doesn’t make me a professional card player. Even if I win 10 or 15 games in a row, it still doesn’t make me a professional card player.

Overconfident investors who jumped on the Internet bandwagon equated their short-term success to their stock-picking skills, yet they were just buying into a giant ponzi scheme.

All ponzi schemes without exception collapse sooner or later as new buyers stop joining the game. It’s the basic law of supply and demand.

Prices rise as demand increases and supply is short. As demand decreases, there is excess supply and prices fall.

If you strive to be a successful investor, being humble will take you much farther. That's because you will invest according to your level of knowledge and as a result will not take unnecessary risks.

Warren Buffett calls this investing within your circle of competence.

Related posts:

Most Common Investing Mistakes - Part 2 (Following the Crowd)
Most Common Investing Mistakes - Part 3 (Focusing on Price Instead of Value)

Learn From Other People’s Mistakes and Get a Head Start

Beginner investors pay a heavy price for their lack of knowledge, blind faith and eagerness to follow the crowds.

Think of investors who bought into the Internet mania and got their life savings decimated by the ensuing market crash.

Think of American homeowners who ruined their retirement years by using their home equity to buy investment properties during the real estate boom in 2006-07 thinking that house prices would go up forever.

It’s unfortunate these investors didn’t get some kind of warning. It’s too bad no one sat down with them and said: “You’re playing a very dangerous game. You don’t really know what you’re doing and yet, you’re putting a lot of your hard-earned money at risk.”

Can you imagine how great it would be if someone explained to you the most common mistakes made by homebuyers before you bought your first home?

How about learning the most common mistakes made by small business owners before you decided to start your own business?

Can you now imagine how far ahead you would be if you started to invest and could avoid the most common mistakes made by investors? You’d be skipping the beginner phase completely and in the process would avoid all the painful financial losses.

It’s like making a huge leap from level 1 investment knowledge to Level 5.

Personally, it was a very humbling experience to find out a few years ago that I had made most of the common investing mistakes.

Warren Buffett once said that individual investors will do quite well if they can just avoid making big mistakes. I hope you take his advice.

Someone who learns from their mistake is wise. Someone who learns from other people’s mistakes is even wiser.

Check out the most common investing mistakes and start learning today.

Learn From Your Mistakes and Profit

Successful people understand that the path to success is often found as a result of mistakes made along the way. Mistakes are simply a way for life to tell us that we’re not headed in the right direction and to adjust our aim accordingly.

They're not meant to tell us that we should give up on our dreams but unfortunately, too many people misinterpret these signals as a STOP sign.

Many investors gave up on investing in stocks altogether after suffering painful financial losses as a result of the dot com crash. There’s no doubt many more investors will give up on investing in stocks after the recent financial crisis as the market declined over 50% from October 2007 to March 2009.

Yet, the signal they were getting after the dot com crash was that they needed to learn to invest the right away instead of speculating on internet start-ups with a shaky balance sheet and unproven business model, or jumping on the bandwagon because “uncle Bob, my neighbor and everybody else is making a killing”.

Another signal investors should be getting after this Great Recession is that they need to be mindful of asset allocation and not be fully invested in equities when stocks are overvalued.

Thankfully, since I was young and didn’t have a lot of money to invest during the Internet boom, I didn’t lose as much money as I could have.

But I did learn from my mistakes and took full advantage of the recent market downturn to invest large sums of money in early 2009 as panic and fear took over the financial markets and solid companies were being given away at ridiculous prices.

Those who cannot learn from their mistakes are doomed to repeat them. On the other hand, investors who learn from their mistakes are wise and will do well over time.

The more you know, the more you grow. The more you learn, the more you earn.

Related posts:

Learn From Other People's Mistakes and Get a Head Start

Why Retail Investors Are Called the Dumb Money

On Wall Street, the institutional investors are referred to as the Smart Money and retail or individual investors are called the Dumb Money. While I don’t agree with Wall Street’s designation of institutional investors as being smart, it's difficult to argue against their view of retail investors.

Retail investors are called the Dumb Money mainly for the three reasons outlined below.

Chasing performance

It’s a well-known fact that the number one factor that mutual fund investors focus on is a mutual fund’s recent performance. This, of course is reinforced by all the ads the industry puts out to highlight their recent performance.

The marketing departments will make sure to put a spin on these ads and focus on whatever period they had success; it could be the past year, it could be their record the past 2, 5 or 10-year period, whatever looks good as long as it’s legal.

The problem that retail investors have when they pile their hard-earned cash in these funds is that they are buying high. Statistically, their chance of seeing the funds they’re buying going higher is very slim.

The reason is simple. The fund manager had some success (or luck) with a particular sector. As investors take notice of the short-term rise in the fund, they jump on the bandwagon. As the fund manager gets more cash, he needs to deploy the cash but the shares he’s buying now are no longer undervalued so in effect, he's buying high.

Emotions

In virtually all aspects of life, it’s never a good idea to act (or react) when you’re emotional. Think of that email you replied to at work and regretted it. Think of things you’ve said to someone you care about when you were in the middle of a fight.

When it comes to investing, it’s no different. The average investor consistently makes the wrong decision at precisely the wrong time by acting/reacting under emotions.

Time and time again, studies backed by decades of data show that the majority of investors will be heavily invested in equities when the market is most overvalued and at risk (i.e. at the height of a bull market - 2001, 2007).

And when the market is at its lowest point during a recession offering attractive valuations (i.e. at the lowest point of a bear market - 2003, 2009), the majority of investors will be on the sideline in cash or bonds.

The reason for this seemingly odd and costly behaviour? Greed and fear.

In a bull market where the market seems to be going up year after year, investors get greedy and jump on the bandwagon. They cannot resist the temptation when they hear people around them boast of making money.

In a bear market, all of a sudden, fear takes over and they cannot stand to see their portfolio drop in value. The media fuels this fear with sensational headlines such as: "$20 billion dollars in market value evaporates as the Dow Jones plummets 700 points in one day!"

Allure of fast money

There is something very appealing about the idea of making a lot of money with little or no effort. That's why there's never a shortage of people playing the lottery every week and this number even increases during recessions.

Investors are no different. They want a quick way to make money. That’s why they jump from one mutual fund to the next. That’s why they trade in and out of stocks. That’s why they fall for those services that offer trading tips on penny stocks.

The reason there is a Smart Money on Wall Street is because of the existence of the Dumb Money. In other words, the institutional investor will always be the predator and the individual investor will always be the prey.

Of course, if you refuse to play Wall Street’s game of chasing short-term gains and invest outside the jungle, you don’t have to worry about what goes on inside the jungle.

You can join the small but increasing number of astute investors who have realized that success in investing comes from having knowledge, patience, the right temperament and independent thinking.

Like them, you can transform yourself into this new breed of investors called the Intelligent Money.

Learn to Think in Probabilities and You Will Succeed

If you’re planning a picnic next Saturday, the first thing you would do is check the weather forecast. If the weather forecast for Saturday is mainly sunny and 0% chance of rain, you’d feel comfortable going ahead with your plans.

What if it's now Wednesday morning and the weather forecast for Saturday has changed to variable cloudiness with a 20% probability of rain, what would you do? You'd start to feel a bit uneasy but would probably still keep your plans while keeping your fingers crossed.

Now it's Friday night and the weather forecast for Saturday (gasp) has changed again; now the probability of rain is 80%! You spend a few minutes uttering profanities at the weather channel but eventually, you still need to make a decision.

Do you go for it, and risk having a lousy time, not to mention hearing all the complaints from friends and family or do you wait for a better day? Most people would make the right decision and reschedule their picnic. That’s just common sense based on the high probability of rain.

Somehow, when it comes to investing, many individual investors just don’t use common sense or to be more accurate, don’t understand probabilities when making investment decisions.

Smart investors understand that success in investing comes down to a matter of probabilities; all their investment decisions are made with the probability of success stacked heavily on their side.

That's why legendary value investors like Benjamin Graham, John Templeton and Warren Buffett only invest in companies that have these characteristics:

• A business they understand very well
• A wide moat (a durable competitive advantage)
• A strong balance sheet with low debt
• A stock price selling at a large discount to their intrinsic value

Companies that have the above characteristics are very likely to do well over time; as their earnings keep rising, their stock price will also go higher rewarding shareholders.

It's obvious that successful investors understand probabilities and this helps them make good investment decisions.

However, to make this point even more clear, let’s invert this. What would it take to have the probabilities stacked against you? The probabilities are not on your side when you invest in a company that has:

• A business you know very little about (i.e. you bought the stock because you know someone who made money on the stock).
• No competitive advantage (i.e. you bought the stock because of takeover rumours).
• A weak balance sheet with high debt (i.e. you bought the stock based on technical charts or opinions from the mainstream media).
• An overvalued stock price (i.e. you bought the stock because its price has been hammered recently and you thought you were getting a bargain). 

There are literally hundreds of thousands of public companies that are traded on stock exchanges around the world every day. The key is to ignore all the headlines, the opinions and noise, and focus only on the small number of companies that offer you the highest probability of success based on your research and analysis.

Invest Only in Companies You Completely Understand

Let’s say you have a solid understanding of the telecom, banking and home renovation sectors. You currently own or are interested in buying companies like Rogers, TD Bank and Rona because you understand the industries they’re in. In other words, it’s clear for you what your area of knowledge is or what is within your circle of competence.

What would you do if you turn on your TV and hear a money manager on a business show recommend with conviction a stock in an industry you don’t know anything about? Would you be influenced by his opinion and be tempted to buy the stock? If your honest answer is "yes" or "sometimes", you would not be alone.

Like many individual investors, if you are influenced by opinions you hear on TV or read on the Internet, you will likely make poor decisions and buy or sell stocks on a whim. By doing so, you would be crossing the boundaries of your circle of competence and going to a place filled with landmines.

If this money manager owns this stock in his portfolio, you can be sure he will only bring up all the positives about the company and how its stock is undervalued or on the verge of going up very quickly.

Sometimes, they’re not completely wrong but will only focus on the positive points, which may not be inaccurate but can be misleading as they don’t make any mention of the negative points or the potential risk and downside.

Not convinced? Consider the appalling behaviour of stock brokers during the dot com boom where they were recommending technology stocks to their clients at the height of the Internet mania just as they were selling at the same time the same stocks in their personal accounts and making huge profits.

The minute you step outside your circle of competence, you go from being a smart investor to being a speculator or gambler. You go from investing with knowledge and confidence to investing with ignorance and hope.

The key is to always stay inside your circle of competence and resist the temptation of investing in popular companies that are widely covered by the mainstream media.

The size of your circle of competence can start off small but as long as you commit to continue to learn, it will grow and you will be able to spot more opportunities across different sectors.