How to manage your psychology in the stock market

Michael Taylor looks at how to manage our psychology in the stock market.

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Many investors believe that other investors are their competition. 

They’re wrong.

Their only competition is themselves. Stock market investors go through a huge range of emotions, from excitement and greed, to fear and self-loathing. But fear not – there are several ways that we can manage our heads in this game and not make some common mistakes. 

Have a self-imposed limit on position size

By having a limit on how big our position is, we are able to stop our greed from ballooning out of control. When we spot a good opportunity in the market, it’s natural that we want to put our best ideas to work there. But this is dangerous – what if we are wrong?

Using a limit on position sizing will prevent us from being burned should we be wrong. If we do pick a winner, then one stock can easily become a large percentage of our portfolio – meaning that our portfolio’s performance is now correlated with that stock. With a position size limit, we’ll be forced to trim the position and bank profits as the position size increases. 

Look for reasons to not buy 

We all love buying stocks. But what we should be doing is looking for reasons not to buy the stock right from the start. That means doing some digging, and looking at whether management are aligned with shareholders. Check the director salaries. Check the director shareholdings. Are they clock punchers? Or are they well motivated to create and deliver shareholder value?

It’s also worth looking at what the company actually does, and going out to speak to its customers. If the customers tell you that the product is nothing special, then that means it is easily replaceable. And if it’s easily replaceable, then it has no moat. 

Check the company’s moat

If a company doesn’t have a moat, then it offers nothing to protect itself from copycats. That means anyone could set up as a competitor and erode our target company’s margins. Always check for the moat and see how strong it is.

Understand why you’re buying and when you’d sell

According to Sun Tzu from The Art of War, a good general wins first then battles. That is exactly what we should be doing with our investments.

If we understand why we’ve bought, then even if the price is showing our position as buying in the red, then we must remember why we bought in the first place and not get scared and shaken out of our position. 

We should also know at what point we’re happy to sell. If certain aspects of the business change, then we know we should sell our shares in the stock. 

Know what our sell triggers are, and then monitor the stock. 

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Views expressed in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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