Investing... is what you make of it ~

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Investing psychology is probably one of the most difficult aspects of the trade (pun intended) to master. 

 

We are only human, and no matter how we convince ourselves that we will act in a certain way, at a certain time, at a certain price, things often don't go to plan – not exactly, at least. 

 

Nonetheless, psychology and emotions are part and parcel of investing, with terms such as "greed", "fear" and "euphoria" often used to characterise the market and its investors.

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In this article, I wish to point out 5 important points related to investing psychology (or mindsets) that you should at least be aware of, as you start out on your investing journey. 

 

To qualify, this is not an exhaustive list, nor is it an authoritative one.  As an investor, I continue learning about the markets, as well as myself as an investor, every single day. 

 

And needless to say, trading psychology varies from investor to investor: there is NO right or wrong that is set down in stone.

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1.  Invest only the funds that you DON'T need.

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Unless you are investing in extremely safe financial assets (e.g. government bonds, which correspondingly deliver far lower rates of return), be prepared to sustain losses on your invested capital. 

 

Neither you nor I can ever expect the market to go our way all the time, and losses should be taken in our stride – you can, in fact, see short-term losses as a form of commission or "tuition fee" for Mr. Market, as you enter his high-level classroom.

 

If you can tell yourself fairly confidently: “Hey, even if I throw all this money away, I still have enough for myself, and won’t find myself desperate for cash”, then it is more likely that you can invest those funds. 

 

For whatever reason, if you’re tight for cash, or expect that you’ll need a lot of cash in the short-term (say, within 1 year), then it is probably better to NOT invest it.  

 

Worse, if you are currently in significant debt, or are struggling to pay for necessities, it is definitely not advisable to invest, as you will need all the cash you need, possibly at short notice.

 

What about confidence?

 

But what if you have sufficient means to invest, but are not confident enough to do so?

 

Well, if this is the case, you can try “paper trading” – a simulated version of investing.  In paper trading, you use the “paper money” or virtual currency (e.g. of $100,000) you are granted when you open a paper trading account with certain stock brokerages. 

 

Using these funds, whatever investments you make are risk-free, although you will get to experience pretty much the same risks of entering the market.

 

This is because most paper trading accounts track and reflect stock prices in real time.  That is, you will experience the volatility of the market as though you were using your own money to make a purchase or sale of stock.

 

The main benefit of paper paper trading would be that it allows you to first test out any investing strategies you have in mind, while not having to bear any “tuition fees”.

 

Personally though, I would NOT encourage you to stick to paper money accounts for too long.  This is primarily because the emotions you feel when using paper money to trade, are FAR from what you will really feel, buying and selling using your own real money. 

 

In real life, especially if you are a novice investor, you will face a host of psychological dilemmas.  I, for one, know that I face the trouble of “pulling the trigger” to buy and sell my assets at the right time.

No matter how daunting the task might be, it is important for you to actually take the leap and experience the real thing for yourself, for you to take ownership, learn from your own mistakes (if you happen to commit them), and GROW from there! 

 

Paper trading is only good for you to go through the motions, or familiarize yourself with the interface of the platform(s) you will eventually use.

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2.  If you are DIY-investing, do your own due diligence (DYODD)

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If you are taking charge of your own investing journey (instead of relying on professionals to invest for you), DON’T just invest because someone told you so, or because you heard some good news about it, or because you think you know about the business. 

 

An obvious example of the above: “Facebook is so big, surely can’t go wrong one”... Well, Facebook's (known today as Meta) stock price these days is down almost 70% from its most recent peak...

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DYODD means that for your asset of choice, you’ll need to properly research its traits, underlying company financial numbers, track record, underlying business, latest news, and price charts, among other things. 

 

Certain asset classes are not backed by any real life business or company, and may have typically limited information about them.  For instance, Forex or Cryptocurrencies. 

 

Be especially wary of trading these asset types, as they have a greater tendency to be speculative (read: gambling). 

 

For assets backed by a proper business, these businesses may not be sound or strong ones either (more in my upcoming discussion on Fundamental Analysis).  Or, their quality may have deteriorated over time.  These would be also assets to avoid (or start avoiding). 

 

By DYODD, you develop greater sensitivity to the bigger picture.  For instance, you might get a sense of which industries that investors are currently paying more attention to.  You could also get a sense of things like the fear in the market.

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"Charity starts from home"

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From a different perspective, as there are so many asset classes in the financial world, DYODD also means knowing your own risk tolerance / profile before choosing an investment product/asset. 

 

A bonus would be if you are able to quantitatively analyse the performance of your assets and portfolio as a whole.  Doing such analysis allows you to estimate how much, for instance, how well you are currently doing relative to the broader markets. 

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Last but not least, as a form of due diligence, you need to be able to monitor your asset holdings from time to time.  Even if you don’t monitor them every day, you should at least monitor their value intermittently (e.g. every quarter). 

 

Monitoring your holdings counts as due diligence, because in this volatile, shock-prone economy, it is very easy for the companies underlying your assets to see a change in their fundamentals (i.e. business prospects and financial numbers). 

 

When you have stocks which you deem no longer viable – be it because their underlying businesses have deteriorated, or there are better, stronger alternatives – it may be time for you to rebalance (update) your portfolio by switching your money to other assets.  

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3.  That which kills returns behind the scenes: (Hidden) Fees

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Commissions are additional charges you pay (sometimes without knowing, if you haven’t done your research) for buying and selling (sometimes even keeping) your assets. 

 

Most buy and sell transactions, no matter how big or small, incur a minimum commission, which varies depending on the type of stock brokerage you use. 

 

For instance, full-service brokerages (e.g. those by the local banks) tend to charge higher commissions than low-cost brokerages (e.g. Tiger Broker; Moomoo). 

 

For typical stock transactions, brokerages run by our local banks impose minimum charges of more than $20 per transaction.  In contrast, Tiger Broker's minimum commission per order is just about $2 for Singapore stocks.

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A snapshot of minimum commissions for Singapore stock brokerage services. 

Note the significant differences between pre-funded accounts and cash accounts.

Source: Dollars & Sense (2023)

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When transacting in assets, it is advisable to ensure that the commissions you pay for each transaction add up to just about 1% of your total transaction amount. 

 

By doing so, it means that the value of your asset holdings must appreciate in value by just 1%, or pay a 1% dividend, in order for you to break even on your investment – a fairly easy feat, assuming you have chosen a quality asset. 

 

In contrast, for actively (professionally) managed investment products, they often come with with initial subscription (or buy-in) charges.  In such cases, one may need to invest for many years before one starts making good returns.

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Besides one-off fees, there are recurrent fees as well.  These can be more insidious, as they continually chip away at your overall return. 

 

Examples of these fees include management fees, which are incurred when you purchase assets such as unit trusts, mutual funds, hedge funds, and Exchange Traded Funds (more on this in the article on Asset Classes). 

 

Illustration: The impact of fees

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A simple numerical example will tell us just how pernicious the impact of fees can be.

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Let's assume that we invest $10,000 in a unit trust for 10 years.  Setting aside any one-off fees, let us also assume that every year, the value of our assets increases by 7%.

 

However, there is a 2% annual management fee charged (while our money is placed with the unit trust manager). 

 

At the end of 10 years, the total value of our assets will be:

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10,000 x [(1 + 7% – 2%) ^ 10] = $16,289

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Now suppose the annual management fee was just 1% higher (at 3% per annum), then at the end of 10 years, our asset value would be: 

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10,000 x [(1 + 7% – 3%) ^ 10] = $14,802

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Compared to the 2% management fee scenario, where we got an approximately 62% gain on our investment over 10 years, a 1% per annum increase in management fees cuts our total gains by 14% (to about 48%). 

 

It is clear from this example that the compounding effect of commissions can end up as a major drag on your returns. 

 

Thus, do take care when choosing an asset class – at least know the fees you are paying.

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4.  Leveraging and Short-selling: Avoid where possible

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Leverage

 

Buying your assets using leverage can be MAJOR trouble when the asset price does NOT go your way.  Buying assets using leverage increases your total downside to BEYOND just the amount of capital you have initially invested. 

 

So what is leverage, and why is it so dangerous?  I shall briefly introduce it here.

 

Suppose, under normal circumstances, you have capital to buy 100 of Stock X at $5 each.  Having spent $500 on the stock, a fall in Stock X's price to $0 puts you at a $500 loss – that is, your capital has fallen from $500 to $0. 

 

Let’s now say that instead, you leverage 2x to buy 200 of Stock X.  It simply means that you are borrowing $500 to buy twice the quantity of Stock X that you can afford.

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A fall in Stock X's price to $0 will then put you at a $1000 loss – aka your capital has fallen from $500 to –$500 (you’re in debt). 

 

In essence, taking leverage will multiply your losses, as much as it could multiply your gains as well.  A similar idea applies to Daily Leverage Certificates (another risky asset class which I will touch on in another article).

 

Short-selling

 

Shorting (or short-selling) a stock can also be disastrous, if its price happens to rise. 

 

Shorting basically means that you borrow a stock, and sell it to market investors for a profit first.  This makes it the inverse of a regular buy-sell transaction. 

 

A short-sell is complete when the investor buys back the asset from the market, and returns them to his/her broker to “cover” his/her position.  You can think of this as making a repayment of your bank loan.

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This practice is only ideal when you can “sell high, buy back lower”.  For instance, if you initially short-sold Stock X and bagged $10,000, you only make a profit if you buy Stock X back for less than $10,000.

Short-selling can go MASSIVELY WRONG for the investor, because the upside for regular asset is is theoretically unlimited. 

 

This, in turn, is because an asset can continue to appreciate in value over time – there is no specific price limit that ANY asset must remain under.

 

This is compared to the maximum possible downside that can occur under normal circumstances: the asset's value simply falls to $0, and that's it – there is a limit in this case, and your shares cannot have a negative value. 

 

This also means that the maximum downside is just 100% of your invested capital – it will NOT leave you in debt, unlike the case if you had short-sold an asset. 

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To be absolutely fair, short-selling and leverage have been responsible for some wildly successful investors.  For instance, the legendary American trader Jesse Livermore made a couple of million dollars within a day when he shorted the US market in 1907.

 

However, unless you are on the ball and are extremely certain that an asset's price will decrease, it is generally advised to NOT engage in either of these practices. 

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To circumvent the problems posed by BOTH these practices, investors can instead turn to Daily Leverage Certificates (DLCs).  We will discuss this asset class separately.

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5.  The MVP of reducing risk: Diversification

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Source: Semantic Scholar

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The above image succinctly illustrates the effects of diversification.  When investing, the risks taken by the investor include systematic (also known as market or undiversifiable) risk, and non-systematic (also known as firm-specific or diversifiable) risk. 

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When investing, one of our aims is to reduce our exposure to firm-specific risks.  And indeed, as you can see from the diagram above, by investing in just about 5 to 7 stocks, the total non-systematic risk of your portfolio is, on average, reduced by 50%.  

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But why exactly is this the case?  The answer is the correlation of asset price movements – which simply means how far the prices or returns of these assets move in tandem. 

 

By investing in multiple assets, you increase the chances of owning one (or more) assets whose performance (or returns) is/are negatively correlated. 

 

The math is complicated, but we can observe the effects of different levels of correlation from the following diagram:

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Source: TEJU Finance

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Assuming a portfolio of just 2 stocks, you can see that as the correlation (⍴) between the price movements of the assets decreases from 1 to -1, higher returns end up being achievable for a lower level of risk. 

 

For instance, for a 6% per annum return, a positive correlation of 0.5 between the stocks would mean approximately 8% level of risk.  However, with a negative correlation of -0.5, a 6% per annum return can be achieved with less than 6% risk.  

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Of course, based on this analysis, it is clear that there are several caveats regarding diversification. 

 

Firstly, to ensure low or negative correlation, you will need to, in the longer-term, diversify across different asset classes (e.g. stocks, real estate trusts, ETFs, etc.) or sectors (e.g. financial; commodities; consumer staples; technology, etc.). 

 

It does NOT make sense that 10 of your stocks are from, say, the technology sector – once a downturn or shift in the tech sector's popularity hits, the value of ALL your holdings will be beaten down.  

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As a proxy for correlation, one can google for an asset's beta (β) to see whether it moves with, or against the market.  The magnitude or numerical value of beta tells us the proportion of stock price movements, compared to the market. 

 

On the other hand, the sign of beta tells us the direction the asset moves, relative to the market.  A positive beta means the stock moves in tandem with the market – and vice versa for a negative beta. 

 

If you have 2 assets in your portfolio, with 1 positive beta and 1 negative beta asset, it is very likely that these 2 assets are also weakly or negatively correlated.

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Proper diversification also applies to the amount invested in each asset.  If you invest $1,000 each in the first 9 assets but $50,000 in the last one, you are still NOT actually diversifying – your portfolio's risk remains vastly concentrated in your final stock. 

 

A diversified portfolio is one where you have, for instance, $10,000 in each of the 10 holdings, or at least a portfolio with a fairly even distribution of capital. 

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Conclusion

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To have the right mindsets and expectations before investing is crucial to avoid unwanted and undesirable losses / surprises. 

 

Having clarity regarding investing psychology ensures that you adopt an approach which either helps grow your wealth faster, or reduces/controls your downside.