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Investor emotions part 3: Remorse

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As I’ve discussed in previous articles, the two most significant negative emotions for investors are greed and fear. Either one on its own can lead to people losing money, but more often than not they are combined in an elegant double-whammy that hits some amateur investors so hard that they leave the market with their tails between their legs and never come back.

Greed leads them to invest more than they can afford to lose, while fear encourages them to change their strategy on the hoof, without rationally considering the circumstances and the consequences of their decisions, thereby increasing the chances that they will lose.

The result is remorse, an emotion that can be either negative or positive: an investor feeling remorse will either go on to make greater losses, compounding their initial error several times over, or they will learn from the experience and modify their trading strategy, becoming a more sensible investor.

I’ll illustrate this with an example. Let’s say you start with an investment pot of £10,000. You use a spread-betting account to go long (i.e. to bet that the share price will rise) on Can’t Fail Property Plc, a company that builds ‘executive apartments for knowledgeable investors’, or so their marketing material claims. But in the wake of house price falls in the US, Ireland, Spain and elsewhere, investors in Can’t Fail Property Plc get cold feet, anticipating falls in the UK housing market too, particularly the sector that builds cardboard flats the size of dog kennels which, if they last that long, will probably end up as tomorrow’s social housing.

Having opened your bet with a high level of leverage (so you stand to gain a lot if the share price moves up a little, but you would also lose a lot if it goes down a little), fear takes hold. You decide that you can’t afford to ride out what might – or might not – be a temporary downturn in the fortunes of this company, so you change your strategy and move your stop-loss upwards.

Your stop-loss is triggered later that day. Due to a combination of greed and fear, you are closed out of your trade with a realised loss of £3,000. Your investment pot is now just £7,000. What you feel, amongst other emotions such as anger and misery, is remorse. You now recognise your mistakes (or think you do) and swear never to repeat them. But what happens next separates the sensible investor from the fool.

The fool looks at his or her initial pot of £10,000, looks again at his or her current pot of £7,000 and says, “Right, I’ve lost £3,000 – I’ve got to make that back quickly.” Ignoring the insanity of trying to make a quick 43 percent return, the fool looks for fast profits, eschewing wise investment practices and jumping into new ventures on the basis of rumours on Internet forums, spurious ‘analysis’ or simply because ‘it feels right’.

You can probably guess the usual outcome of such frantic attempts to recover losses; the fool repeats his or her original mistakes, making a few gains but many more losses, eventually fulfilling Woody Allen’s description of a stock-broker as someone who invests your money until it is all gone. The fool is out, game over, no replay, thanks to a spiral of remorse-driven desperation and an ill-considered attitude to the realities of investing. This situation is very common: a significant proportion of inexperienced investors will end up in this ’spiral of death’ once they experience their first major loss.

The sensible investor, on the other hand, takes a step back from the £3,000 loss. Switching off the PC, he or she takes a deep breath and goes for a long walk, perhaps stopping for a nice hot cup of reality at the local coffee bar. Swearing a few times and maybe kicking the odd small puppy, the sensible investor understands what went wrong and vows never to repeat the greed-fear investment mistakes that led to the current situation.

After a break of a few days, or perhaps a week, the sensible investor returns to the computer (or copy of the FT and the phone number of a good broker), having mentally written off the £3,000 loss as the price paid for a necessary learning experience, and being determined to avoid losing such a significant amount ever again.

With the pain of loss still firmly etched in memory, the sensible investor starts again, this time with a much smaller trade size and much lower leverage. True, he or she stands to make much smaller potential profits on each trade from now on than would otherwise have been the case. But the corollary is that, should everything go Tango Uniform again, the sensible investor has the option of either riding out what may be a temporary dip in the value of their investment, or cutting their losses without incurring such a massive wipe-out of their investment pot.

A great many remorseful investors end up as the fool in this scenario. Those who modify their trading strategy and learn from the experience are much more rare, but they are also much more likely to go on to become successful investors.

It helps to look at investment as a type of business. When you start your own business, you usually expect to make a loss in the first year or two because there’s a learning experience to undergo and you may also have capital costs to recoup. If you treat your first forays into investment as a business, you will be able to be more sanguine about your early losses; but only if you learn from the mistakes that led you to make them!

Investment is all about learning; learning about yourself as well as learning about the markets. A remorseful moment is to be expected in the early stages. How you cope with it will decide whether your investment ‘business’ succeeds or fails in the longer term.

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