Eight Mental Traps to Avoid
Investing is as much an exercise in controlling emotions as harnessing the intellect.
With inherent uncertainty and high stakes, investing is as much an exercise in controlling emotions as it is an intellectual exercise. We're only human, after all. To make better decisions, it makes perfect sense to try to identify our natural weaknesses and biases to attempt to correct them. As outlined in the August issue of Morningstar StockInvestor, below are some of the common mental anomalies relevant to investing that could inhibit rational decision-making.
Anchoring is the act of latching on to a given piece of information and using that as a point of reference for making decisions. Unfortunately, many investors anchor on things that are irrelevant to a business's value, such as their own personal cost basis in a given stock or the 52-week trading high. Rather, we should focus on the thing that matters the most, the estimated future cash flow of a company.
As an example, have you ever thought to yourself, "If I can only get back to break-even on this stock, then I will sell." If you have, then you have fallen victim to anchoring on a piece of irrelevant information. Our cost basis in a given stock has absolutely nothing to do with the estimated intrinsic value of a business, so we are wise to utterly ignore cost basis when making buy and sell decisions. The same goes for any piece of data that does not inform one regarding future cash flow and true value.
Paul Larson has a position in the following securities mentioned above: DELL, HD, LOW, PAYX. Find out about Morningstar’s editorial policies.
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