How To Control Your Emotions When Investing

Includes: CB, JNJ, KO, PEP
by: Kurtis Hemmerling

Many new investors think that as long as they have a superior stock picking strategy and timely recommendations to buy and sell, that is all they need. If we were a computer firing off trades, this might be true. Yet our emotions cloud our better judgment as we make rash decisions to buy when stocks are already over-extended, and to sell when the market is down hard. How can we work against our inherent nature to 'buy low and sell high'?

First of all, we need to admit that we have a problem before we can address how to improve. It's not our fault - studies have shown that we are hard-wired to lose money in the stock market by following the herd or recent market trends. This is short-term momentum investing at its worst. The markets could have fallen 50% in a short period of time and our gut reaction is to sell out of the fear of more losses - when in fact this is one of the most logically profitable times to buy. Or we might be inclined to buy after an extended bull market, since we don't want to 'miss out' on all the gains others have been making over the past few years.

In this regard, I must say that dividend investors searching for high yields have an advantage. When markets are up and current yields are shrinking due to increasing valuations, they hold their positions and simply collect income. When the markets crash they suddenly get quite excited as their favorite stocks are now available with great yields. In their minds, they are locking in at a strong yield and, provided the dividend isn't cut or reduced, they have consistent and increasing income yields based on their cost.

Income investors know the secret

First, take a few of stocks from the Dividend Aristocrat universe and see how this works. A dividend investor looks to these sound stocks with increasing dividends and tries to buy when the yields spike. When the stock has a decreasing yield, regardless of total dividends paid out, he looks for other stocks to buy. For this investor, it is all about the income as he tries to ‘lock-in’ yields when they are rising instead of falling.

Look at how this would work for Chubb Corp (CB).

(Click all charts to enlarge)

In general, he is a bear market buyer as he accumulates during market declines. Between 2004 and 2006 he mostly holds his positions and begins aggressively buying between 2008 and 2009. This system may work well since he saves up his cash to make large purchases when yields are increasing and he may actually look forward to the next major down market.

Or what about the investor that wants to accumulate Johnson and Johnson (JNJ)?

Of course, not all stocks are as clear-cut. But during steep market inclines during the latter part of 2004, the investor tapers off his purchases. As the market begins to drop he resumes buying in 2005. There are very few times with JNJ that he holds off buying. However, he is also not easily shaken out of his positions. This may or may not be the best timing system for picking up stocks – but the point is that this investor is in full control of his emotions and, in general, accumulates during market crashes for a fair entry price.

What about Pepsi (PEP)? The yield had a fairly smooth gradual climb although there were periods where yield spiked which would have encouraged this type of investor to buy and lock in yields more aggressively.

And lastly, look at Coca-Cola (KO). If you picked up shares during periods of spiking yields feeling that you were locking in at a higher price – you could accumulate during periods of better valuation.

While income stocks are not bond yields, we need to get inside the investor's mindset in order to understand his process for controlling emotions - and the process works fairly well.

So am I saying that you should base buying targets solely on increasing yield and total dividends? Hardly. while this timing system is simple and somewhat subjective - it does solve the problem of controlling emotions, which allows the investor to buy at a time where the upside is more probable.

But this is not the only way. In the article, High-Yielding Dividend Growth Strategy For Any Market, I consider another method using the Dividend Aristocrat index that picks up dividend growth stocks when valuations are lowest with hedging to smooth out volatility. Think of a Dogs of Dividend Aristocrat index combined with the above method and a couple other valuation-targeting tricks.

Reining in emotional trading

The bottom line is that you absolutely should not make any investment decision based on the capital in your account, or its fluctuations. Decisions need to be based on the market and stocks - is the stock a good buy right now? If yes, then who cares that your current investment in it is down it up! Is the stock giving you an indication that it is highly overvalued and the market is weak? Then sell it off and don't look at the 30% gains you made over the last year, thinking it is bound to repeat last year's success.

When you figure out a system for controlling your emotions - whether it be delegating the execution of your strategy to an advisor or by using a system you are comfortable with - you will be learning the aspect of investing that is not dealt with frequently enough. Learn to control your emotions before they control you.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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