FINANCE
less intense, even though your
risk tolerance remains unchanged
because your perception of the
risk has evolved.
By understanding your risk toler-
ance, you can avoid those invest-
ments which are likely to make
you anxious. Generally speaking,
you should never own an asset
which keeps you from sleeping in
the night. Anxiety stimulates fear
which triggers emotional respons-
es (rather than logical responses)
to the stressor. During periods of
financial uncertainty, the investor
who can retain a cool head and
follows an analytical decision pro-
cess invariably comes out ahead.
3. Control Your Emotions
The biggest obstacle to stock mar-
ket profits is an inability to control
one’s emotions and make logical
decisions. In the short-term, the
prices of companies reflect the
combined emotions of the entire
investment community. When a
majority of investors are worried
about a company, its stock price is
likely to decline; when a majority
feel positive about the company’s
future, its stock price tends to
rise.
A person who feels negative
about the market is called a
“bear,” while their positive coun-
terpart is called a “bull.” During
market hours, the constant battle
between the bulls and the bears
is reflected in the constantly
changing price of securities. These
short-term movements are driv-
en by rumors, speculations, and
hopes – emotions – rather than
logic and a systematic analysis of
the company’s assets, manage-
ment, and prospects.
Stock prices moving contrary to
our expectations create tension
and insecurity. Should I sell my
position and avoid a loss? Should
I keep the stock, hoping that the
price will rebound? Should I buy
more?
Even when the stock price has
performed as expected, there are
questions: Should I take a profit
now before the price falls? Should
I keep my position since the price
is likely to go higher? Thoughts
like these will flood your mind,
especially if you constantly watch
the price of a security, eventually
building to a point that you will
take action. Since emotions are
the primary driver of your action,
it will probably be wrong.
When you buy a stock, you should
have a good reason for doing so
and an expectation of what the
price will do if the reason is valid.
At the same time, you should es-
tablish the point at which you will
liquidate your holdings, especially
if your reason is proven invalid or
if the stock doesn’t react as ex-
pected when your expectation has
been met. In other words, have an
exit strategy before you buy the
security and execute that strategy
unemotionally.
4. Handle Basics First
Before making your first invest-
ment, take the time to learn the
basics about the stock market and
the individual securities compos-
ing the market. There is an old
adage: It is not a stock market, but
a market of stocks. Unless you are
purchasing an exchange traded
fund (ETF), your focus will be
upon individual securities, rather
than the market as a whole. There
are few times when every stock
moves in the same direction; even
when the averages fall by 100
points or more, the securities of
some companies will go higher in
price. The areas with which you
should be familiar before making
75
your first purchase include:
• Financial Metrics and Defini-
tions. Understand the definitions
of metrics such as the P/E ratio,
earnings per share (EPS), return
on equity (ROE), and compound
annual growth rate (CAGR).
Knowing how they are calculated
and having the ability to compare
different companies using these
metrics and others is critical.
• Popular Methods of Stock
Selection and Timing. You should
understand how “fundamental”
and “technical” analyses are
performed, how they differ, and
where each is best suited in a
stock market strategy.
• Stock Market Order Types. Know
the difference between market
orders, limit order, stop market
orders, stop limit orders, trailing
stop loss orders, and other types
commonly used by investors.
• Different Types of Investment
Accounts. While cash accounts are
the most common, margin ac-
counts are required by regulations
for certain kinds of trades. You
should understand how margin
is calculated and the difference
between initial and maintenance
margin requirements.
Knowledge and risk tolerance are
linked. As Warren Buffett said,
“Risk comes from not knowing
what you are doing.”
5. Diversify Your Investments
Experienced investors such as Buf-
fett eschew stock diversification
in the confidence that they have
performed all of the necessary
research to identify and quantify
their risk. They are also comfort-
able that they can identify any
potential perils that will endanger
their position, and will be able to
liquidate their investments before