Beginners are prone to the hindsight bias when it comes to investing. They look at historical price charts and they think that they can spot which asset will move the most. As a result, they believe that the best strategy is to go all-in on an asset. Experience shows us that this is not the case. The best approach is to hold a diversified portfolio.
Another result of the hindsight bias is that you can know the tops and bottoms of an asset. As a result, the more you trade those tops and bottoms, the more money you are going to make. This is another fallacy that the beginners are prone to.
Our psychology is our biggest enemy when it comes to trading stocks and commodities.
Our psychology makes us stick to losing positions until we can’t take it anymore which is usually the turning point. That means we buy and sell at the worse moments. Does that mean we shouldn’t invest at all? Not at all.
The central banks are aiming for a slight inflation in their currencies. That means your savings lose their value slowly over time. That is official government policy. To offset that loss, we need to invest. At the same time, we need to avoid trading frequently. We need to find the sweet spot between not investing at all and day trading.
The best strategy in transaction frequency is the following.
- Determine the investment hypothesis.
- Hold the investment as long as the hypothesis holds and you don’t need money.
My Experience: A Value Stock
I have spotted a stock with a price to earnings ratio significantly lower than the S&P 500 average. When I read the reports of the company, I couldn’t find any reason to justify the underpricing of that stock. The reasons for that underpricing might be that the company was around for a long time but still remained a small cap stock. It didn’t promise a huge growth or a technological breakthrough. It didn’t make any headlines in the news. It wasn’t in the S&P 500 index. It wasn’t sexy enough to get investor attention.
My investment hypothesis was the following. If the company kept its current profit levels, it would be a better investment than the S&P 500 index fund. I invested into the stock and started to wait. The price of the stock didn’t increase for a long time. On the contrary, it decreased to some extent for a few months. There wasn’t any news to justify the decrease in the price. I kept holding to the investment, because my hypothesis wasn’t disproved yet. I was able to stay calm, because my portfolio was diversified enough. This stock didn’t represent a significant portion of my portfolio.
The stock kept posting steady profits and reported to be included in the Russell 3000 Index after a few quarters. That bumped the stock prices. Holding on to the stock as long as it kept satisfying my investment hypothesis paid off for me. I still hold the stock, as it keeps satisfying my investment hypothesis.
Ripple (XRP)
I bought some Ripple (XRP), a cryptocurrency, because of its deflationary policy. After a while, I changed my mind and sold my holdings. The price wasn’t moving anywhere. I thought its main use case, being an interbank currency, meant that its price should stay stable. Within a month after I sold my Ripple holdings, its price increased tenfold. I wrote a detailed post about my experience.
Bitcoin
I started investing in Bitcoin when it was around $5000. My last investment was around $7500. When Bitcoin broke through $10K, I sold 2/3’s of my holding. Its price increased until $20K and it’s still above $15K at the time of writing this post. Had I stuck with my initial holding, I’d be better off with my investment. However, I let my emotions dictate what to do with my savings and I missed some profits.
I don’t mind too much missing out on some potential profits in Ripple and Bitcoin, because my investments in both of them weren’t more than 5% of my portfolio. I also didn’t panic when the price of the first stock decreased, because my investment was less than 5% of my portfolio. As you see, maintaining a diversified portfolio helps with staying calm when the price doesn’t move in your favor. That is one of the many benefits of diversification.
Summary
I know that three examples are not enough to prove a point, but they all point to a conclusion. The more you trade, the more you lose. The best strategy for an individual investor is to stick with an investment as long as the investment hypothesis holds or money is needed.
Disclosure and Disclaimer
This post is for information purposes only and not intended to be investment advice. At the time of writing, 4% of my savings were in Bitcoin.