I’ve always known that, as investors, we can sometimes make emotional decisions about when to buy and when to sell.
If you’ve been investing for any length of time, you know by now that buying and selling stocks can emotional.
New York Times columnist and “financial illustrator” Carl Richards elegantly captures this reality in his whimsical drawings at BehaviorGap.com. Here, for example, is one of my personal favorites:
Looks familiar, doesn’t it?
What I never full realized until now, however, is that we also get emotional about how much to buy … and what a profound impact these “how much” decisions have on our investment outcomes.
When it comes to deciding how much to invest, the emotions that drive us aren’t fear and greed. Fear and greed are pretty easy to see. Our “how much” emotions are more subtle.
Take a minute to stop and think about it …
What do you think the emotions are that influence our decision making about how much money to put into a new investment idea?
Got your answer?
I’ve got my answer. The emotions which can influence our decisions about how much to invest are … boredom and excitement.
When it comes to deciding how much money to put into a new investment we tend to put less money into stocks we think are boring and we tend to put more money into stocks we find exciting.
Come on now … admit it. You know it’s true!
More often than not, boredom and excitement in the stock market correspond to one thing – volatility.
Boring stocks are less volatile. Exciting stocks are more volatile.
I love investing in exciting and big ideas as much as anyone. I love swinging for the fences. What I’ve learned, – the hard way I’m afraid, and what my new research has convinced me of beyond the shadow of a doubt – is that the single biggest mistake we make as investors is putting too much money into our most exciting ideas and not enough money into our steady workhorses.
That’s exactly why sizing our investments with volatility in mind is so powerful!
I’ve written many times before about how trailing stops help us to flip our poor decision-making on its head by forcing us to limit our losses and un-limit our gains (exactly the opposite of what we want to do emotionally).
Position-sizing for volatility is another tool that lets us flip our potential to make bad decisions upside down. Emotionally we are drawn to volatility and excitement … and we’re bored with steadiness and predictability. Our emotions drive us to invest more in our volatile investments and less in our “boring” investments.
Position sizing for volatility does exactly the opposite! It forces us to put more money into our boring investments and just the right amount of money into our most exciting investments.
Moreover, it tends to have the additional benefit of making our “boring” investments more interesting to us because we end up with larger position sizes.
I’ve used the examples of Johnson and Johnson vs. Tesla many times but let’s look at it again in this new light.
Say that we decide to risk $1,000 on both of these potential investments. By “risk” I mean approximately how much we’re willing to lose if we’re wrong. (A good rule of thumb here is typically about 1% of your total portfolio size.)
The current VQ on JNJ is 11.61%. If we divide our $1,000 risk by 11.61% we get $8,613.26. The latest close on JNJ (as of this writing) was $102.48. If we divide $8,613.26 by $102.48 we find that we can purchase 84 shares of JNJ.
The current VQ on TSLA, on the other hand, is 41.52%. Again taking our $1,000 risk, we divide it by 41.52% to get a position size of $2,408.48. Dividing that by the latest close of TSLA ($220.01) we find that we can buy 10 shares of TSLA and still remain within our position size.
So we can invest about $8,600 in JNJ and $2,200 in TSLA based on our stated risk of willing to lose up to $1,000.
If your $8,600 investment in JNJ falls 11.61%, you’ll be down about $1,000. If your $2,200 investment in TSLA falls 41.52%, you’ll be down about $1,000.
That’s how you do it right!
That’s how you use math to still have your cake and eat it too. You get to actually make money in the markets by investing more money in great long term safe equities like JNJ, and you get to still have some fun by taking the occasional flyer on stocks like TSLA – and maybe even hitting one out of the park.
I don’t know about you but when I think about investing $8,600 in JNJ vs. $2,200 in TSLA, it almost starts to feel like JNJ is the more exciting investment. Doesn’t it?
To exciting and successful investing,
Richard M. Smith, PhD