After 15 years of helping investors do a better job of managing their portfolios and managing risk, I can confidently say that all of my research points to a single idea that has the most potential impact on investor performance…
Unlimiting your gains.
Be careful not to just gloss over this simple idea. It’s the distilled wisdom of over 15 years of my research and its practical application to investors.
Over the years I’ve shown the following chart more than once. It’s a chart from behavioral finance that shows how our gains don’t mean as much to us as our losses.
The vertical axis in this chart is a measure of the level of emotional intensity that we experience about our gains and our losses. As our gains increase to the right of the chart, the emotional impact of those gains tapers off. The more we make, the relatively less impact of those gains.
On the other hand, as our losses increase to the left of the chart, the “pain” we experience from our losers intensifies. It doesn’t taper off. We can become obsessed with and consumed by our losers. We do everything we can to “avoid” these losses – everything but letting go of them.
Once we experience first-hand how destructive such “loss-aversion” can be, we start working to find a way to not touch that hot stove again. We learn, one way or another, to limit our losses. This moves us to what I’ll call the intermediate level of investing. The behavioral response of the intermediate investor looks something like this:
The intermediate investor learns to limit their losses. The intermediate investor starts to break-even and hold his or her own. The pain of big losses is avoided by never letting losses get out of control in the first place.
The real key to successful investing, however, is in learning to fall in love with your winners. Cherish them. Nurture them. Attend to them. In doing so you will achieve the behavioral response profile of the truly advanced investor:
For the advanced investor, losses are quickly forgotten while gains – and the way to increase these gains – becomes the center of attraction.
What we put our attention on grows. Put your attention on your winners. Remove your attention from your losers.
It’s your attention. Use it wisely.
Richard M. Smith, PhD