PDSnet Online Investment Course

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In this module, we will try to distinguish which mental attitudes make for successful investing. In other words, how should you manage your involuntary feelings towards the share market and your shares so that as far as possible you can make the right choices and time your transactions accurately.
 
This is what is called mental attitude or Mental Posture. William O’Niel, a respected American stock analyst and editor of the Investors Daily newspaper, says, “the most important element of stock market success is mental posture”.
 
Your mental attitude is your emotional response to the share market in general – and your shares in particular. In other words, how do you feel about these things? Are you optimistic or pessimistic? Are you scared of losing or feeling the greed that comes from money made too easily? Are you elated or depressed? The powerful emotions of fear and greed can and will have an enormous impact on exactly what you end up doing in the share market.
 
OVER-INVESTING
 
One of the most notorious contributors to a bad mental attitude or posture is over-investing. This can happen in two ways:
 
<ul>
<li>You invest more than you can handle emotionally into the share market, or</li>
<li>You put too much of your available funds into a single trading idea.</li>
</ul>
 
To avoid the first type of over-investing, you need to prepare yourself for share market investing. This means you should try to eliminate all of your debt (credit cards, overdrafts, trade accounts with retail shops and motor car debt) – except for the mortgage bond on your house. Once you reach this point you can begin saving into a stockbroking account – although, even at this point, we would advise you to split your surplus cash between paying down your bond more quickly and saving into your stockbroking account. Taking this approach will reduce your financial stress and you will be well-placed emotionally to handle the stress of share market investing. The money you invest in the share market should be money that you can afford to lose. If it is, then your mental posture will be the better for it.
 
The rule for the second type of over-investing is to avoid putting more than about 20% of the capital you have set aside for the share market, into any single trading idea. When you begin in the share market, you should begin by buying one share for about R10 000 – and this means that, for a while, you will have all your eggs in one basket. However, as soon as you can save another R10 000, you will choose a different share to buy and so reduce your risk by diversification. Gradually as your portfolio grows you will diversify more and reduce your exposure to any single share. This diversification will significantly improve your mental posture.
 
You may wonder how we arrive at the minimum figure of R10 000 per investment. That figure is a function of the dealing costs which are an inevitable part of buying shares on the JSE. You will have to pay about 3% of the value of your trade in various fees to buy in and sell out (these costs are dealt with in module 13). The problem is that if you buy shares for less than R10 000, your fees will become a much larger percentage of your investment. For example, it costs almost as much to buy R1000 worth of shares as it does to buy R10 000 worth. This means that if you buy shares for R1000, your investment will have to appreciate much further before you go “into-the-money” (i.e. before the investment becomes profitable). So, for this reason we suggest that you save until you have R10 000 to invest.
 
The second form of over-investing is a major problem with beginners in the share market. It results from having more money invested than you can handle emotionally.
 
How will you know that you are over-invested? The clearest sign is that you will fail to sell out on your stop-loss signal. If that happens, then you need to reduce your exposure to the market in general or to that specific share. You must always try to invest in the market at a level that you can cope with emotionally. Coping means sticking to your stop-loss strategy (if you are not sure about stop-loss strategies re-read module 12). Obviously, as you become more and more experienced you will learn to handle larger amounts with objectivity and good mental posture.
 
Let us consider some examples of the effect of mental attitude on your decision-making process…
 
Suppose that you have bought some shares for 1000c each and that they have now fallen to 800c – what are you feeling?
 
You are feeling pain. You are feeling ‘sick’ at your loss – especially if you were “over-invested” in the first place. And you are most probably saying things like,
 
“I can’t sell the shares, because then I will lose money.”
 
or, worse still,
 
“I have not lost the money until I sell the shares.”
 
This is nonsense – of course. You have already lost the money – you just don’t want to admit it! A share is only ever worth what you can sell it for today in the market – after paying your dealing costs.
 
But when you say things like this to yourself you are, in effect, making the price which you paid for that share, perhaps six months or a year ago, the single most important factor in deciding whether you will hold the share now or sell it. And the price which you paid, six month ago or a year ago is completely and utterly irrelevant to this decision. It has absolutely no bearing on what will happen to the share from here. The only thing that matters now is whether the share will go up from here, or down.
 
If you make an utterly irrelevant piece of information the key factor in your decision, how can you possibly hope to succeed? The simple fact is that you have allowed your emotions to influence your decision-making process. You don’t want to admit that your decision to buy was wrong or that you should have sold out weeks ago. You chose the wrong share or timed your transaction incorrectly – or both – and now you are compounding that mistake by not selling out on stop-loss. Successful investors ruthlessly acknowledge their mistakes. If what you expected to happen does not happen, it is always better to sell out sooner rather than later. It’s not going to get any better!
 
Another example…
 
Let us suppose that you are a complete beginner in the share market, but you have been saving your money and you have been watching a particular share closely. You have done your homework. You have studied the company’s financial statements and been watching its charts. At last, you gather up your courage and decide to buy. You allocate a small amount from your savings and buy 100 shares (your very first share market transaction!) and you hold your breath…
 
To your absolute delight, the shares go up – and in a few short months you have doubled your investment. You can’t believe your eyes! It’s amazing! But you get nervous and decide that a “bird in the hand is worth two in the bush”, so you sell your shares and put the money safely into the bank. And you walk around with that big R200 smile on your face. You make no secret of your achievement…
 
And everyone is very impressed – your wife, your friends, your colleagues at work. Suddenly, you have acquired “guru” status. Your friends come and ask you for your advice on their investments. The guys down at the pub ask, “What should they do here and what should they do there?” Everyone wants to know your opinion of their investments. And you are very liberal with your advice…
 
And then, to your absolute horror, the share continues to go up! First, doubling then tripling and finally quadrupling the price at which you sold! Its agony! Every day you open your charting software and you stare at this wretched share! You wish it would go down! You feel cheated. You feel that somehow this share owes you money.
 
Eventually, you decide that the only way to get your money back from this share is to buy it again – only this time you will correct the other “mistake” that you made on your first transaction. This time you will go in BIG (a second mortgage on your house etc.).
 
Can you see that you are now ready to make the most monumental blunder in the share market? You are going to buy the share, right at the top of its cycle, with far more money than you can afford or cope with emotionally. You are going to overtrade horribly at the worst possible time.
Now let us consider the emotional content in this story.
 
Every day when you open the business pages of your newspaper you will see a section called the “Weekly Top Ten Up” which shows you those shares that have risen by the greatest amount in percentage terms over the past week. What is very interesting about this list is your emotional reaction to it – which is absolutely zero! You simply feel mild curiosity.
 
Yet, here are ten shares that you completely missed and which could have made you a handsome profit, but you are totally unmoved. You have no emotional response at all.
 
And yet the share that you sold three months ago, and which has since gone up so strongly makes you angry and frustrated to the point of screaming! Can you see how your involvement with this share has caused you to lose your objectivity and become the victim of your emotions.
 
Of course, the professional investor knows that there will always be many opportunities in the share market which he misses. That is just the nature of the market. Once a professional investor sells a share it joins the 300-odd listed shares that he does not own. It has no greater or lesser significance than any of the others.
 
The truth of the matter is that your first trade described in this story was a very professional trade. You purchased a modest number of shares which was comfortably within your ability to manage emotionally and you bought them right at the bottom of the cycle. You held them and doubled your money in a few months before sensibly taking your profit and putting it in the bank. If you could only continue making such trades you would become very rich, very quickly.
 
Here is another story:
 
Consider this diagram of the typical cycle of a share’s price…
<figure class="figure"><img class="figure-img img-fluid" src="/onlinecourse/images/diagram_pic_1.png" />
<figcaption class="figure-caption">Cycle of a Share - Diagram 1</figcaption>
</figure>
 
Here you can see a share price oscillating above and below its “real value” (represented by the gently rising horizontal line). Some analysts might argue that there is no such thing as a “real value” for a share – but the same analyst, probably in the same breath, will say that such-and-such shares are under-priced or over-priced, or cheap or expensive – in relation to what?
 
Obviously, in relation to his perception of their real value. And you and I have no doubt at all that shares continuously oscillate from being over-priced to being under-priced and back again. That is just common sense.
 
So, let us examine this cycle and see what is happening.
 
At the bottom of the cycle (“A”) the smartest money is buying the share – by definition. They are the investors who have been watching the share for some time as it fell. They are thoroughly familiar with its business and have been just waiting for the downward trend to come to an end.
 
And their purchases cause the share price to move up just slightly. A little after they have bought the share, another group of investors begins buying the share. These guys are not quite as smart as those who bought right at the bottom – but they’re still pretty smart. They also did their homework. The difference is that they needed that little upward move in the share’s price to act as a confirmation of the new upward trend. And their purchases move the share a little further up the cycle.
 
After they have bought, another group buys in – who are again not quite as smart as the second group of buyers – and so the trend continues as the share rises, with less and less smart investors getting in at each point and pushing the share just a little higher. At some stage the share price crosses that magical barrier (the “real-value” upward sloping line) and becomes “over-priced”. And the interesting thing about the share market is that, despite the fact that the share is now over-priced, it continues to go up, with less and less smart, or if you like now, more and more stupid investors getting in at each point.
<figure class="figure"><img class="figure-img img-fluid" src="/onlinecourse/images/diagram_pic_2.png" />
<figcaption class="figure-caption">Diagram 2</figcaption>
</figure>
 
Somewhere near the top of the cycle, by complete coincidence, Joe Citizen happens to have an appointment with his dentist. Now Joe Citizen is a music teacher, who does not read any newspaper, let alone a business newspaper, and he knows nothing about the share market. But he is stuck in the dentist’s waiting room for half an hour and on the table is a copy of the Business Day newspaper with a front-page story about the share – complete with a graph.
 
So, he picks it up and starts reading – and he is amazed. What an incredible company! They have wonderful products, great management, they are beating the competition to hell and they have covered forward on their foreign exchange (a point which Joe Citizen does not quite understand, but which sounds very impressive). And above all that the share price has doubled in the last six months! That’s all the proof that Joe Citizen needs. That clearly shows that this share is a real winner (of course, the graph does not show the coming downtrend, because that is still in the future).
 
Joe Citizen borrows the phone from the receptionist, contacts his stockbroker/bank manager and arranges to buy a large parcel of the shares.
 
The bank manager has no problem with this because a look at his computer shows that Joe Citizen owns a house – collateral.
 
Excitedly, Joe Citizen tears the article out of the newspaper and rushes home to tell his wife the good news. They are going to be rich! He shows her the article and extols the virtues of his purchase. But she is not convinced. All she can see is that he has spent a great deal of money on something that he really does not understand (she’s quite right, of course). After a time, Joe Citizen gives up trying to persuade her and goes down to the local pub. Here, all evening, he loudly proclaims the share to all his mates, and anyone else who will listen, as a great opportunity.
 
In any event, as you and I know (because we are privileged and can see into the future), shortly after Joe Citizen’s purchase, the share turns and begins to fall. At first, Joe Citizen is blasé – clearly, the share is undergoing a “correction” in an overall “bull trend” (you can see how he learns the language of the share market!). Soon it will recover, and everything will be fine.
 
But the share does not recover and continues its relentless downward trend. Now Joe Citizen is becoming worried. His wife is on his back about the money – she could have bought a new motor car with what he has thrown away. And the guys down at the pub are beginning to laugh at him. When he comes into the pub, they ostentatiously open the newspaper and loudly ask him, “How much did you lose today?”
 
And still the share falls – fifty cents today, a hundred cents tomorrow, and an agonised Joe Citizen watches, mesmerised as his money dribbles away. Of course, there are moments of pathetic hope and renewed optimism, when the share rises for a few days, but always, sooner or later, the underlying bear trend reasserts itself and the downward trend continues.
 
Finally, Joe Citizen just can’t take it anymore. The pressure and agony are just too much – and so he sells the shares – right at the bottom of the cycle (point “C” in the diagram above). And we all know who buys them back from him – the smart money, of course. Consider the following chart:
<figure class="figure"><img class="figure-img img-fluid" src="/onlinecourse/images/high_quality_share_out_of_favour.png" />
<figcaption class="figure-caption">High-quality share that falls out of favour with the big institutions. Chart by ShareFriend Pro.</figcaption>
</figure>
 
Here you can see a high-quality share that is out of favour with the big institutions and falls heavily until it is well below its “real value”. Then there is a period of sideways movement when the bullish and bearish forces are evenly balanced. This gives rise to an “island” formation. Finally, the share breaks up out of the island into a new bull trend. You will also note that the moving average superimposed on the chart gives almost perfect “buy signals” and “sell signals" (the moving average is covered in module 23).
 
Cycles like this go on in the share market year in and year out. They have always been there – and will continue to be there for so long as we have investors with different levels of knowledge and experience coming into the market at different times.
 
The main point that you need to grasp is that novices in the share market typically get excited only when a share is going up. They are not well-informed, so they are the last people to find out about the upward trend and the last to buy – which brings us to the point of this story:
 
If you want to buy the share at the bottom of the cycle (point “C”), you must find the share while it is falling (the green line in diagram 3, below) – and begin watching it.
 
Then, when the turning point finally arrives, you will be ready and waiting.
 
<figure class="figure"><img class="figure-img img-fluid" src="/onlinecourse/images/Picture3.png" />
<figcaption class="figure-caption">Diagram 3</figcaption>
</figure>
 
One final point. Look at the diagram again. The arrow on the diagram above shows the place at which the smart money is taking their profits and selling out of the share. Their sales typically cause a temporary correction in the upward trend. You should note that they strive to sell out about two-thirds to three-quarters of the way up the trend while their risk is still relatively low.
 
A professional investor is a person who sells too soon.
 
Logically, the lowest risk point in the cycle is at the bottom of that cycle. As the share moves up, the risk increases steadily. Professionals always try to take the low-risk portion of the cycle and sell out while there is still strong demand for the share. If you sell a share, make a profit and then the share continues to go up – you should congratulate yourself on having executed an extremely professional trade.
 
Only amateurs hold on to the bitter end – and they inevitably end up chasing the share down.
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