If you think that the market is the reason that people lose money investing then I want to change your mind. In fact, I want to tell you the three real reasons people lose money when investing.
Reason #1: Emotions
Emotions are the silent killer in the markets. Let me paint an example to prove my point.
Pretend that you just bought a value stock three days ago.
You bought this stock after a huge amount of research. You were absolutely convinced, based on all the good data you uncovered, that this company was a great one to invest in.
However, three days after buying the stock, some bad news comes out and the stock drops 7 percent and you have lost $700 on paper.
I am sure you can imagine the feeling that loss will give you. Regret, anger and fear of losing even more money. If you let them, these emotions will make you do something hasty just like yelling out “I hate you!” and selling the stock for a $3,700 loss.
However, if you were able to contain these emotions and trust your process, then you would learn that the news was not as bad as you thought. All that research you did still shows what a good company this is.
Six months later that news would have passed, and because this is such a good company the share prices gains 8 percent from where you bought it and you are now sitting on an $800 gain.
By controlling your emotions, you didn’t make a stupid decision and were better off in the long run.
So what should investors do to remove emotions from their investment decisions?
Action Step:
To do it, you need to set up an investment system and structure that takes the guesswork out of your decision-making process. There should be nothing left to decide if your process is sound.
Each and every index fund, mechanical investing screen, mutual fund, individual value stock, or bond should have a very specific place in your portfolio. It should fit within your risk tolerance and associated asset allocation. That way, the process will protect you and those individual decisions will have less of an impact on your overall results.
Reason #2: Not all stocks come back to even
There are time when stocks that have gone down do not recover to where they started from. Take a look at this chart from BAC:
After 2008 this stock never did recover from that brutal 2008-09 period. That is the risk inherent in blindly buying and holding individual stocks.
All investors who buy individual stocks need concrete rules around when they buy and when they sell. Buying just because of a strong dividend (like many did with BAC) is not enough. And only selling when the stock gets to even is a fool’s errand.
Action Step:
Instead, have rules that you adhere to religiously when buying and selling stocks. If you are going down the individual stock path, then you need to have these rules in place. Don’t fall for the return to even trap.
Have a rule like selling when your stock is down 7 to 8 percent to protect your capital.
Which leads me to Reason #3
Reason #3: They don’t protect their capital
The final reason people lose money when investing is the investing mindset.
For every stock I have ever bought, there is always a quick flash in my brain of what my investment will be worth if that stock goes up a million percent.
For example, when I bought  Facebook (FB, Financial) at the IPO I had visions of Apple (AAPL, Financial) in my head. My $34 per share investment was going to go to $600 in no time. I was going to be super rich (ok, I only had 100 shares but still!). That didn’t happen.
The problem was my mindset. I was focused on the wrong thing. Instead of focusing on how much money I would make with your portfolio (you will never really know), I should have been focused on how I was going to protect my capital while going for those gains.
If you are always focused on what your stocks can rise to, you will be blinded by that.
As an individual investor, I think that you should change your mindset to think more about how you are going to protect the capital you have. That way, you will make decisions that are in the best interest of your overall portfolio rather than that one flier.
That doesn’t mean you don’t buy stocks like FBÂ or even a biotech like TrovaGene Inc. (TROV, Financial) based on future growth potential and opportunity. Quite the opposite. You buy stocks like that because they provide you with opportunity for big growth within your well-structured portfolio. Just don’t put too much on the line.
Action Step:
Before you buy an individual stock, make sure you have your portfolio structure set up in a way to protect your capital. Select the right asset allocation based on your risk tolerance. Fill it first with high-quality and low-cost index funds to get the right diversification. Then look for the big opportunities to spread your money around a bit more, be it with riskier mechanical investing strategies or individual stocks.
Summary
All investors lose money at some point in the markets. However it is not the market’s fault. It is that investors fault.
I do not want to suggest that even if investors control their emotions, have good buy and sell rules, and protect their capital they won’t lose money. However, if they focus on best practices within each of these three areas they will stand a much better chance of getting it right in the long run.
Jeremy blogs and writes about his core index fund and mechanical investing strategy at Robotic Investing.
