serenity and the stock market

God grant me the serenity to accept the things I cannot change, Courage to change the things I can, And the kind of money where I don’t really care either way.

OK, not really, but yesterday’s announcement that Apple would be giving some of its tens of billions of dollars back to its stockholders in the form of buybacks and dividends sparked a conversation with a friend of mine, so I thought it would be a good time to talk about emotions and the stock market.

Anyone with spare cash will often find themselves invested in the stock market. Those who are compensated partially in stock (hello, fellow engineers!) pretty much have no choice. And everyone will, sooner or later, find themselves selling that stock at a particularly bad time, and slapping themselves in the face because of it. “If only I had sold sooner/later!” How do we avoid this?

First, know that you’re going to get it wrong sometimes. People have varying takes on how efficient the market is, how predictable it is, and how much it’s just a random walk (see Burton Malkiel). I side with the random walkers, but pretty much everyone admits that there’s some amount of “noise” in the market, some amount of movement that you simply cannot predict without getting lucky. Accept that and move on. Yes, you could have timed things better, or put more into this stock when it was low, but you didn’t have a crystal ball, so don’t beat yourself up over it.

Accept that you are heavily biased. Humans have all kinds of cognitive biases, and most of us refuse to believe that we’re affected by them. A particularly deadly one is the fact that we tend to “accept wins at face value and tend to explain away losses”, per this paper among others. In the stock market, this encourages us to take more risk than we really should, and to overestimate our skill. The first step to countering this is to acknowledge our weaknesses. The second step?

Develop a plan, stick to it, and leave your emotions at the door. Do NOT go with your gut; when it comes to the stock market, your gut is lying. Make a plan: I will buy at this predetermined point, and I will sell at this point. (“Dollar-cost averaging into a broadly diversified portfolio and regularly rebalancing” is a good start.) If the market starts plummeting or soaring, keep ignoring your gut: following the crowd is a recipe for buying high and selling low. (And make no mistake: blindly doing the opposite of the crowd is almost as bad.)

Diversify. There’s a common saying in the financial planning world: diversification is the only free lunch. If you have individual stocks, keep them under a small percentage of your portfolio (say, 5%), and during your regular rebalancing session, make sure they don’t exceed that percentage. [Edit: This means the rest should be in a diverse allocation of mutual funds. I’ll talk about that more in a future post.] This has several advantages: it will help you limit your risk of a single company causing your portfolio to nosedive, it’ll help you sell the winners at a good time, and it’ll help you obsess a little less over your company’s fortunes. Speaking of which:

Don’t own stock in the company you work for. Unless stock options are your main form of compensation, you’re already heavily invested in your company: they’re the ones writing your paycheck! Don’t double down, even if you work for Apple: if your employer gives you stock, in the form of options or ESPP’s, sell it as soon as it vests and invest it elsewhere. (Worried about taxes? You shouldn’t be. I’ll cover that in a later article.) For every story of an employee who retired rich off his company’s stock, I can give you 10 (at least!) of employees who wiped out their wealth by failing to diversify in this way.

Above all: unplug, unplug, unplug. Watching “Mad Money”, reading articles like “5 Stocks To Watch”, and the like will just give you heartburn and tempt you to ditch your plan. They certainly won’t help you make money; make no mistake, they’re entertainment. Following the latest trends just leads to buying high and selling low, because there are thousands of people watching and reading the exact same media. Get the information it takes to follow your plan, only as often as your plan requires. (Hint: if it involves checking prices and other research more than once a quarter, it’s probably too involved.) If you think you may want to change your plan, force yourself to go slowly: wait until next quarter — or next year! — before even beginning to implement that change.

In other words: mind the gap.