The ability to control your emotions is an important skill for investing (and life). Human beings are emotional animals. That’s a fact. That fact shows itself in the stock market every year.
Stocks become overbought or oversold all the time. Basically what that means is that when humans react to news, they tend to over-react, both positively and negatively. They see a company that has grown at 20% for 6 straight quarters and bid up the stock price to astronomical triple-digit P/Es and untenable valuations. They see a company whose revenue remains flat (or goes down) for a quarter or two and all of a sudden the sky is falling. In reality what should happen is almost always more muted than what does happen.
Why is that? Emotion. People see the price going down and see their hard earned money “disappearing” and panic and sell before more of it is “gone.” Or they see the value of their account growing at a fantastic rate and think the good times will keep on rolling. Overreaction to the downside can be explained by loss aversion — losses hurt more than gains feel good. Loss aversion is a well studied and documented psychological phenomenon.
So, how do we avoid emotion in investing? One way I like to use is something called a dividend reinvestment plan (DRIP). DRIP investing is a form of dollar-cost-averaging — that is, investing the same amount of money in a stock at regular intervals, generally monthly. A DRIP program takes it a step further and also automatically reinvests any paid dividends. Dollar-cost-averaging helps remove the emotion from investing because you are creating a plan. You are going to invest X dollars on the 1st day of every month. It doesn’t matter if the stock was up or down the previous month.
One awesome side effect of this is it makes you agnostic about the direction of the stock price. If the stock price goes down, fine — you get to buy more shares for your X dollars. If the stock price goes up, fine — you are making money. The short-term gyrations of Mr. Market matter a lot less. This is summed up perfectly in this quote:
In the short run, the market is a voting machine. In the long run, it is a weighing machine. — Benjamin Graham
In the short term, emotion controls stock price. Over time, the price of a stock will reflect the value of the business.
Many companies allow you to establish DRIPs through ComputerShare where you can invest as little as $50 monthly for low to no fees. Alternatively, you can build your own DRIP using Robinhood. The stock market can be an extremely volatile place. You will find at least a 10% swing from high to low for almost every year on record. Committing to a dollar-cost-averaging approach is a great way to take some of the emotion out of investing.