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Investor psychology: Overcoming biases

1. Identify your biases.

2. Know why you are investing.

  • Avoid vague goals, such as: I want to be comfortable when I retire.
  • Set specific goals, such as: Since I will receive $20,000 annually in Social Security and retirement benefits, I'll need $55,000 in investment income. I will need $800,000 in principal to generate that much income.

3. Set and stick to quantitative investment criteria

  • Positive earnings
  • Maximum P/E ratio
  • Minimum annual sales growth of 15 percent
  • Minimum of five years of being traded publicly

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4. Diversify

  • Own different types of stocks and funds.
  • Own very little of the company you work for.
  • Invest in bonds.

5. Control your investing environment

  • Check your stocks once a month.
  • Make trades once a month and on the same day of each month.
  • Review your portfolio annually, and compare it with your specific goals.
  • Consider setting some play money aside. Set up two brokerage accounts, one for the bulk of your wealth and another that allows you to aggressively trade a small portion of the total.

6. Other rules of thumb

  • Avoid stocks selling for less than $5 per share.
  • Chat rooms and message boards are for entertainment only.
  • Set a goal of earning the market return.
  • Before placing a trade on a stock that does not meet your criteria, remember it's unlikely that you know more than the market.
  • Review your psychological biases annually.

From: Investment Madness: How Psychology Affects Your Investing ... And What to Do About It by John S. Nofsinger.

-- Updated: May 11, 2004

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