Until now, my educational columns have focused almost exclusively on fundamental stock analysis, prudent money management, and techniques that you can use to spot undervalued companies. While I believe these topics form the foundation of a successful investing strategy, they are only part of the equation. Knowing when to buy and sell can sometimes be more important than knowing what to buy and sell. And when the time comes to make those critical decisions, it is vital that any emotional impulses be suppressed.

Over the long haul, achieving market-beating returns requires not only solid analytical skills, but also an even temperament. It has been said that fear and greed rule the market, and any investor who allows such emotions to dictate his or her decision-making process will soon discover that they are an impossible handicap to overcome.

For many investors, the ultimate goal is to become an expert at stock selection. However, even the most astute analyst will ultimately earn sub-par returns if he or she lets emotion become too much of an influence. To demonstrate this point, let's evaluate the behavior of a theoretical investor named Jane.

As an experienced investor, Jane has learned quite a bit about stock analysis. Using that knowledge, she uncovers a sharply undervalued company called Acme Ball Bearings that she feels has a promising outlook. Jane immediately calls her broker and places a large buy order for 1,000 shares at $10 per share. In the months ahead, her confidence grows as Acme's shares begin to soar. Within six months, the stock has more than doubled, and Jane begins to wonder whether she should lock in her profits and sell. However, Acme seems to be in all the financial headlines, and while she deliberates, the stock rises even more. At this point, the shares have already surpassed Jane's intrinsic value estimate, but she just can't force herself to liquidate a stock that seems to go nowhere but up. Rather than sell, she is angry for not having bought even more. This sentiment is reinforced the next week when Acme rallies further still, finally topping out at $25 per share.

Then it happens: the stock drops sharply one day -- all the way back to $18. Jane is unconcerned, though, and dismisses the sell-off as a minor correction. She knows that she could still liquidate the position and pocket a tidy gain, but hesitates because just a week earlier the position was worth $7,000 more -- money that she feels has now been lost. She promises herself that as soon as Acme rebounds back to its peak at $25, she will instruct her broker to sell. Only the stock never climbs back to its old highs. Instead, amid deteriorating sales and earnings, Acme continues to retreat slowly back towards the $10 level where Jane first purchased the shares. Not wanting to lose any money, she finally decides to sell the stock at $10, exiting the trade at breakeven.

Frustrated with herself, Jane begins to search for a new stock in which to invest the proceeds from the disappointing Acme sale. Soon, she finds another -- a retailer called Low-Mart -- that seems even more attractive. However, her confidence is now rattled, and she is unsure of trusting her own judgment. Instead of taking any chances, Jane decides to wait on the sidelines and monitor the stock for a few weeks. As it happens, her conclusions were accurate, and the stock begins to move higher -- marching from $40 to $45. Jane is even more upset now, and she decides to purchase Low-Mart as soon as it returns to $40. However, instead of falling, the stock continues to gain ground and eventually reaches the $50 mark. Jane has determined the shares are worth $65, so even after the recent advance, she could still possibly book a substantial profit. Unfortunately, after the $10 spike in the stock, Jane feels she has "missed her chance" and stubbornly refuses to pay $50. Sure enough, Low-Mart goes on to hit her $65 price target.

Hopefully, this overly simplified case study has pointed out something that many investors fail to realize -- that profitable trading involves more than just accurate stock selection. Jane's analytical work uncovered two stocks that could have generated hefty gains. Because of emotion, though -- greed in the first case and fear in the second -- she didn't earn a single penny in profits from either idea.

Warren Buffett and many other well-known investors have noted that successful investing is rarely correlated to intelligence. In fact, a number of recent studies have even suggested that mentally challenged people might make the best investors. A person need not possess a razor-sharp intellect to be successful. Instead, he or she needs to be able to control urges and resist the temptation to trade impulsively.

Academics have long been puzzled as to why some stocks become astronomically overvalued while others languish well below their real worth. In an efficient market, nearly all companies should trade for their intrinsic value -- no more, no less. However, in order for a market to be truly efficient, it is simply assumed that all participants will make rational trading decisions. After years of study, researchers have determined that this is simply not the case. In fact, an entire field of study has evolved that attempts to address this imbalance and explain the impact that psychology has on investing -- Behavioral Finance.

If every investor sold his or her stocks when they became dramatically overvalued, then there would be no market bubbles. Conversely, if every investor decided to purchase stocks when they were severely undervalued, then the market would never crash. However, anyone who witnessed the dot.com boom of the late-1990s followed by the great bear market from 2000 to 2002, is probably well aware that investors do not always follow such common sense guidelines.

Perhaps author Robert Hagstrom said it best -- "At the height of optimism, greed moves stocks beyond their intrinsic value, creating an overpriced market. At other times, fear moves prices below their intrinsic value, creating an undervalued market."

In the end, investors who base their decisions on emotions or hunches rather than thorough research will eventually run into problems. With that in mind, I thought it might be instructive to delve deeper into the subject of behavioral finance. Understanding what motivates others into making irrational decisions can be beneficial for two reasons. Not only can such insight give us a valuable edge, but it can also help prevent us from making similar mistakes with our own portfolios.

In the analysis below I provide an overview of several of investors' most common cognitive mistakes:

My Stock will Come Back Eventually
Researchers have found that investors are typically more upset from losses than they are elated from gains. In fact, some studies have shown that the average person derives twice as much disappointment from a $1 loss than he or she receives pleasure from a $1 gain. Inevitably, this makes it difficult for some people to cut their ties to poorly performing investments. After a stock is sold, a loss on paper becomes an actual realized loss. Many people forlornly hang on to losers in the hope that the price will eventually rebound -- or "come back." This illogical tendency can turn modest losses into enormous ones. 

If someone buys a stock at $20 that turns out to be worth just $10 a year later, should they sell? The question to ask is not "how much has the stock dropped over the past year?" but "what is it likely to do in the coming year?" Have the company's underlying fundamentals improved? Deteriorated? Remained constant? Assuming there has been no material change, it may indeed be a good idea to hold, or even to buy additional shares. However, if the assumptions that drove the original purchase decision are no longer in place, then it is senseless to hold onto the stock out of sheer hope. Here at StreetAuthority, we take a buy and hold approach to investing -- not buy and hope.

One of the cruelties of mathematics is that after a 50% drop such as the one above, it takes a 100% return just to breakeven. Even if the stock does manage to achieve that goal in the years ahead, it still doesn't mean that holding it was the correct decision. Instead, the proceeds could have possibly been invested elsewhere in a stock that earned +200%. Remember, losses from a mistake can be recouped anywhere -- not just from your original investment.

Don't base a sell decision on how much a stock has fallen in days already past. Instead, ask yourself, "Is this the best place for my money in the days ahead." If the answer is "yes", then you should continue to hold the stock. If the answer is "no", then you should cut your losses. 

Overconfidence
Overconfidence can take many forms and can be a dangerous -- and costly -- problem for the unwary investor. Some investors have such confidence in their abilities that they invest too heavily in a small group of securities. This often results in extremely concentrated and volatile portfolios. Others might assume that they know everything there is to know about a specific company or industry, and thus decide to discontinue any further research coverage. Finally, there are those who refuse to read or even contemplate any contradictory viewpoints. Often, if someone is bullish on a stock, they will only read other bullish opinions and will quickly dismiss any bearish forecasts. 

Each of these problems is easily avoided. Don't invest more than is prudent in any one holding. Maintain a properly diversified portfolio. And don't automatically ignore an opposing viewpoint; it may open your eyes to unforeseen troubles (or benefits) on the horizon.

Nobody is infallible; sooner or later even the most well-informed, sophisticated investor will make a mistake. When that time finally comes, try to take something positive away from the experience.

Following the Crowd
Following the crowd is an easy -- but rarely profitable -- trading strategy. It is simple to understand why so many novice investors adopt a herd mentality. It is a common trait to assume there is safety in numbers. If everybody is buying tech stocks, then maybe I should too. If everyone is selling their small-cap stocks and rotating into large-caps, then maybe I need to get out before it's too late.

Instead of following the crowd, it is often better to be a contrarian by going against the grain. Whenever the markets are full of optimism and everyone is buying, it stands to reason that stocks will be overvalued, and thus ripe for selling. On the other hand, whenever the bears have the upper hand and stocks have fallen sharply, this can be the best time to pick up undervalued shares.

Many technical analysts follow contrary leading indicators such as the Equity Put/Call ratio to determine the sentiment of the average trader. When investor sentiment moves to one extreme or the other, it might be a good idea to bet against the crowd.

Risk Aversion
Risk aversion can be a powerful motivator -- one that often works to the detriment of long-term returns. While the overconfident might place too much money in a stock, the overly cautious might invest too little -- or even none -- in a company that has merit. This can be particularly true after several previous unsuccessful trades.

Ultimately, everyone must determine their own risk tolerance and then invest within those boundaries. Certainly there is nothing wrong with avoiding risk and volatility; that is, after all, one of the primary objectives of all value investors -- to invest in companies that offer a definitive margin of safety. However, even the strongest of companies will inevitably suffer short-term setbacks and knee-jerk sell-offs. In these circumstances, it is essential not to let temporary concerns cloud your long-term outlook. Panic selling might make you feel better initially, but it will erode your returns over time. Trust your judgment, and try to ignore any day-to-day price fluctuations.

Price Obsession
Many investors are unduly focused on arbitrary stock prices. It is quite possible for a stock to be overvalued at $30 per share, for example, and then a year later (with better fundamentals) for that same stock to be undervalued at $40 per share. On the flip side, it is not unusual to see a stock with sluggish financial results look like less of a bargain at $10 than it may have been a year earlier at $20. In the end, it is not the price that matters, but the difference between that price and the stock's current intrinsic value.

In the case study above, Jane was overly concerned with stock prices. She refused to pay $50 for a stock that she believed was worth $65, simply because she had already lost out on an earlier opportunity to buy it at $40. Many investors have lost money waiting on a stock to "pull back" even though it offered a compelling risk/reward profile at current levels. Remember, you don't need to buy at the exact bottom -- or sell at the exact peak – in order to be a successful investor.

Once a stock has reached my fair value estimate, I will take my profits, or at least place a stop loss order to protect the gains. Although it can be frustrating to see a recently sold stock continue to climb, it's not nearly as frustrating as hanging on to one too long and watching your gains quickly evaporate.

Conclusion
Each of these concepts is somewhat intuitive and easy to understand, but putting them to practical use can be quite difficult. When emotions enter into the picture, there will always be a tendency, for example, to hastily unload a stock after disappointing news, or to fall in love with a profitable pick and never want to sell. Such emotions are simply part of human nature and thus can be difficult to eliminate.

Once removed, though, your portfolio will be free of emotional errors and psychological distractions. In their place, calculated decisions will be based strictly on the fundamentals. Ironically, removing all emotion from the process will make for a more successful -- and thus happy -- investor.

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Important Note: The above article was merely a small excerpt from a recent issue we sent to subscribers of our premium value investing service -- Half-Priced Stocks. The mission of Half-Priced Stocks is to help our readers identify securities that are trading at the steepest discount to their intrinsic net worth. In some cases this discount can reach up to 50% or more, giving savvy value investors the chance to purchase quality stocks for just pennies on the dollar. To receive your copy of our most recent issue of Half-Priced Stocks, as well as other guidance similar to this twice per month, you'll need to subscribe to this publication. To learn more, please visit:
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