Psychological Traps for Investors

By recognizing how emotions can lead them astray, investors can take steps to protect themselves from their worst impulses. Here are some traps to avoid.

1. Holding losers too long
Cut your losses early. Love the company, but not the stock. No one is ever right 100 percent of the time. Use risk management before you buy a stock. Decide how much you're willing to risk on any investment or trade and scale your position size accordingly. Never risk more than two percent of your portfolio. Use stop losses to protect yourself.

For example, if your portfolio is $10,000, then a $200 loss would be acceptable. If you buy a stock at $20, then place your stop at $18 for 100 shares, $19 for 200 shares. 

2. Selling winners too soon
If the reason you bought the stock has not changed, do not sell too soon. There are different strategies for managing a trade that has turned profitable on paper. You can sell half your position and let the rest ride. Or you can use trailing stops, moving the stop in line with the price of the stock. For example, if you bought 100 shares at $20 with a stop at $18, if the stock moves to $22, move the stop to $20. 

3. You're overconfident and take excessive risks
Many investors overestimate their skills and underestimate external risks, says Cornell University behavioral economist Vicki Bogan. Investors may believe that they can outsmart the market by picking individual stocks (most studies say that’s unlikely). They may also be overly optimistic about the prospects for stock returns, resulting in too much equity exposure in a retirement account.

How much equity exposure depends on many things. I recommend you read Rule #1 Investing by Phil Town.