Ask Colin

Last week (mid October 2005) I was looking at a large unrealised profit.  This week I am looking at less than half that unrealised profit. How do you stay calm, when you see over 50% of your profits walk away?

This is an interesting question. The short answer is experience combined with rehearsal of your investment plan.

 

Experience is being there many times before. There is no real substitute for experience in any profession or in sport for example. If you have been there before, felt the emotions and dealt with them, taken action (or froze) and learned the lessons from the experience, you are better equipped to deal with the situation next time.

 

However, it is not possible to have experienced everything that could happen many times. Life is too short and some events are rare or unique. All athletes use rehearsal. They visualise all the possible situations that could occur and then visualise how they deal with them. They do this over and over again. Then when one of these things actually happens, they know instinctively what to do.

 

I had never lived through a 25% overnight fall in the market as happened in October 1987. Yet I was surprised how well I handled it. I think it was because I had rehearsed what it is like and what to do in a sudden drop in the market. I had previously had that unhappy experience in one stock (which I should have sold, but didn't), so I guess I had some experience. But essentially the key was that I had rehearsed what had to be done. I then sat there calmly and id what I had to do over the next two days.

 

Most people have trouble imagining alternative futures. It is a good skill to develop. Try to postulate all the things that could happen - likely or otherwise - and work out what you would do. Try to imagine it clearly and feel the emotions. Try to list the alternative options you have and weigh them up - see my article in AFR Smart Investor November 2005. Ask what is the best or worst you might expect. Then check out one stage worse that you think is possible.

 

You have arrived as an investor when you know instinctively what to do in any situation. Experience and rehearsal of your plan will get you there.

 

The other thing is to have a good investment plan that provides guidelines for decisions, of course. You need to have studied how it works over hundreds of previous situations. For example, my investment plan involves a sell stop which will always be somewhat below the absolute high of the trend. It will mean giving back a fair bit of the paper profit at the end in order to capture the meat of the trend. If you do not understand the implications of your investment plan, and have rehearsed it over and over, then these things will continue to be a challenge.

 

Your plan has to know whether you are trying to capture most of every swing up in the market - in which case your recent experience is a failure of the plan. Or are you intending to sit through the corrections and capture a big part of the bigger trend. In this case you must have rehearsed and internalised the sort of situation you have just experienced. The market was up 10% or so in a few months. You must know that cannot continue. Your plan must be the result of you thinking through what you will do in such a situation. Will you grab the profits and run or will you hold. If you hold, you must have rehearsed how it feels like and internalised the balance between the regret and the ultimate aim of your plan.

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