There Are Two Types Of Capital Involved With Investing - Mental & Physical - But Which One Is More Important?
For many market participants psychology is the most dominant factor in successful trading or investing over a period of time, whether they realise it or not. In fact, some report that the psychological influence of the game is as much as 90%. Investors should therefore look at their accounts as two separate amounts of capital -
- The amount of money that is in their account, and
- Mental capital
And for the majority of us this mythical 'mental capital' is far more important and potentially expensive than the money capital because mental capital can do more damage.
Two Ways Mental Capital Can Hurt Us
1. Over Exuberance & Cockiness
- We've all been there, sometimes everything goes the way we planned. In our portfolios we own ABC stock, XYZ stock, some of the banks, a little bit of technology and over the last few months all the companies have rocketed in price - Perhaps this game isn't so hard after all?
- But whenever you start to get this sure of your abilities (maybe your skill was nothing more than right place, right time) disaster is usually around the corner
- Perhaps the stockmarket goes into freefall or you decide to buy more stock right at the top, whatever the case cocky investors usually get their comeuppance when cockiness is around
- One broker we know reports that a failsafe way to make money is bet against clients that have had a good run in the markets who then start crowing about their performance and profits
- One way to defeat this over-exuberance is to be aggressive in taking partial profits when you feel things just can't get any better alongside thinking the game is easy
2. Letting losses get out of control
- The best investors in the world all understand one simple truth, that successful investing is far more about understanding and managing risk than making money, defence instead of offence so to speak
- Of course, making money is the end result that's aimed for but the key question is normally how much risk was assumed to make a given return
- One of the ways to reduce risk is to start by asking how much money you'd want to lose on an investment should it go wrong. Surprisingly many investors never contemplate this, instead always concentrating on how much money they'll make when the stock rises in value
- But if you do at least some rudimentary risk analysis then you will also reduce the risk of your mental capital being lost because a loss won't come as a shock
- Here's an all too familiar occurrence that can deplete our mental capital and note the part hindsight plays within all of this
- Mr A buys a stock at £5.00 expecting it to go to £8.00
- However, it starts to fall in price moving to £4.50, Mr A now feels that he should have perhaps never bought the stock and will be very happy to sell it if it moves back to around £5.00
- The stock moves higher to £4.80 but then collapses to £4.00, now Mr A feels that of course he should have sold at £4.50+ when he had the chance, but won't miss £4.50 again should the stock rally
- It moves from £4.00 to £4.25 before going down to £3.00, the whole process of second guessing with hindsight goes on and on so massively depleting Mr A's mental capital
- And how is the reduction of mental capital affecting Mr A's other investment decisions?
- Mr A will likely be angry and negative with both himself and the stockmarket so it's highly likely he won't be concentrating on other investments or new investment decisions. Perhaps he'll miss some great opportunities or have no extra money to take advantage of them
- We've all been in situations such as these and so can easily relate how psychologically damaging it can be
So How To Keep A Good Supply Of Mental Capital
As we said above perhaps the most important way is to as we said above focus more on the potential risks than the rewards. This primarily means figuring out what you'll do should an investment go either up or down in value. For example if you bought ABC stock at £5.00 why not think like this -
Potential Upside Strategy - Buying the stock initially at £5.00
- If the stock rallies to £6.50 I'll sell 25% of my holding to lock in some gains, I'll also sell the whole position should it move back down to £5.00 after selling at £6.50
- I'll sell another 25% at £7.50, another 25% at my overall target price of £9.00 and as long as I still like the company and general stockmarket environment I'll leave myself with a 25% holding
Potential Downside Strategy - Buying the stock initially at £5.00
- If the stock moves 10% against me (to £4.50) I'll sell 25% of my holding
- If the stock moves 15% lower to £4.25 I'll dump another 25%
- And at £4.00 I'll sell the whole lot
- If I sell at £4.00 I will re-evaluate the situation to find out why things went wrong as well as figuring out whether the stock is still worth keeping an eye on
Of course, with the downside strategy above there's always the risk that you'd be selling out at the lows and then the stock rises sharply back to £5.00 and above. That is always a real possibility and it has happened and will continue to happen to disciplined traders who utilise some sort of stop loss strategy with their investments.
But the important point is that using such a strategy stops both your physical capital AND mental capital being entirely and viciously depleted by the potential big losses that are always dogging investors, especially us retail investors.
Summary
Describing mental capital is not easy but if we look at the above examples and how they relate to us personally, understanding mental capital becomes easier. The first successful strategy of using mental capital to our advantage is to recognise that it exists and is critical, then look at ways at controlling it. And in our view this is normally achieved by concentrating on potential losses and how you'll manage your investments in such situations.
