This Common Bias Could Be Hurting Your Returns

Editor's note: The biggest mistakes on Wall Street often come from fear – fear of losing money or making the wrong move. According to Dr. David "Doc" Eifrig, CEO of our parent company MarketWise, a few simple safeguards can help investors control their emotions. In this issue, adapted from the Health and Wealth Bulletin e-letter, Doc shares three secrets to help investors stop "gambling" with their portfolios...

Don't fall for these headlines...

Several years ago, the New York Times reported that "trust your gut" could be profitable advice on Wall Street... while the Financial Times described "gut feelings" as key to financial trading success.

A 2016 study led by the University of Cambridge showed that better traders have better instincts... or a stronger connection between their mind and gut.

Researchers ran heartbeat-detection tests on their subjects. The idea is that the more accurately you can detect changes in your body, the better you are at reading complex and subtle market changes to make better trade decisions.

They gathered successful high-frequency traders – folks who held their trading positions for seconds or minutes, or a few hours at most – and compared them with undergraduate students as a control group. Sure enough, the traders scored far higher on the tests. Even more telling, the longer that someone had been a trader, the better his score.

Successful high-frequency traders may have a sort of "sixth sense" that helps them take in information and make snap decisions. For a certain group of investors, "trust your gut" may make them money.

However, the vast majority of us don't have this sixth sense. Instead, most people make terrible investing decisions when they listen to their "gut."

The Investor Psychology of Loss Aversion

The biggest trap investors fall into is something called "loss aversion."

Loss aversion is a well-known phenomenon. It has been studied and reported in financial and economic literature. Yet it trips up educated and ignorant people alike. It's very human. And if you're not aware of it, you'll lose thousands of dollars before you know it.

Longtime readers might remember the story of my friend Dr. Sue. She's a good example of loss aversion. Instead of cutting her losses early, Sue watched her entire portfolio tank. She was so afraid to make a mistake, she just kept watching her losses get greater and greater.

It's one of the most common mistakes in investing. And it's among the hardest lessons to learn.

Loss aversion goes hand in hand with something else called the "disposition effect."

The disposition effect basically means people hate losing far more than they like winning. It's the basic principle behind why people can lose their shirts in Las Vegas – they're more likely to take a gamble when they've been losing.

Dr. Sue was, in a sense, gambling with her portfolio. Instead of cutting her losses, she kept "gambling" on the chance they would bounce back. So her losses kept adding up.

This kind of behavior stems from fear – fear of losing money and of making mistakes. And fear comes from a tiny part of our brain called the amygdala.

Here's my secret: You don't need a sixth sense to figure out how to be a good trader. What you need are some tools...

How to Become a Better Trader

Secret No. 1. Control your fear.

Your amygdala senses threats, and your brain releases chemicals that trigger the "fight or flight" response... You get sick to your stomach, your pupils dilate, and you want to run and hide. Learning to calm your amygdala helps you evaluate things more logically, without falling prey to fear.

Meditation is my favorite way to reduce the activity in the brain's amygdala. Since the amygdala also contributes to anxiety disorders and stress, quieting this brain region bolsters more positive feelings.

In a 2011 study from the brain research journal NeuroImage, beginning meditators showed reduced amygdala activity when faced with fear-inducing images.

Another study from the National Bureau of Economic Research discovered that traders with happier, more positive moods (and, thus, quieter amygdalae) performed better in their portfolios.

Secret No. 2. Spread out your wealth.

Asset allocation refers to how you divvy up your capital across several asset categories. Changes in the market get smoothed out by the diversified nature of your portfolio... leaving you to sleep well at night.

The key is doing it from the start and sticking to it.

First, you should set aside some cash for emergencies... Then, start with a simple allocation: Decide how to weight stocks and bonds.

If you have a longer-term view and a high tolerance for risk, you might allocate 80% to stocks and 20% to bonds. If you're closer to retirement and don't like volatile returns, you could do 30% stocks and 70% bonds.

Most of us fall somewhere in between those extremes. The key is to find a balance that best suits your risk tolerance.

And remember, don't sink all of your 401(k) into one company or one sector. If it drops, you'll lose everything.

Secret No. 3. Use stop losses.

Stop losses take all the emotion out of your choices – replacing it instead with a decision to sell when your stock hits a certain price. No questions or hesitations.

There are two types of stop losses: hard stops and trailing stops.

Hard stops use a set price or percentage below the purchase price. If the stock falls to that amount at any time, you sell.

Let's say you purchase Stock X at $10 and set a 20% hard stop at $8. No matter what the stock price rose to, once it fell to $8, you would sell.

Trailing stops use a percentage below the purchase price, but the price doesn't stay the same. As the price rises, the trailing stop follows it.

For a trailing stop, let's say you initially set it at 20% below your purchase price. So for Stock X, you'd start out at $8, the same as a hard stop.

Here's the difference... As Stock X's price rises, its trailing stop also rises. So if the stock rises to $11, the stop would rise to $8.80. If Stock X kept going up to $15, the stop would be $12.

Both strategies work well in different situations. But in any case, you need stop losses to protect your investments.

You might never develop that sixth sense for the markets. But if you follow these three steps, you'll be well on your way to becoming a successful trader.

Good investing,

Dr. David Eifrig

Editor's note: Next Tuesday, five of Stansberry Research's most senior experts will reveal our official "Game Plan 2026." This is the single money move they believe every investor should make this year... built to perform even as markets are on a knife-edge. Plus, they'll each unveil their No. 1 stock idea for 2026.