The psychology of investing

Hi Lindsay,

This is an excellent question because the hardest part of investing is rarely finding an interesting idea; it is managing ourselves once money is involved. The answer here is a bit of a long one, but it’s a topic that could/and does, fill many books. Here’s the most succinct take we can come up with, without describing a rudimentary system like running a stop loss that takes you out of the trade if the price drops by a certain amount.

The first point I would make is that emotions cannot be eliminated. Even professional investors feel fear when a position falls, regret when a stock rises after they have sold it, and overconfidence after a successful trade. The objective is not to become emotionless, but to build a process that prevents those emotions from making the decision for you.

Your Elixir Energy example is a good one. Buying at 4 cents and selling at 16 cents was clearly a successful investment, but the subsequent fall to 8 cents does not prove the original decision was brilliant, just as a continued rise to 30 cents would not have made the sale a mistake. Every investment contains a mixture of research, judgement and luck. The better question is: did you have a sound reason for buying, did the position size reflect the risk, and did you follow a sensible process when selling?

In this case, taking a fourfold return from a speculative small-cap energy stock was certainly not an irrational decision. The share price had moved a long way, geopolitical developments had likely accelerated the move, and the potential downside had increased materially. You may have sold too early relative to the absolute peak, but capturing a substantial profit while the market was offering it is very different from panic-selling a quality company simply because it had risen.

One of the most common behavioural traps is the disposition effect: investors tend to sell profitable positions too readily while retaining losing positions for too long. Loss aversion contributes to this because crystallising a loss forces us to admit that the original decision may have been wrong, whereas selling a winner provides the immediate satisfaction of being proven right.

However, the answer is not simply to hold every winner indefinitely. Some winners continue higher because earnings and business quality are improving; others have merely experienced a speculative rerating that is unsupported by fundamentals. The discipline/skill lies in distinguishing between the two.

For a medium-term investor, I would suggest the following framework:

1. Define the thesis before buying. Write down why the stock should rise, what timeframe you are considering and which developments would prove the thesis wrong. A thesis such as “eastern Australian gas shortages will improve the value of Elixir’s resource” is more useful than simply believing the price will rise.
2. Separate the company from the share price. A good company can be a poor investment at an excessive valuation, while a speculative company can produce an excellent trade from the right entry point. Always ask whether the potential reward still justifies the current risk.
3. Size speculative positions appropriately. The more uncertain the outcome, the smaller the initial position should be. Correct position sizing reduces the emotional pressure to sell during normal volatility and ensures one mistake cannot materially damage the portfolio.
4. Decide in advance what would trigger a sale. Valid reasons include the original thesis breaking down, management disappointing, funding or balance-sheet risk increasing, valuation becoming excessive, price momentum materially deteriorating, or a more attractive opportunity emerging.
5. Consider trimming rather than making an all-or-nothing decision. After a position has risen substantially, selling part of it can recover the original capital or reduce the position to a more sensible portfolio weight while retaining exposure if the story continues to develop.
6. Use price discipline, but allow for normal volatility. For medium-term positions, the relevant question is whether the trend has genuinely changed, not whether the stock has experienced an ordinary pullback. Stops can help, particularly in speculative stocks, but they need to reflect the volatility of the security rather than being set at an arbitrary percentage. A volatility based measure here is some like like 2x the Average True Range over 20 days (short term) or 20 weeks (long term).
7. Keep an investment journal. Record the thesis, expected catalysts, risks and reasons for buying or selling. Review the decision several months later, but judge it using the information available at the time—not with the benefit of hindsight.
8. Assess the process across many investments. One trade tells you almost nothing about skill. A repeatable record over 20, 50 or 100 decisions is far more informative. Good decisions will sometimes lose money, and poor decisions will sometimes make money.

A useful question before selling is: “If I did not already own this stock, would I buy it today at the current price?” If the answer is clearly no, holding purely because you already own it may be an example of emotional attachment. Conversely, if the thesis remains intact and the risk-reward is still attractive, selling simply to secure the psychological comfort of a profit may be premature.

We actually wrote a note to members & investors last week highlighting a tweak to our approach given changing dynamics in the market, and some shortcomings identified in our annual review of our results – the note can be read here. 

The books I would recommend are:

• The Psychology of Money by Morgan Housel — probably the most accessible starting point. It explains how behaviour, personal experience, patience and risk management often matter more than raw intelligence in financial outcomes.
• Thinking, Fast and Slow by Daniel Kahneman — a more detailed examination of loss aversion, overconfidence, anchoring and the distinction between instinctive and deliberate decision-making.
• Thinking in Bets by Annie Duke — particularly useful for separating the quality of a decision from the eventual outcome and for thinking in probabilities rather than certainties.
• The Art of Execution by Lee Freeman-Shor — highly relevant to your question because it examines how professional investors respond after an investment begins winning or losing.
• The Most Important Thing by Howard Marks — excellent on risk, cycles, second-level thinking and avoiding the emotional extremes of markets.

Ultimately, disciplined investing is not about selling at the exact top or buying at the exact bottom. That is largely unrealistic. It is about repeatedly making decisions where the prospective reward is attractive relative to the risk, which is why we often write in terms of risk/reward, protecting capital when the thesis changes (something we can do better), and allowing genuine winners enough time to make a meaningful contribution.

On the basis of what you described, I would not regard the Elixir trade as dumb luck. Research identified the opportunity, the market provided a very strong return, and you chose to realise it. Luck undoubtedly influenced the extent and speed of the move, particularly around geopolitical events, but recognising that distinction is itself a sign of sound judgement. The key now is to turn that experience into a repeatable process rather than concluding that every position should be sold after it rises fourfold, or that every winner should be held indefinitely.

Sorry for the long winded answer, but hope that helps.