The biggest investing and trading mistake that people make is that they don't have a plan. They hear about a great stock, do a little research, buy it and then wait for the gains to pile up. Their only tactic that is employed is hope that that they made a good choice. The plan is to do nothing but wait until they are proven correct.
This approach works often enough that many people keep repeating it. It is similar to what makes a slot machine so addictive. The winners occur randomly but often enough to create the illusion that the jackpot is about to occur at any moment. Eventual funds are depleted and the game is over.
The reason that buying a stock without a plan is sure to produce suboptimal results is because the default position is to do nothing. You embrace inertia and inaction when you buy a stock with some vague hope that it will eventually pay off. Platitudes about patience help to reinforce the inclination to do nothing.
The primary reason that traders and investors don't make plans is that it is hard work. It is very complex and can require tremendous effort to try to anticipate a spectrum of outcomes. Where should a buy or sell stop be set? Where is a good place to take gains? What if market conditions shift? What if earnings or significant news, like FDA approval, is due? The possibilities are endless and there is no way to anticipate everything. Why make a plan when we are likely to be surprised anyway?
The reason you develop a plan is because it forces you to act. You must address the situation and not ignore it. One tactic the fund manager Lee Freeman-Shor used was to force his portfolio managers to make a decision when a stock is down 20%. Either sell or buy more. A decision has to be made to break the inertial of doing nothing.
Developing tactics and strategies for each stock you hold will put you far ahead of the crowd. Simply anticipating what action to take if a trade doesn't work is more than what 80% of other traders will do. However the danger of inertia of always lurking. Our tendency is to sit and do nothing further as we watch. We don't cut our losses and we don't take action to build on winners.
Having a plan is the first step but the second step is action. Every stock that you own should be reviewed with one question in mind 'do I sell or do I buy more?' Force yourself to make that choice. Doing nothing is not an alternative. If you are sitting on a losing position, do you have conviction to add to it or are just holding it because that is the easy decision? Can your money be better used elsewhere? Are you convinced that the market is simply mispricing this stock and that it will be a winner.
There is always risk that you will make the wrong decision but the opportunity cost of inertia is high and you will make the right decision often enough that there will be a net advantage.
Legendary investor Peter Lynch would use a process where he reviewed every stock he was holding as if he was hearing about it for the first time. If the fundamentals were worse and the price higher then he would be a seller. If the fundamentals were better but the price was lower, then he would be a buyer. The important thing was that he was forcing himself to make a decision and take action. Inertia was not an alternative.
An important component of this approach is to maintain flexibility. Don't go 'all in'. Always make sure that you have sufficient capital to buy more if a favored stock is taking a hit. What wipes out more traders than anything else is constantly adding to a position that is sinking and then panic selling when it doesn't bounce. When a position becomes too big, emotions take hold and decision making is impaired. Always maintain flexibility. 'All in' is a tactic for poker, not for investing or trading.
In investing and trading you always have to be ready to reduce very large position sizes so that you can regain your flexibility. If you are aggressive at selling then you can always buy more when the time is right.
Effective trading is primarily about managing your emotions. Our inclination to avoid hard decisions is one of those tendencies we have to deal with constantly. The easy thing to do is nothing but make that a conscious choice rather than a default position.
