Defeat Your Investments’ Worst Enemy
“Jupiter has bestowed far more passion than reason—you could calculate the ratio as 24 to one.”
That’s how 16th-century philosopher Erasmus of Rotterdam compared the power of the emotional brain to the rational brain. In other words, when emotions are in high gear, they are 24 times stronger than the rational mind.
Now I don’t know if the ratio is scientifically valid, but in my experience, it sounds about right.
All of us have experienced events in our lives when our emotions overtook our rational thoughts. I’m certain most of us have:
- Said something out of anger that we later wished we had not said.
- Been attracted to someone we knew was not good for us, but still went out with them or, worse, married them.
- Have cried, or seen someone cry uncontrollably, because of the loss of a loved one.
- Done something intentionally to hurt someone we love because we were hurt.
- Had our heart broken and not gotten over it for a long time.
When it comes to risking money, I’ve seen people do the same thing.
Just watch the stock market. In most markets, there is no logic, only the emotions of greed and fear.
But there are ways to take back control of your investment decisions from your emotions. Here are the most important three secrets that have led me to success…
1) Make a Plan
My rich dad said, “The problem with being young is that you don’t know what it feels like to be old. If you knew what being old felt like, you would plan your financial life differently.”
He also said, “The problem with many people is that they plan only up to retirement. Planning up to retirement is not enough. You need to plan far beyond retirement. If you’re rich, you should plan for at least three generations beyond you. If you don’t, the money could be gone soon after you’re gone. Besides, if you don’t have a plan for your money before you depart from this earth, the government does.”
Rich dad explained to me that investing is not what most people think it is. He said, “Many people think investing is this exciting process where there is a lot of drama. Many people think investing involves a lot of risks, luck, timing, and hot tips.”
Some realize they know little about this mysterious subject of investing, so they entrust their faith and money to someone they hope knows more than they do.
Many other so-called investors want to prove they know more than other people—so they invest, hoping to prove that they can outsmart the market.
But while many people think this is investing, that is not what investing means to me. “To me,” my rich dad said, “investing is a plan—often a dull, boring, and almost mechanical process of getting rich.”
2) Stick to It (FOCUS)
I like to think of the word FOCUS as Follow One Course Until Successful. My favorite two words of that acronym are these: until successful. Focus is essential for becoming a successful investor.
Focus is also power measured over time. For example, it is easy for me to stay on my diet from breakfast to lunch. But to stay focused for years on the diet is the true power of focus. I have gone on diets, lost weight, gained it back, and had to lose the weight again. That is the lack of focus over time.
The same thing happens in the world of money. People get rich, and then lose it all. Lottery winners and sports stars are prime examples of the loss of focus over time. Many professional athletes spend years practicing hard to make the big money in professional sports but are broke five years after retiring. They focused on sports, but not on their financial intelligence.
Focus also means staying successful beyond the goal. This means hanging on to the money after you make it, or keeping the weight off after you lose it.
Success eludes millions of people simply because they lack the power of focus. When people are in a focused state, the words “I can’t,” “I’ll try,” “I’ll do it tomorrow,” and “maybe” get forced out of their vocabularies. In many ways, being focused means “do or die” and “for as long as it takes.” When the going gets tough, many people lose focus and quit.
3) Limit Risk
Position size is merely the amount of money you are comfortable losing in a trade. One major mistake investors make is they size their position to the reward they want rather than to the risk.
My advisor on paper assets, Andy Tanner explains position sizing like this:
Suppose you have an account of $100,000 and you determine that your risk tolerance is 1 percent. It could be 2 percent or 0.5 percent, but for now, we’ll stick with 1 percent. So the risk in the trade as far as your stop-loss is concerned is $1,000, which is 1 percent of your total account.
You want to enter a long position at $39 and put in a stop-loss exit at $37. That means you could lose $2 in this trade. Under your position-size rule, the most you are prepared to risk is $1,000. So the largest position size you can take is 500 shares. This doesn’t mean you have to buy 500 shares, but it does mean you aren’t buying more than 500 shares. With this limit, if you must exit the position at your exit point of $37 you won’t lose more than $1,000. So if it goes against you and you lose it, you still have $99,000. Just as a table limit keeps the casino in business, your position size allows you to trade another day.
That’s an over-simplification, but it sums up the basic idea. With education and experience, you will improve your percentage of winners to losers. You will limit your position size so that you are only risking a minimal percentage of your account in any one trade.
To avoid this mistake of position sizing to the reward rather than the mistake is to commit to what you are willing to lose.
Conclusion: Never Stop Learning
I want to leave you with the most important lesson of all I learned from my rich dad.
I believe that the lack of financial education is why nine out of ten new businesses fail in the first five years, and why most investors think investing is risky and do not make or keep much money.
Most people leave school looking for jobs, not opportunities. They have been taught to work hard for ordinary earned income rather than passive income or portfolio income, and most have never been taught how to balance a checkbook, much less read and write a financial statement.
Rich dad said, “The difference between a rich person and a poor person is much more than how much money they make. The difference is found in their financial literacy and the standards of importance they put on that literacy.”
Simply put, poor people have very low financial literacy standards, regardless of how much money they make. He also said, “People with low financial literacy standards are often unable to take their ideas and create assets out of them. Instead of creating assets, many people create liabilities with their ideas just because of low financial literacy standards.”
Editor, Rich Dad Poor Dad Daily