The Most Common Mistake Investors Make During a Correction

The most common mistake investors make when stocks act poorly is they freeze. When a stock suddenly drops sharply, the attitude is that it is too late to do anything about it, so I'll hold on, and hope it will recover. When you aren't sure what to do, then the great likelihood is that you will do nothing. You will hide from the problem and not even look at it.

Sometimes patience is rewarded, and a broken stock bounces back nicely after it is pounded, but far too often, it goes even lower and never recovers. Most of the time, the best stocks to help recover losses aren't the same ones that caused the losses.

Inertia is an extremely powerful force. Newton's first law of motion is that an object at rest remains at rest until an outside force intervenes.

Once you fail to take action, it becomes increasingly difficult to act, and quite often, the situation has to become even worse before enough anxiety is created to drive capitulation. That is not a good way to make decisions, but those emotions are powerful and challenging to overcome.

So, how does a trader or investor break this tendency toward inertia and inaction?

The answer is sheer willpower. We must find ways to force ourselves to take action. The best way to do this is not to allow inaction to be a choice. Every stock should be reviewed regularly or after a big move, and then a choice must be made — sell or buy more. Why are you holding if you don't have the confidence to add to the position? Reduce the position if you have doubts and buy it back when you don't. If you believe that the thesis for the trade is still in place and that it will be a winner, then buy more.

Since most individual traders and investors don't have a boss looking over their shoulders and forcing them to act, they have to be their own bosses and force themselves to make decisions. Our default response will be to do nothing, so we have to eliminate that choice.

What is most important about this process is that it breaks the inclination toward inertia. Once you act, subsequent action becomes much easier. Most traders experience great relief when they finally dump a stock that has been bothering them, and they wonder why they waited so long to do something so simple.

When a decision is simplified to either buy or sell, it is easier to implement. One of my favorite pieces of market advice is from George Soros: "It's not whether you're right or wrong, but how much money you make when you're right and how much you lose when you're wrong."

That advice requires that you constantly consider the "sell or buy more" decision. Your chances of avoiding significant losses are increased, and your chances of making big money are enhanced. You will inevitably make mistakes and buy when you should be selling and vice versa, but the tendency toward action helps you to minimize the impact of mistakes.

Legendary investor Peter Lynch used a variation of the "sell or buy more" approach. He reviewed every stock he held as if he were looking at it for the first time. If the fundamentals were worse and the price higher, he would be a seller. If the fundamentals were better but the price lower, he would be a buyer. The important thing was that he forced himself to make a decision and take action. Inertia was not an alternative.

Lynch is well known for being a very active investor. He didn't just buy and hold. When he had a loser, he cut it quickly, but when he had a winner, he was more aggressive with his buying.

The tendency toward inertia is primarily caused by never making a plan in the first place. When forced to react to something that wasn't anticipated, the default reaction is to do nothing. A lack of planning is at the core of this problem. People hear about a great stock, do a little research, buy it, and then wait for the gains to pile up. The only tactic that is employed is hope that they have 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. Eventually, capital is depleted, and the game is over.

The reason that buying a stock without a plan is sure to produce suboptimal results is that you will do nothing further. 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.

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 in a losing position, do you have the conviction to add to it, or are you 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?

The most common reaction to anxiety is inertia, but the easiest way to wipe out substantial gains is to freeze and do nothing.

At the time of publication, DePorre had no position in any security mentioned.