It’s usually easier to do the wrong thing than the right thing. Or to do something poorly than to do it well. This is particularly true when it comes to your money – whether you’re investing it, or spending it.
But asking yourself these three questions – before you spend or invest – may help you avoid (or minimize) some of the most expensive mistakes.
1. Why am I buying it/investing in it?
There aren’t that many reasons to buy an asset. It might be something you need, like a refrigerator. Maybe you’re buying a bungalow on the beach because you want a relaxing place to get away. Or you might buy a stock because you want it to go up in value, or pay you dividends.
Whatever the reason, anything you buy is an investment – even if you don’t think of it that way. You expect to get a return from it – whether that “return” is keeping your beer cold, the feel of sand between your toes, or more cash in your brokerage account.
Just be sure that you remember why you’re buying something. After all, you wouldn’t be upset if that biotech stock you bought doesn’t keep your wine chilled – that’s not what you bought it for. In the same way, if your beach bungalow collapses in value, it shouldn’t bother you too much – because remember, you bought it as a vacation getaway, and not as an investment.
And take the time to think it through. As famed investor Peter Lynch said, “Invest at least as much time and effort in choosing a new stock as you would in choosing a new refrigerator.”
2. When am I going to sell?
If you don’t have a goal, you’ll never know if you’ve achieved it… and you won’t know to sell if you don’t have an idea about when (or why) you’re going to sell.
You should sell something when the reason that you bought it is no longer valid. Like if the fridge heats instead of cools, the beach house is no longer relaxing, or the stock falls in value. If these things happen, your investment isn’t providing the “return” that you expected. That’s the time to re-evaluate your investment, and decide whether to sell it and put the money to better use.
When you buy an asset, you probably don’t know exactly when you’re going to sell (and in fact, you probably shouldn’t). It’s not going to be a date on the calendar, circled in red one day in the future. But the day you buy something, you should know what your criteria will be for selling – and be ready to sell when those criteria are met.
With stocks, it’s easy… you should set a stop-loss that will trigger the decision to sell. If the stock falls, a stop-loss will limit your losses. And if what you buy goes up in value, a stop-loss will ensure that you keep most of your gains.
3. What am I not buying?
There are an infinite number of things that we could buy. But we don’t have an infinite amount of money (unfortunately). So whenever we buy one thing, we’re making an explicit decision to not buy many other things. And there is a cost associated with that decision – it’s called the opportunity cost.
When you’re investing in stocks, the opportunity cost is easy to figure out. You can see how other stock prices changed after you made an investment decision, and (if you want to torture yourself) look at how much money you might have made.
But the “cost” of what you didn’t buy is less clear with respect to other types of goods. The money you spend on surf getaway is cash that you’re not putting away for your children’s education. You’re also not buying shares in a stock that could double or triple in price in coming years (or in a stock that could fall to zero).
When you understand what you’re not buying, you might change your mind about your purchase. Or, you might decide that, given your aims and objectives (see point 1 above), what you’re buying is the best possible use of your funds.
After you’re finished answering these three questions, there’s one more thing to remember: You’re buying everything you own again right now. So ask yourself: “If I had the cash in my hand to buy this thing right now, instead of the thing itself [whether it’s a refrigerator, beach bungalow or stock], would I still buy it right now?”
Every moment that you’re holding onto an asset, you’re using valuable capital that you could put to a different use… so every day you are “buying” something that you already own.
Answer these three questions, and you’ll avoid a lot of the ways that our emotions can be investment pitfalls. (Click here for a report we put together on how some of the world’s best investors have let their emotions get in the way of their investment decisions – and paid the price.)