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Building upon the last chapter, we are now ready to explore and face the mistakes that nearly every beginning investor makes. Do not skip over this or any other part of the book because you need to be aware of these mistakes. Otherwise, you may spend years learning these lessons the hard way. Practicing these errors versus not practicing them makes a very large difference in your rate of return, not just a small difference. Generally, in fact, it will make the difference between a large positive rate of return and a large negative rate of return.
Obviously, there is a relationship between the investor myths of the last chapter and the errors reviewed here. Each of these mistakes is traceable to the myths. As was said earlier in the book, if you are to change your investment results, you must first change your thinking. If you have read and understood what's been written so far, you are well on your way to doing this.
No matter how well or poorly founded, every stock selection strategy produces both losers and winners. In the case of both losers and winners, the reason for selling a stock is always the same: To preserve capital and allow you to re-deploy it to more profitable investments. The relevant question is, "how to determine the right time to sell?"
The time when you can think most clearly about why you would eventually sell a stock is before it is purchased. Before you buy anything, you have no emotional attachment to it, which means you can make totally rational decisions. Once you own something, you tend to get either greedy or scared. These emotions lead to a desire to preserve profits, leading to prematurely cutting off an ascending price trend.
Big losses are one thing which destroys most investor's performance, and these are almost always a direct result of the investor failing to plan, before entering a trade, how he will exit it. Since the potential gains from a stock are always higher than the potential losses (100% loss potential versus unlimited upside potential), an even bigger source of under-performance is selling too soon when you do find a great winner.
An exit plan is one thing that experienced investors/traders always have before initiating a position. The reason is simple: you must have a plan and stick to it, or else every decision you make will be emotional, not rational. Worse yet, the larger the position is, the less rational your decision-making will be. Therefore it is vital to make all decisions up front, before you are scared (if the position happens to go down), or greedy (if it soars). Emotional decisions almost always are poor ones, leading to large losses and small gains.
The pitfalls of trying to manage a stock portfolio without a plan are many and varied. The advice of friends, stockbrokers, market advisors, and the like are all likely to have a magnifying effect on the natural elements of fear and greed that are present in every investor. These influences can cause someone who does not have a well-thought-out plan to abandon profitable positions and hang on to losing ones. This is exactly why the majority of amateur investors under-perform the market: they do not have a plan. As the saying goes, "when you fail to plan, you plan to fail." This saying is as true in the stock market as it is in any other aspect of life.
With emotions running rampant from a loss or a large gain, it is virtually impossible to make a good decision. This is precisely the point at which most investors fail: They have no preconceived plan for exiting a stock before they buy it. As a result, when they hear a tip or rumor on a stock they get so excited that they forget to ask themselves what they will do if it turns sour, or if it soars, what will be their plan for letting the profit ride? If the investor who doesn't plan ahead also happens to believe some of the myths presented in Chapter 1 then his/her chances of making a good decision are almost nil. If you are a decision-maker of any kind, you no doubt realize that making decisions based on wrong assumptions renders your chances of success to be miniscule. For this reason, the need for an exit plan based on sound theory before a stock purchase cannot be overemphasized. Unfortunately, most investors don't want to think about planning ahead, (especially for adverse possibilities) when they are buying a stock - they put the selling criteria decision off until it is unavoidable, and usually too late.
An exit plan must be identified for every investment before the investment is made. This plan should cover all possible outcomes of the trade, both profit and loss.
Another common error committed by many investors is plunging. This means that the investor makes two mistakes: First, they purchase entirely too large a position in a single stock. Secondly, they do it all at once. The real problem with doing this is that the investor puts themselves in a perfect position for their emotional decision-making to run wild. Typically what happens is the following: First, the plunger takes a huge position. Then, his stock either begins declining or increasing. In either outcome, the emotions of plunging work against the poor investor. For if the stock declines, the plunger will either get scared and sell out with a loss that is a sickening percentage of his capital, or hold on in hopes of an increase in value (which may well never happen). If the stock increases in value, the investor will often have a large dollar gain that is hard to resist cashing in. In this latter case, the investor makes the mistake of cutting his winnings short. In short, plunging leads to cutting your potential gains short and letting your losses keep mounting...exactly the opposite of what you should be trying to accomplish.
Almost always, the plunger lacks an exit plan for the purchase before buying. If the plunger had thought about an exit plan beforehand, he probably would have realized the potential pitfalls and would have taken a more appropriately-sized position.
Plunging can work occasionally if one is fortunate enough to select a stock that immediately increases in value and never looks back. However, in most cases the plunger has such a large percentage of his capital riding on a single stock that the emotions of greed and fear work against him in a major way. The normal fluctuations of stock prices have an exagerrated effect on the plunger's emotions by virtue of the huge amount of capital represented by the position.
Taking too large of a position leads to emotional involvement which leads in turn to poor decisions. It also exposes you to the potential for lots of damage from one bad trade. Diversify - don't bet the farm.
A certain percentage of stocks you choose will show themselves to be losers. Count on this fact. These losers must be dealt with in some way in order to limit their impact on your overall performance. Once a stock starts to decline it can become a viscious cycle, leading to even more declines. As unbelievable as it seems to the novice investor, the more and longer a stock declines the more it is apt to continue declining, or continue going sideways.
Even if a stock does come back, it will likely take a long, long time to do so, and time is money. For this reason, it is important to stop the bleeding once it becomes apparent that you have chosen a loser. Here as elsewhere, the actions of most investors are opposite the logical course of action. Most hold on to their losers, hoping against hope that the stock will someday pull itself together. Some also hold on because they can't face up to the fact that they made a mistake. They reason (poorly) that as long as they don't sell, then they haven't really lost anything. This is a error because the value of their stock is the current market price, not what they paid for it - but their rationalization helps them feel better about themselves. The driving force behind this type of thinking is dealt with in Chapter 3.
The other compelling reason for selling losers is the concept of opportunity cost, that is, the money you could have made by re-deploying your capital to a more promising investment. Often, the opportunity cost of holding a losing stock is far greater than the loss on the stock itself. Let's say we have $10,000 invested in a particular issue and it declines to where it is worth only $8,000. There are two reasons to consider selling the stock in this example. First, the stock is clearly in a downtrend, and like most trends, the decline is most likely to continue. If it does, the decision to sell may save us as much as $8,000, the current market value of our stock.
The second reason for considering cutting our loss short is that by re-deploying the $8,000 into a stock that is trending upward, we increase our chances of making up the $2,000 loss more quickly than if we'd continued to hold the losing stock, waiting for it to come back. The distinct possibility exists that we could make up the $2,000 loss and make an additional $8,000 profit by re-deploying our capital from the declining stock to the ascending one. All the while, the original purchase may still be languishing far below where we dumped it. While there are no guarantees that the ascending stock will continue ascending, it is a much better bet statistically than the declining one. In the stock market, going with the long-term statistics is a key to long-term success.
Beware of the common compulsion to hold onto your losers. If you do succumb to this temptation, your portfolio may still be profitable (as long as you also do not sell your winners), but it will not be as profitable as it could be.
Another error that cuts seriously into many investors results is the error of selling a winning stock too soon. Though it might seem that this is a relatively minor problem, it actually is a very serious error because it robs you of your really big profits. I believe it is a bigger mistake than failing to cut your losses, because in a properly diversified portfolio the potential profit from any one stock is far more than the potential loss. That's simply another way of saying that the most you can lose on a single stock is 100% of what is invested, but the potential gain from every stock is unlimited. If your objective is to make as much money as you can, then you must put yourself into a position to hold onto really big winners when they come your way. If you have a strategy that emphasizes taking the money and running every time you get a double or triple, then you are seriously shortchanging yourself.
I believe the reason most investors fail to hold onto winners long enough is that they simply do not realize how big a move can sometimes be realized. They wrongly assume that if a stock has doubled or tripled then that is about the best they can hope for. However, investors who take the time to study the history of stock trends know better. Sometimes a stock that has doubled will go on to make another tenfold increase from there. It can (usually does) take years for this type of move to occur, but over a several year time frame your chances of finding a huge upward trend is far better than you'd think. Again, the best way to convince yourself of this is to get a long-term stock chart publication and start studying it.
Another insidious reason for investors selling too soon is the use of price objectives. This is when you buy a stock and set a price that you will sell at if and when the stock makes it to the target price. These target prices are usually arrived at as a certain percentage above the entry price, or else are based on some analyst's assessment of the 'value' of the stock.
However arrived at, I feel that the use of target selling prices is a seriously flawed practice. One of the enigmas of the stock market is the tendency for what seems overvalued to keep going higher still, and what seems reasonably valued or cheap to keep on retreating. The reason is that when a company's earnings are (or are about to start) growing rapidly, the price of the stock may be high relative to the current earnings, but only a few times the next year's actual earnings, if next year's earnings could be known. The stock may even be selling for many times the earnings estimate for next year, because it takes time for good trends to be recognized and assimilated by stock analysts. Thus, stock analysts' earnings estimates for coming years tend to lag when something good is brewing, just as they often lag when bad things are in the works. The thing to remember about this is that the aggregate consensus of all market participants (as reflected in the stock's price trend) tends to be more accurate and more timely than published earnings estimates.
If you study stock trends I believe you will come to the conclusion that the trend of a stock is a more accurate indicator of when to sell than are calculated estimates of a stock's ‘value.' Why then are price objectives used? The reason they are so popular is because of the need for retail brokerage houses and newsletter writers to give some sort of selling advice to large numbers of retail clients. Through the use of price objectives, the task of giving advice to large numbers of people is made manageable for the advice-giver. However, it seldom results in the best possible outcome for the client. This is a good reason to become your own investment advisor and portfolio manager. The use of price selling targets mostly results in you capping your profits, as you cannot possibly make more of a profit than that which is reflected in the target price. Finally, it should be obvious to all that capping your profits is not a good thing. If you employ a strategy which cuts your losses but also caps your gains, by definition you'll be worse off than if you had bought your stocks and done nothing but sit on them forever.
Don't try to guess how far a stock can move up. If you do not give your stocks a lot of room to move upward, you will guarantee that your stock market profits will be below average.
Buying stocks which are in a downward price spiral is the most common mistake among novice investors. In order to profit from such a strategy, you need to be right about two things at once : First, that the stock's slide will end (a surprising number never do until they become worthless), and secondly, the timing of when (and at what price) the stock's slide will end. Your chances of being right about both things are slim.
The typical scenario for this particular mistake is an inexperienced investor scouring the stock pages looking for stocks near their 52-week lows, since this information is readily available. The novice wrongly assumes that if a stock is near its low for the year then it must be "low" and therefore in an opportune position to be bought. As we have seen, the hapless bottom-fisher finds out after it is too late just how easy it is for such a stock to keep on making new (and even lower) 52-week lows.
As an aside, it's interesting to note that it's fairly common that a stock which is today making a new 52-week high has as its 52-week low a price that was a 52-week high< a year ago. That might seem like a confusing statement but if you think about it, it will make a lot of sense. If the stock has been in an uptrend for a year or more, that price which was once a new high will now be listed as the lowest price for the past 52 weeks. Beginning investors usually do not even consider the possibility that this could be true, so they keep on buying dogs until their portfolio looks like a kennel.
Often, investors convince themselves that buying a stock from the 52-week lows list is not a risky proposition because of that stock's low price relative to past earnings, book value, or some other measure of "value." But in reality buying a downtrending stock is always risky, as you are betting against the entire market's assessment of the company's earnings trend. If a stock is making a serious decline it is because market participants know some facts about the company's future earnings potential - facts that you may not be aware of no matter how well you research the company. Seldom is the entire market wrong about these matters. Sometimes the market is wrong, of course, but your chances of finding those exceptions are mighty slim because you are only one of thousands of people who are looking for such leads. It is very hard for one person to correctly second-guess the sum total wisdom of thousands of other investors. Try to keep in mind that your objective is to maximize profits, not to outsmart the market. The two objectives are vastly different.
Much of the problems associated with this strategy have already been dealt with in Chapter 1, under the section: Buy Low and Sell High. There is no need to re-hash that section now. However, the practice of buying downtrending stocks is such a pervasive and major error that the importance of eliminating it from your bag of tricks cannot be overemphasized.
Listen to the signals of the market. If a stock is trending steadily downward, there is a good reason for it. Find greener pastures elsewhere.
Another strategic error commonly practiced by many amateur investors is adding more money to a losing position. The reasoning in the mind of the investor who does this goes something like this: "I bought the stock when it was $40. Now it is $20, so it's twice as good a deal as it was at $40. Besides, my average cost per share will come way down once I add to the position." Sometimes this is called dollar cost averaging - putting an certain dollar amount into a stock at specified time intervals or at specified price intervals when the stock drops in value.
When an investor adds to a position on equal time periods (ie, $1,000 every quarter) independent of the price of the stock, I call it Time-Based Dollar Cost Averaging. When an investor invests an equal dollar amount each time a stock declines in price by a certain level (ie, $1,000 with each 20% decline in price), it is called Price-Based Dollar Cost Averaging - (this practice is sometimes called Scale Trading and is discussed in Chapter 6). What you need to remember is that while Time-Based DCA can make sense if done in a controlled manner, Price-Based DCA makes no sense in any circumstances and is sure to bankrupt you if practiced consistently. The rest of this section I want to devote to explaining why you must never practice Price-Based DCA as a strategy, because it is the most destructive of all investor mistakes and represents in the extreme why you should never add to a losing position.
The fallacy of Price-Based DCA can best be illustrated by the following example. Let's assume we have the ability to anonymously observe a certain naive investor, Mr. Jones, who is going to pursue a Price-Based Dollar Cost Averaging strategy. Mr. Jones picks a portfolio of ten stocks and puts $10,000 into each stock, for a total investment of $100,000. Just for fun, let's also assume we know ahead of time that one of the stocks in Mr. Jones's portfolio is going to go bankrupt (that is, decline until it becomes worthless) sometime within the next year. (Of course Mr Jones doesn't know this, and we aren't going to tell him, either). But, since he is a devout Price-Based DCA advocate, his trading rule is that whenever one of his stocks declines 50% in price from his purchase point, he will sell $5,000 worth of one of his better-performing stocks and use the proceeds to buy more shares in the declining stock. If the issue declines another 50% from his second purchase point, he will sell another $5,000 of one of his other stocks and again add to this declining stock. Can you guess what will happen to Mr. Jones over the next year as we watch him trade? It should be an agonizing thing to watch because, as you may have figured out by now, Mr. Jones's strategy will over the course of the next year automatically allocate all of his capital to the stock that is to go bankrupt. This is because there are an infinite number of sequential 50% declines that can occur between his initial purchase point and zero. He will lose his entire $100,000 unless he has the good sense at some point to realize what a bloody poor strategy he has.
If you pursue a Price-Based DCA strategy consistently, eventually you will encounter a Waterloo as Mr. Jones is about to. This is because inevitably you will someday get a stock in your portfolio that is bound for the scrap heap. When you do, cut the loss and don't even think about adding to the position! Otherwise, you may find yourself standing in bankruptcy court with Mr. Jones.
When you have a losing position, it means something is starting to go wrong. Never add to a losing position.
It's a common mistake to have a good run with a stock and then decide that you will never sell it. Some folks have a hard time parting with something that has done so well for them, but again, what your emotions tell you to do and what you should do are two different things. Save the ‘till death do us part' thing for your marriage, not for your stocks. Even a noted long-term investor like Warren Buffett takes profits occasionally. As of this writing (1995) many people are of the mindset that bull markets go on forever, but few remember that Buffett cashed out nearly completely in the late 1960s. Besides, few people have the skill to pick truly long-term investments the way Warren Buffett has. So for most of us the time comes when it makes sense to re-deploy our assets to something more productive.
Every gardener knows that the fruit of even the best-growing plants eventually needs to be picked before it turns overripe and finally, rotten. Likewise, even the stocks that grew so well in their season eventually need to be sold. Some plants are annuals, lasting but a single outstanding season and then dying. Others are like apple trees, bearing fruit year after year, but eventually they decline in productivity and die or produce substandard fruit. A stock can have a phenomenal rise that lasts many years, but most will eventually start lagging and break down. In the most extreme case, they may go from star to oblivion and bankruptcy. Therefore we must reap, but we need to make sure that our reaping is not done prematurely but allows for long-term growth. The perfect system would be one which tells us the exact top, but that is impossible in reality. We must instead find a balance between selling too soon and selling too late. It must not be done based on guesswork but instead on the actual performance of the stocks in your portfolio. There is no doubt that our chances of making really big money on a stock increases commensurate with the length of time we hold it. As you will see later, the Reverse Scale Strategy sets its parameters so that we do not engage in short-term trading.
Try to remain emotionally unattached to a stock so that you are not blinded to what the market is telling you about it.
One of the big investor mistakes I've observed is that some investors, once they've taken a loss on a stock, keep looking for an opportunity to buy that same stock. Without realizing it, they become enamored of the stock simply because it has "done them wrong." Like an adolescent who's been beaten up, they are looking to "get even." "I'll show that stock," they say to themselves. By so doing they lose focus of what they are trying to do: Make money, not save face. There are thousands of companies available for them to invest in , so why do they keep coming back to a proven loser? The answer is, of course, ego. Ego is one of the most destructive forces that you can unleash on your investment performance, and we will take a close look at how it manifests itself in the next chapter, so you can recognize it. It crops up in everyone now and then, but when it does, you must resist it and think logically.
If you are fishing and a fish slips off your hook, do you refuse to pull in any fish other than the one that got away, from then on? Of course not - you throw your line back into the water in hopes of catching "a fish," not "the fish." It seems obvious when fishing, but unfortunately, many people's common sense goes out the window when it comes to the stock market. They keep gunning for that one particular stock, ignoring the other rich targets which abound around them. Thus, one mistake begets another.
Sometimes, people also return to a stock because they had such a good experience with it. They made some good money off this stock and so they have warm, fuzzy feelings for it. Again, this is not logical thinking unless the stock has recovered and is showing itself still to be one of the stronger stocks in the market.
Once you have sold a stock, forget it, whether it was sold for a profit or a loss.