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| Avoid
Common Investing Mistakes by Keeping Your Emotions in Check |
Published: January 10, 2006
Until now, my
educational columns have focused almost exclusively on fundamental stock
analysis, prudent money management, and techniques that you can use to
spot undervalued companies. While I believe these topics form the
foundation of a successful investing strategy, they are only part of the
equation. Knowing when to buy and sell can sometimes be more important
than knowing what to buy and sell. And when the time comes to make those
critical decisions, it is vital that any emotional impulses be
suppressed.
Over the long haul, achieving market-beating returns requires not only
solid analytical skills, but also an even temperament. It has been said
that fear and greed rule the market, and any investor who allows such
emotions to dictate his or her decision-making process will soon
discover that they are an impossible handicap to overcome.
For many investors, the ultimate goal is to become an expert at stock
selection. However, even the most astute analyst will ultimately earn
sub-par returns if he or she lets emotion become too much of an
influence. To demonstrate this point, let's evaluate the behavior of a
theoretical investor named Jane.
As an experienced investor, Jane has learned quite a bit about stock
analysis. Using that knowledge, she uncovers a sharply undervalued
company called Acme Ball Bearings that she feels has a promising
outlook. Jane immediately calls her broker and places a large buy order
for 1,000 shares at $10 per share. In the months ahead, her confidence
grows as Acme's shares begin to soar. Within six months, the stock has
more than doubled, and Jane begins to wonder whether she should lock in
her profits and sell. However, Acme seems to be in all the financial
headlines, and while she deliberates, the stock rises even more. At this
point, the shares have already surpassed Jane's intrinsic value
estimate, but she just can't force herself to liquidate a stock that
seems to go nowhere but up. Rather than sell, she is angry for not
having bought even more. This sentiment is reinforced the next week when
Acme rallies further still, finally topping out at $25 per share.
Then it happens: the stock drops sharply one day -- all the way back to
$18. Jane is unconcerned, though, and dismisses the sell-off as a minor
correction. She knows that she could still liquidate the position and
pocket a tidy gain, but hesitates because just a week earlier the
position was worth $7,000 more -- money that she feels has now been
lost. She promises herself that as soon as Acme rebounds back to its
peak at $25, she will instruct her broker to sell. Only the stock never
climbs back to its old highs. Instead, amid deteriorating sales and
earnings, Acme continues to retreat slowly back towards the $10 level
where Jane first purchased the shares. Not wanting to lose any money,
she finally decides to sell the stock at $10, exiting the trade at
breakeven.
Frustrated with herself, Jane begins to search for a new stock in which
to invest the proceeds from the disappointing Acme sale. Soon, she finds
another -- a retailer called Low-Mart -- that seems even more
attractive. However, her confidence is now rattled, and she is unsure of
trusting her own judgment. Instead of taking any chances, Jane decides
to wait on the sidelines and monitor the stock for a few weeks. As it
happens, her conclusions were accurate, and the stock begins to move
higher -- marching from $40 to $45. Jane is even more upset now, and she
decides to purchase Low-Mart as soon as it returns to $40. However,
instead of falling, the stock continues to gain ground and eventually
reaches the $50 mark. Jane has determined the shares are worth $65, so
even after the recent advance, she could still possibly book a
substantial profit. Unfortunately, after the $10 spike in the stock,
Jane feels she has "missed her chance" and stubbornly refuses
to pay $50. Sure enough, Low-Mart goes on to hit her $65 price target.
Hopefully, this overly simplified case study has pointed out something
that many investors fail to realize -- that profitable trading involves
more than just accurate stock selection. Jane's analytical work
uncovered two stocks that could have generated hefty gains. Because of
emotion, though -- greed in the first case and fear in the second -- she
didn't earn a single penny in profits from either idea.
Warren Buffett and many other well-known investors have noted that
successful investing is rarely correlated to intelligence. In fact, a
number of recent studies have even suggested that mentally challenged
people might make the best investors. A person need not possess a
razor-sharp intellect to be successful. Instead, he or she needs to be
able to control urges and resist the temptation to trade impulsively.
Academics have long been puzzled as to why some stocks become
astronomically overvalued while others languish well below their real
worth. In an efficient market, nearly all companies should trade for
their intrinsic value -- no more, no less. However, in order for a
market to be truly efficient, it is simply assumed that all participants
will make rational trading decisions. After years of study, researchers
have determined that this is simply not the case. In fact, an entire
field of study has evolved that attempts to address this imbalance and
explain the impact that psychology has on investing -- Behavioral
Finance.
If every investor sold his or her stocks when they became dramatically
overvalued, then there would be no market bubbles. Conversely, if every
investor decided to purchase stocks when they were severely undervalued,
then the market would never crash. However, anyone who witnessed the
dot.com boom of the late-1990s followed by the great bear market from
2000 to 2002, is probably well aware that investors do not always follow
such common sense guidelines.
Perhaps author Robert Hagstrom said it best -- "At the height of
optimism, greed moves stocks beyond their intrinsic value, creating an
overpriced market. At other times, fear moves prices below their
intrinsic value, creating an undervalued market."
In the end, investors who base their decisions on emotions or hunches
rather than thorough research will eventually run into problems. With
that in mind, I thought it might be instructive to delve deeper into the
subject of behavioral finance. Understanding what motivates others into
making irrational decisions can be beneficial for two reasons. Not only
can such insight give us a valuable edge, but it can also help prevent
us from making similar mistakes with our own portfolios.
In the analysis below I provide an overview of several of investors'
most common cognitive mistakes:
My Stock will Come Back Eventually
Researchers have found that investors are typically more upset from
losses than they are elated from gains. In fact, some studies have shown
that the average person derives twice as much disappointment from a $1
loss than he or she receives pleasure from a $1 gain. Inevitably, this
makes it difficult for some people to cut their ties to poorly
performing investments. After a stock is sold, a loss on paper becomes
an actual realized loss. Many people forlornly hang on to losers in the
hope that the price will eventually rebound -- or "come back."
This illogical tendency can turn modest losses into enormous ones.
If someone buys a stock at $20 that turns out to be worth just $10 a
year later, should they sell? The question to ask is not "how much
has the stock dropped over the past year?" but "what is it
likely to do in the coming year?" Have the company's underlying
fundamentals improved? Deteriorated? Remained constant? Assuming there
has been no material change, it may indeed be a good idea to hold, or
even to buy additional shares. However, if the assumptions that drove
the original purchase decision are no longer in place, then it is
senseless to hold onto the stock out of sheer hope. Here at
StreetAuthority, we take a buy and hold approach to investing --
not buy and hope.
One of the cruelties of mathematics is that after a 50% drop such as the
one above, it takes a 100% return just to breakeven. Even if the stock
does manage to achieve that goal in the years ahead, it still doesn't
mean that holding it was the correct decision. Instead, the proceeds
could have possibly been invested elsewhere in a stock that earned
+200%. Remember, losses from a mistake can be recouped anywhere -- not
just from your original investment.
Don't base a sell decision on how much a stock has fallen in days
already past. Instead, ask yourself, "Is this the best place for my
money in the days ahead." If the answer is "yes", then
you should continue to hold the stock. If the answer is "no",
then you should cut your losses.
Overconfidence
Overconfidence can take many forms and can be a dangerous -- and costly
-- problem for the unwary investor. Some investors have such confidence
in their abilities that they invest too heavily in a small group of
securities. This often results in extremely concentrated and volatile
portfolios. Others might assume that they know everything there is to
know about a specific company or industry, and thus decide to
discontinue any further research coverage. Finally, there are those who
refuse to read or even contemplate any contradictory viewpoints. Often,
if someone is bullish on a stock, they will only read other bullish
opinions and will quickly dismiss any bearish forecasts.
Each of these problems is easily avoided. Don't invest more than is
prudent in any one holding. Maintain a properly diversified portfolio.
And don't automatically ignore an opposing viewpoint; it may open your
eyes to unforeseen troubles (or benefits) on the horizon.
Nobody is infallible; sooner or later even the most well-informed,
sophisticated investor will make a mistake. When that time finally
comes, try to take something positive away from the experience.
Following the Crowd
Following the crowd is an easy -- but rarely profitable -- trading
strategy. It is simple to understand why so many novice investors adopt
a herd mentality. It is a common trait to assume there is safety in
numbers. If everybody is buying tech stocks, then maybe I should too. If
everyone is selling their small-cap stocks and rotating into large-caps,
then maybe I need to get out before it's too late.
Instead of following the crowd, it is often better to be a contrarian by
going against the grain. Whenever the markets are full of optimism and
everyone is buying, it stands to reason that stocks will be overvalued,
and thus ripe for selling. On the other hand, whenever the bears have
the upper hand and stocks have fallen sharply, this can be the best time
to pick up undervalued shares.
Many technical analysts follow contrary leading indicators such as the
Equity Put/Call ratio to determine the sentiment of the average trader.
When investor sentiment moves to one extreme or the other, it might be a
good idea to bet against the crowd.
Risk Aversion
Risk aversion can be a powerful motivator -- one that often works to the
detriment of long-term returns. While the overconfident might place too
much money in a stock, the overly cautious might invest too little -- or
even none -- in a company that has merit. This can be particularly true
after several previous unsuccessful trades.
Ultimately, everyone must determine their own risk tolerance and then
invest within those boundaries. Certainly there is nothing wrong with
avoiding risk and volatility; that is, after all, one of the primary
objectives of all value investors -- to invest in companies that offer a
definitive margin of safety. However, even the strongest of companies
will inevitably suffer short-term setbacks and knee-jerk sell-offs. In
these circumstances, it is essential not to let temporary concerns cloud
your long-term outlook. Panic selling might make you feel better
initially, but it will erode your returns over time. Trust your
judgment, and try to ignore any day-to-day price fluctuations.
Price Obsession
Many investors are unduly focused on arbitrary stock prices. It is quite
possible for a stock to be overvalued at $30 per share, for example, and
then a year later (with better fundamentals) for that same stock to be
undervalued at $40 per share. On the flip side, it is not unusual to see
a stock with sluggish financial results look like less of a bargain at
$10 than it may have been a year earlier at $20. In the end, it is not
the price that matters, but the difference between that price and the
stock's current intrinsic value.
In the case study above, Jane was overly concerned with stock prices.
She refused to pay $50 for a stock that she believed was worth $65,
simply because she had already lost out on an earlier opportunity to buy
it at $40. Many investors have lost money waiting on a stock to
"pull back" even though it offered a compelling risk/reward
profile at current levels. Remember, you don't need to buy at the exact
bottom -- or sell at the exact peak – in order to be a successful
investor.
Once a stock has reached my fair value estimate, I will take my profits,
or at least place a stop loss order to protect the gains. Although it
can be frustrating to see a recently sold stock continue to climb, it's
not nearly as frustrating as hanging on to one too long and watching
your gains quickly evaporate.
Conclusion
Each of these concepts is somewhat intuitive and easy to understand, but
putting them to practical use can be quite difficult. When emotions
enter into the picture, there will always be a tendency, for example, to
hastily unload a stock after disappointing news, or to fall in love with
a profitable pick and never want to sell. Such emotions are simply part
of human nature and thus can be difficult to eliminate.
Once removed, though, your portfolio will be free of emotional errors
and psychological distractions. In their place, calculated decisions
will be based strictly on the fundamentals. Ironically, removing all
emotion from the process will make for a more successful -- and thus
happy -- investor.
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Important Note: The above article
was merely a small excerpt from a recent issue we sent to subscribers of
our premium value investing service -- Half-Priced
Stocks. The mission of Half-Priced
Stocks is to help our readers identify securities that are
trading at the steepest discount to their intrinsic net worth. In some
cases this discount can reach up to 50% or more, giving savvy value
investors the chance to purchase quality stocks for just pennies on the
dollar. To receive your
copy of our most recent issue of Half-Priced
Stocks, as well as other guidance similar to this twice per
month, you'll need to subscribe to this publication. To learn more,
please visit:
https://web.streetauthority.com/subscribe-hps.asp
Thanks for reading!
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Nathan Slaughter
Editor
Half-Priced Stocks, The ETF Authority
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