Stock Investing: Do You Want to Feel Right or Make Money?
By Timothy Lutts, Chief Investment Strategist, Editor of Cabot Stock of the Month Report
If we asked thousands of investors what their main desire was, the most popular answer would undoubtedly be "to make money." And who can argue with that? It seems natural that every person investing in stocks is doing so to add to their wealth, which can then be used to improve their own lives. Increasing one’s wealth can help people pay for their children’s college tuition, a better house or a secure retirement and thus seems the only plausible goal for investors.
However, believe it or not, our 30 years of investment experience have taught us that one of the most pervasive desires of the average investor is something other than making money. Most investors have a secret craving to feel right. At first glance, these two goals appear to be synonymous. But as we will explain, nothing could be further from the truth. Here’s how a typical investor’s story progresses.
When an investor is getting ready to put his money to work, a lot of time is put into finding the best available stocks for purchase. Most investors will read various write-ups about certain stocks (possibly in the Cabot Market Letter or Cabot Top Ten Report), page through a few annual reports and study earnings estimates. After what usually turns out to be many hours of research, the investor comes to a conclusion on which stocks to buy. He then commits his hard-earned money to these stocks, feeling confident (maybe even excited) about the prospects for his investments.
Naturally, not all of these investments go the right way. It’s most troubling, as he watches some of the stocks he had the highest hopes for drop in price right after his initial commitment. Still brimming with confidence, the investor sticks with these losers, confident the decline is just temporary. But, as the weeks pass, these poor performers do not rebound; in fact, they sink to even lower levels.
Stunned by this development, the investor declares to himself that these stocks have become bargains. After all, if they were good buys when he bought them, then they must be even better buys at these lower price. Thus, he continues to hold on and at times even buys more of these stocks, hoping they will return to their previous heights.
On the other side of the ledger, the investor watches some of his choice selections soar from the get-go. He’s extremely pleased with this development…so much so that he’s eager to take his profits. His thorough research has obviously served him well, so the investor figures he’ll take the money off the table, garnering a quick gain of 30% or 40%. Feeling satisfied, he takes his wife out to dinner, and proceeds to tell her how smart he is.
The two investment actions described above both make the investor feel right. By taking profits out of a stock quickly, he feels as though his research was justified. After all, what can justify your efforts more than an increase in your brokerage account? And by holding on to the rest of his investments, which simply haven’t "come around" yet, he feels right by owning these well-researched and undervalued stocks.
It all seems so right, but there is nothing more wrong. This investor has sold his winning stocks while holding on tightly to his losers—the exact opposite of a successful investing strategy. By following his emotions (desire to feel right), he has sown the seeds of his portfolio’s demise. His portfolio now consists of a bunch of lemons and no good performers. And what good is that?
A statement from the book, Reminiscences of a Stock Operator which profiled the life of Jesse Livermore, one of the most successful and flamboyant stock speculators ever, sums up our thoughts: "Experience has taught me that the way a market behaves is an excellent guide for the [investor] to follow. It is like taking a patient’s temperature and pulse or noting the color of the eyeballs and the coating of the tongue."
With that said, it’s clear that holding on to your losers while selling your winners is the wrong way to go. The market is telling you that your losing stocks are losers for a reason…maybe because something is wrong with the company or new competition is coming on board. Conversely, your winning stocks are profitable for a good reason—namely, the market sees an ever-brighter future for those companies.
Thus, if you really want to make money, you have to discard your desire to feel right all of the time. Instead of giving yourself instant gratification by taking small profits, work to let your winners run while cutting your losses short. This way, your portfolio will consist of a bunch of strong performers with few, if any, lemons. And that will position you to make more money over the long run, which is the ultimate goal of investing.
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