Selling Stocks - Lesson 3

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 make money, 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 nicer house or a secure retirement. It seems the only plausible goal for investors.

Believe it or not, our more than 35 years of investment experience has taught us that one of the most pervasive desires of the average investor is actually something other than making money. Most investors have a secret longing to feel right. Now, at first glance, it may seem that these two goals are synonymous. After all, when you make money in the stock market, you feel right. But, in practice, these two goals are diametrically opposed. Let’s take a look at how a typical investor’s story progresses.

When an investor is getting ready to put his money to work, a lot of time is spent trying to find the best available stocks for purchase. Most investors will read various articles about certain stocks, 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 his prospects for making money in the stock market.

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. Weeks pass, but these poor performers do not rebound; in fact, they sink to even lower levels. Stunned by this development, the investor tells himself that the stocks have become bargains. After all, if they were good buys when he bought them, they must be even better buys at these lower prices. Thus, he continues to hold on and perhaps buys even more of these stocks, hoping they will return to their previous highs.

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 good he is at making money in the stock market.

The two investment actions described above 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 strategy that will help you make money in the stock market. By following his emotions (his 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. Is that any way to make money in the stock market?

A quote from Reminiscences of a Stock Operator, which profiled the life of successful and flamboyant stock speculator Jesse Livermore, 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.”

Clearly, 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 of those companies.

If you really want to make money in the stock market, 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 in the stock market over the long run, which is the ultimate goal of investing.

J. Royden Ward knows how to make money in the stock market. He’s also a value investing expert and Chief Analyst of Cabot Benjamin Graham Value Investor

Next: Investor Sentiment

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Roy Ward uses the PEG ratio to determine if the stock is undervalued or overvalued.

For AMZN to be undervalued, the stock would need to fall to 393. 50.

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