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The Dangers of Being a Promiscuous Investor

John Price, Ph.D.

The idea of choosing stocks that are rising quickly and then ditching them when they slow down in favour of other fast-risers is very seductive. It is like the old pony express riders who would hop onto new horses when the ones they were riding began to tire.

If only it was that easy. There are a number of things that make this highly unlikely in practice. First of all, just because a stock price rises quickly over a period of time such as a month is no indication that it is going to continue doing this over the next month. At the same time, it is no indication that it is going to do the opposite over the next month.

Actually it is a little more complicated than this. One large scale study showed that, on average, stocks that outperformed the market for a month tended to underperform over the next month whereas outperformers over 12 months continued to outperform over the next month. But these effects are small and vary enormously between stocks.

Large scale studies in the USA show that investors who try to time the market earn less than inflation.

In other words, it is very difficult to know whether a pony is really tired and you should change to another, or whether it is just having a breather while getting ready for the next charge. For example, from 1996 to 2002 the return on Cochlear was an average of 50 percent per year. Then it took a dive, but over the last twelve months the return has jumped back to 70 percent.

The average total return for Cochlear since it floated at in December 1995 has been 30 percent per year. At the same time the company has restored the hearing of tens of thousands of people around the world.

Another thing that makes it difficult, according to a number of studies, is that on average when investors sell a stock to take a profit they end up putting their money into another stock that underperforms the first one. In other words, it is not just a question of “taking a profit”, but also what you are going to do with the money.

What is the answer? I think of buying stocks as similar to getting married. You do all the decision making before the event with the intention that you are getting married for the rest of your life. It may not end up that way, but that is your intention.

You need to resist the temptation for any stock market one-night stands or short-term flings. At the same time, as Warren Buffett says, if you “put together a portfolio of companies whose aggregate earnings march upwards over the years, then so will the portfolio’s market value.”

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