all know what an acute disease is. You might have
to take a few days off work or even go to hospital.
More problematical are chronic diseases. They tend
to creep up on you so that you are not really sure
how to describe the symptoms. Perhaps you feel a
bit low, not the energy that you used to have.
It is the same in the share market.
Acute diseases are very clear. They are when you
invest in companies such as Enron or Citigroup in
the USA. Or HIH or ABC Learning Centres in Australia.
However, it is the chronic diseases that can play
havoc with your investment health year upon year.
An outcome of chronic investor diseases are that,
no matter what you do, the results of your investing
activities are mediocre at best with the whole process
of investing becoming increasingly stressful.
In the end you begin thinking that
investing in stocks is not for you. You start thinking
about putting your money in investments that supply
a fixed interest rate or handing your money over
to a financial planner.
Over the years I have studied
the symptoms of chronic investor diseases; in this article
I will describe three that are particularly damaging.
The first is get-evenitis. This is the disease of hanging
on to losers, shares that have dropped in price, and not
selling until you can get your money back.
If you buy XYZ for $20 and
it drops to $12, you now own a $12 stock. It does not
matter how it arrived at this price. The question now
becomes, “If I had $12, would I buy a unit of XYZ
or would I buy something else?” If the answer is
to buy XYZ, then hang on to it. Otherwise consider selling
it. The only thing that is important is getting maximum
profit on the $12 from this point onwards. The past is
the past. Unfortunately our ego will goad us into all
sorts of rationalisations why we should not sell at a
loss. Just as in real life, sometimes we have to face
our mistakes and accept a loss before we can move on.
Get-evenitis has an associated
disease called consolidatus profitus. Where you see one,
you usually see the other. Sufferers of consolidatus profitus
are often heard intoning “You can’t lose money
by taking a profit.”
You may not lose money for
that particular stock, but in the end what makes the difference
is what we do with our profits. What if we put the money
from the sale into a stock that is a major underperformer?
We may be able to say that we made a profit on a particular
stock. What we are not saying is that our portfolio went
down because of the way we spent the profits.
If ABC goes from $20 to $30,
then you now own a $30 stock. In the same way that you
examined the losers above, think what you would do with
$30. If you would buy ABC for $30, then keep the stock.
If not, then consider selling it.
Of course, in real life things
are a bit more complicated since we have to take into
account transaction costs and taxes. But I think the general
idea is clear ? evaluate your stocks on what return you
expect to get from them in the future, not on what they
have done in the past
|Evaluate your stocks on
what return you expect to get from them in the future,
not on what they have done in the past
Just how wide-spread are these
diseases follows from a large-scale study carried out
by Terrance Odean of the University of California in Davis.
Reporting in the Journal of Finance, 1998, he found that
people tended to trade out of winners into stocks that
performed less well. Overall he found that people would
have been better to sell their losers and keep their winners.
Instead, they did the opposite, namely keep their losers
and sell their winners.
The difference between the
two strategies is even more marked when taxes are taken
into account. When you claim a loss you are getting a
tax rebate and so you want this as early as possible.
In contrast, with a profit you are paying tax so you want
to delay this as long as possible. But, as we just learned,
the average investor tends to take profits early and losses
late ending up on the wrong side of the tax office.
Another prevalent chronic disease
I call tradophilia, the love of trading. Odean carried
out another study to see who were the better investors,
men or women. He found that the women outperformed the
men. But ladies, before you start congratulating yourself
on your superior intelligence and analytical abilities,
we need to look at why your sex did better. The reason
is that, as a group, you traded less. Many studies have
shown that the more often a person buys and sells stocks,
on the average their performance goes down.
How do you cure chronic investor
diseases? Just like regular chronic diseases, you need
to diagnose them, treat the specific disease, and then
strengthen the (investor) immune system so that they don’t
The most important step
is to perform an honest analysis of your portfolio …
and of yourself. Imagine that all the shares in your portfolio
that have gone down in price were suddenly turned into
their cash values. Would you buy the same shares again,
or would you more likely put the money into different
shares. If the latter, you may well be suffering from
get-evenitis, the belief that you should always hold on
to a stock if the price goes down.
|The most important step
is to perform an honest analysis of your portfolio
… and of yourself.
Now look at the recent sales
you made? Did you sell simply to take a profit? What did
you do with the money? Have you made more money with it
since the sale? Or would it have been better to have left
it where it was. If this is the case, you may be suffering
from consolidatus profitus, the chronic disease of always
wanting to sell shares when their price goes up.
Conscious Investor provides
a rigorous analysis of all companies so that you are less
likely to be pulled down by chronic investor diseases
such as those described above or others that I have identified.
It builds up the investment immune system to protect against