Investing: When to bet the farm

Big payoffs often require big risks. 

• Bet wrong, and you could lose everything. 
• Do you have what it takes? 
• And how do you assess whether a dicey investment is worth it?

You want a big return? 

• How big a risk do you want to take to get it? 
• Gauging the risks associated with really promising investments, and 
• handling those risks appropriately, can change your life.

"It's never safe to take a risk, by definition." 

• Yet successful investors take major risks all the time. 
• They succeed because they do their research, can afford to lose the money they invest in high-risk schemes and are able to make up any losses they incur with other investments, which frequently involve complementary or counterbalancing risks.
• Whether considering an investment in a stock, a privately held startup or a hedge fund -- all high-risk propositions -- investors should start by digging through the details of the business case to figure out how the return on investment is likely to be generated. 
• How big a payoff might the investment produce? 
• And how likely is success?
• Successful investors look hard at the downside as well. 
• What would the price of failure be? 
• And how likely is that?

Just jump in and take a risk

• And what about all the outcomes in between?
• Successful investors tend to have a broad view, taking the downside into account with the upside. 
• They plan on an outcome somewhere in the middle of the range of possibilities. That is their "expected return."
• "An expected return is an average. It's the probability of all of the outcomes."

Risk assessment gets pretty sophisticated at risk-oriented hedge funds.

• These funds combine and counterbalance risks to put together exotic investment strategies that increase an investor's upside while controlling the downside -- all for a price. 
• But the basics are just common sense.

Our own personalities add complexity to high-risk situations.

• There are risks associated with overly emotional reactions.
• "What you don't want to happen is for people to get emotional with the market."
• The more emotional we get, the more likely it is we will make a mistake.
• A company's business prospects can be measured and evaluated statistically, but there is no easy measure for mood swings. 
• Before making any moves, people contemplating high-risk investments should come to grips with their emotional makeup and know how they are likely to react.

Three ways to analyze a company

• (Quantitative, Qualitative and Technical Analysis)
• Where risk is high, the investor needs to analyze his or her life situation.

Is financial risk really risky?

• "There are times in your life when it's appropriate to take different levels of risk."
• Age is a big factor. Age changes us in a lot of ways. We gain emotional maturity. At the same time, the nature of our financial obligations changes, and the time horizon for risk gets tighter.
• "Let's say you're young, in your mid-20s,"  "If you take a big risk and something goes wrong, you have time to recover." 
• On the other hand, the middle-aged homeowner probably needs a bigger safety net, especially if there are kids who need braces or there are college costs to consider.
• Even a high-risk investment can be a very positive part of a portfolio when it's appropriate to a person's situation and is well-managed."In investing and in life, you have to look at everything on a risk-and-reward basis.  Volatility is not the end of the world."

Risk lesson from owning the business

• He left the investment firm to start his own firm. 
• He knew most new businesses fail, but he had a lot of confidence in his own investment skills. If the business went under, he reasoned, he could always get a job with another firm.
• "Careers are actually the easiest place to take risks, as long as you don't burn your bridges." Younger investors, particularly, should be ready to gamble with their careers. 
• But in the same breath he cautions as professional investors often do: Risk only as much as you can afford to lose, he says.

The Twelve Silliest (and Most Dangerous) Things People Say About Stock Prices

1.  If it's gone down this much already, it can't go much lower.

2.  You can always tell when a stock's hit bottom.

3.  If it's gone this high already, how can it possibly go higher?

4.  It's only $3 a share:  What can I lose?

5.  Eventually they always come back.

6.  It's always darkest before the dawn.

7.  When it rebounds to $10, I'll sell.

8.  What me worry?  Conservative stocks don't fluctuate much.

9.  It's taking too long for anything to ever happen.

10.  Look at all the money I've lost:  I didn't buy it.

11.  I missed that one, I'll catch the next one.

12.  The stock's gone up, so I must be right, or ... The stock's gone down so I must be wrong.


Reference:
One Up on Wall Street by Peter Lynch

The importance of understanding your own behaviours in relation to your actions in investing; once understood, you will be able to apply your preferred investing style consistently without emotional or psychological bias.

The  person capable of standing back may notice that change is the one constant.  

One might do well to stand back and consider whether a perceived truth is indeed so, or whether in fact the more things apparently change, the more some things do indeed remain the same.

Following the crowd and abandoning a commitment to a long-term approach in a business you bought into believing it to be sound could lead to a real loss, especially if, six months later, it turns out that the crowd consisted of ill-informed speculating lemmings and now the shares you sold have doubled in value as sanity returned to the market.

The importance of understanding your own behaviours in relation to your actions cannot be over-stated. 

Once understood, you will be able to apply your preferred investing style consistently without emotional or psychological bias.  Something which is easier said than done.  

"An optimist will tell you the glass is half-full;
the pessimist, half-empty; and
the engineer will tell you the glass is twice the size it needs to be."

Behavioural Finance Solutions

Dale Carnegie ..... How to stop worrying. What is the worst that can happen if you take a decision. Analyze the facts and the situation: it may not be as bad as you think. Be prepared for the worst. GO AHEAD AND TAKE THE DECISION.

Ignore shares and get poorer.

Diary of a private investor: ignore shares and get poorer
Our private investor is back - and he says that savers who are prepared to take some risk will prosper.

Despite the Gulf of Mexico oil spill last year, BP shares are doing well Photo: PA

By James Batholomew

10:51AM BST 06 Jun 2011

After the glorious year of 2010 - for the stock market anyway - this year has, so far, been a damp squib. First it was up, then it relapsed, then it rose once more before retreating again. As I write, it is within 2pc of where it started.

As Lady Bracknell said in The Importance of Being Earnest, "this shilly-shallying is absurd". Which is it to be? Will shares finally rise or fall?

On the bearish side, I'm told, by people who ought to know, that Greece is bust, whatever the politicians say. Another well-placed individual has the same opinion about Ireland.

If either is right, shares could fall heavily on the day the default is announced. Some people say "it is already in the price", but I doubt it.

On the other hand, shares still look good value. I own some in BP which, at 458p, stands at a mere 6.8 times forecast earnings for 2011.

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Its adventures in Russia do worry me a bit and, of course, the shadow of the disaster in the Gulf of Mexico still hangs over it. But rarely in its history have the shares been treated with such disdain.

Professional and lifelong investors are now generally back in the stock market. But many private individuals are still holding back.

Over the past few years, I've talked to quite a few people about their investments and found they can be divided into four sorts.

The first thinks shares are too risky. They remain almost entirely in cash. In some cases they have good reason. Some have a limited amount of money and a very specific thing - such as school fees - which they want to be sure they can pay.

Others argue that shares are unpredictable and they don't know anything about them. Better to keep the money safe in the bank. These people have their reasons. But over the long term, I've seen so many of this sort, who were once well off, become very gradually much less so. I knew the daughter of a Seventies multi-millionaire who inherited her fair share. She kept the money in a building society and is now, frankly, just getting by. It's frustrating. She could have stayed rich.

The second group consists of those who have made quite a bit of money but have not had much time or interest in managing it. They were then persuaded by persistent, charming salesmen to invest in certain funds. For these salesmen, nothing was too much trouble. They visited them in their homes. They brought wonderful, sophisticated brochures and "personalised" recommendations.

The untold story which the salesmen never quite got around to explaining in detail was the full extent of the commissions and expenses involved. The people in this group have generally had a pretty thin time of it over the past dozen years.

The FTSE 100 is still rather lower than it was in January 2000, and all those commissions have eaten a substantial hole in the dividend income.

The third sort are thrill-seekers. To be honest, I know only one person in this group. There was a time when he got very excited about shares and was dealing on an hourly basis, following recommendations from a broker. After initial success, he lost a bundle and decided to give it all up.

Long-term, persistent portfolio investors are the fourth group. They have built up experience and understanding. They tend to have done best.

But where does that leave the sort of person who has other things to do and does not want to spend time building up experience in shares?

My flippant answer would be "poorer". You make your choices and live with the consequences. Trying to be more helpful, let me suggest this: how about putting, say, 15pc of free cash in a selection of lowest-possible-cost tracker funds? And then increasing the amount each year up to a level with which you are comfortable?

This way, you will not give away a fortune in commission. You will keep most of the dividends. You will not have to worry about selecting individual shares. And you are likely - though not guaranteed - to be richer in 10 years than otherwise. You could go for a mixture of, say, half of the invested amount in a FTSE 250 shares fund, a fifth in a Far East fund, another fifth in a US fund and a 10th in an emerging markets fund.

http://www.telegraph.co.uk/finance/personalfinance/investing/shares/8558975/Diary-of-a-private-investor-ignore-shares-and-get-poorer.html

Risk taker

7 keys to mistake-free investing

6/15/2011 11:55 AM ET.

By U.S. News & World Report


7 keys to mistake-free investing

In a survey, wealthy investors acknowledge a tendency to let emotions drive investment decisions. Plus: Why women are better at long-term investing.

Overcoming emotional and personality-driven investing mistakes is widely recommended but hard to achieve. One of the keys to success is recognizing that a problem exists and devising mechanisms to control or limit bad decisions.

According to a recent global survey by Barclays Wealth, a large percentage of wealthy investors not only realize their tendency to make decisions based on emotions but would welcome help in dealing with the problem.

The report, "Risk and Rules: The Role of Control in Financial Decision Making," also revealed an extensive set of control strategies that people use to limit bad decisions. The most successful at doing so happen to be the wealthiest, although there could be other factors contributing to high-wealth achievement.


Psychology of successful investors

Perhaps the most interesting finding of the research involved what the report called "the trading paradox," said Greg Davies, who directs Barclays Wealth's work in behavioral and quantitative finance. Many wealthy investors believe they need to trade frequently to maximize investment gains. At the same time, wealthy investors were most likely to believe their overall returns suffered because they traded too much.

"Almost 50% of traders who believe you have to trade often to do well think they overdo it," the report said.

"Failures of rationality," as the report called them, were seen in four types of investment decisions:

1. Failing to see the big picture. Considering decisions in isolation and not including their impact on an entire portfolio was cited as a problem.

Consequence: Investing too much in a single asset class, industry or geographic market because you know a lot about it and are comfortable with such decisions.

2. Using a short-term decision horizon. Ignoring the appropriate goal of long-term wealth accumulation in favor of short-term returns hindered investors.

Consequence: Statistically, losses are more likely in the short run. Because people are twice as sensitive to losses as to gains -- a behavioral phenomenon known as "myopic loss aversion" -- their willingness to take short-term risks is too low and they often make the wrong investment decisions.

3. Buying high and selling low. Investors tend to do what's comfortable amid bullish or bearish market conditions.

Consequence: Buying when markets are high or selling when markets are low is a risky strategy that fails to take advantage of market opportunities. A buy-and-hold strategy is superior.

4. Trading too frequently. Multiple emotional and personality traits produce an irrational bias toward action.

Consequence: Investment costs are higher, and the frequency of other poor decisions is increased.

"This lack of control over our emotions is not an abstract problem," the Barclays study said, and "it can have tangible, detrimental effects on both investor satisfaction and performance."

Over the past two decades, the average equity investor earned 3.8% a year, while the Standard & Poor's 500 Index ($INX) returned 9.1% annually, according to a recent Dalbar study into investor behavior.

The report also found substantial improvement in investment decisions as people aged. Older investors were much less likely to trade too often, try to time the market or base investments on short-term considerations.

They were also more satisfied with their financial situation.

Barclays Wealth also found that women are better long-term investors than men, who tend to take more risks and are more likely to favor frequent trading and efforts to time the market.

"Women tend to have lower composure and a greater desire for financial self-control, which is associated with a desire to use self-control strategies," the report said.

"Women are also more likely to believe that these strategies are effective." As a consequence, women tended to trade less and earn higher returns over time.

Barclays Wealth sponsored surveys of more than 2,000 people from 20 countries who had at least $1.5 million in investment assets, including 200 with at least $15 million. These investors may not have known the details of their emotional flaws as documented by behavioral economists. But they were aware that they were prone to bad decisions and were open to getting help.

The report identified seven self-control strategies to help people counter their tendencies to make bad decisions. The use of these strategies was not limited to investments and often included other behaviors, such as big-ticket purchases or dieting and exercise.

Here are the seven strategies and their application to financial decisions:

1. Limit the options. Purchase illiquid investments to avoid the urge to sell investments when the market is falling.

2. Avoidance. Avoid information about how the market or portfolio is performing in order to stick to a long-term investment strategy.

3. Rules. Establish and use rules to help make better financial decisions, such as spend only out of income and never out of capital.

4. Deadlines. Set financial deadlines. For example, aim to save a certain amount of money by the end of the year.

5. Cool off. Wait a few days after making a big financial decision before executing it.

6. Delegation. Delegate financial decisions to others, such as allowing an investment adviser to manage your portfolio.

7. Other people. Use other people to help reach financial goals. An example would be meeting with a financial adviser to make and execute a financial plan.


This article was reported by Philip Moeller for U.S. News & World Report.

Market Behaviour: Control Yourself (Patience)

Patience is a virtue you must learn in order to excel as a value investor.  You must think outside the box and move in a direction the crowd likely is not following.

If you want to invest intelligently according to the basics established by value investing master guru Benjamin Graham, you must control the following:

1. Your brokerage costs
2. Your ownership costs
3. Your expectations
4. Your risk
5. Your tax bills
6. Your own behaviour

----

1.  Your Brokerage Costs

Find yourself a good broker who doesn't charge too much to handle your stock trades.  If you feel confident that you know how to handle stock trading, do it yourself with an Internet discount broker.

We don't recommend full-service brokers because you don't need their research services and you certainly won't want to follow their advice - unless by some lucky break you find a broker who truly believes in value investing.

Also, don't trade too often and waste your money jumping in and out of stocks.  Most value investing gurus hold on to stocks for four to five years.

Learn to be patient and give a stock you've picked time to recover.  Its price may go down after you buy the stock, so don't get discouraged.  Few people can actually buy at the absolute lowest price.  Most value investors choose a stock on its way down.

But don't be so patient that you end up losing all your money.  Sometimes, you will make a mistake when picking a stock.  Just admit your mistake, accept your losses and move on.

2.  Your Ownership Costs

If you decide to invest using mutual funds, be sure to buy no-load funds with very low management fees.  Few funds are worth the cost if their management fees are more than 1 percent.

Remember, for a mutual fund manager to meet the returns of a stock market index, he or she must beat the index by at least the cost of the mutual fund's management fees.  Management fees are a drain on all mutual funds.  

Unless for some reason you've picked a particular mutual fund manager you want to follow, your best bet is to invest using an index fund.  Fees for many index funds are just 0.15 to 0.35 percent.

3.  Your Expectations

Always be realistic about the returns you want to get out of a stock purchase.  Even if you decide to follow some newsletters that specialise in value investing, don't get caught up in someone else's hype.  You'll never be disappointed if you carefully assess the true value of a stock and are conservative about the cash flows you can expect from the stock purchase.

4.  Your Risk.

Keep a close eye on the amount of risk you can tolerate.  Determine the asset allocation that best manages your risk tolerance.  

Periodically re-balance your portfolio so you know that you're maintaining your portfolio at a risk tolerance level that you can tolerate.

Determine how much of your portfolio you can afford to put at risk.  Stock investing is a risky business.  You can afford to take more risk if you have a longer time frame before you need the money.  

For example, if you won't need the money for 10 years or more, you can take on the greatest amount of risk. If you plan to use the money in two years, put that money in a cash account.

5.  Your Tax Bills

Each time you sell a stock, you may have to pay taxes on the amount of profit you make from the transaction. If you hold a stock for less than 12 months, the taxes you pay are based on your current tax rate.  

If you hold a stock for more than 12 months, your tax bill could be as little as 5 percent for capital gains, if you are in the 10 percent or 15 percent tax brackets.  You'll pay 15 percent capital gains tax if your tax bracket is 25 percent or higher.

Unless you've made a terrible mistake picking a stock, you should always hold it for more than a year, to minimize the tax hit on any gain.  The only exception to this rule is fi you have a significant profit in a stock and you're afraid the stock could take a tumble.

6.  Your Own Behaviour

It's human nature to get excited and follow the crowd in feeling good about a stock.  The crowd shows its enthusiasm when it bids the price up so high that the P/E ratio tops 20.  Learn to resist these feelings.

It;s also human nature to get frightened when everyone is running from the stock market.  Get your emotions under control and start to take a look for good buys when everyone else thinks it's time to escape.

Related topics:

Market Behaviour: The Least You Need to Know
Market Behaviour: Crowd Impacts on Stock Prices

Market Behaviour: Can You Beat the Market?
Market Behaviour: Bull Runs
Market Behaviour: Bear Stalls
Market Behaviour: Pendulum Swings (Volatility)
Market Behaviour: Irrational Exuberance
Market Behaviour: Unjustifiable Pessimism
Market Behaviour: Control Yourself (Patience)

Behavioural Risks

Sunday, November 28, 2010

Investment Madness

We are all prone to having psychological preconceptions or biases that make us behave in certain ways. These biases influence how we assimilate the information we come in contact with on a daily basis. They also have an impact on how we utilize that information to make decisions.

Our very own psychological biases have an impact on our investment decisions and affect our attempts at building wealth.

Psychological Bias	Effect on Investment Behavior	Consequence
Overconfidence	Trade too much. Take too much risk and fail to diversify	Pay too much in commissions and taxes. Susceptible to big losses
Attachment	Become emotionally attached to a security and see it through rose-colored glasses	Susceptible to big losses
Endowment	Want to keep the securities received	Not achieving a match between your investment goals and your investments
Status Quo	Hold back on changing your portfolio	Failure to adjust asset allocation and begin contributing to retirement plan
Seeking Pride	Sell winners too soon	Lower return and higher taxes
Avoiding Regret	Hold losers too long	Lower return and higher taxes
House Money	Take too much risk after winning	Susceptible to big losses
Snake Bit	Take too little risk after losing	Lose chance for higher return in the long term
Get Even	Take too much risk trying to get break even	Susceptible to big losses
Social Validation	Feel that it must be good if others are investing in the security	Participate in price bubble which ultimately causes you to buy high and sell low
Mental Accounting	Fail to diversify	Not receiving the highest return possible for the level of risk taken
Cognitive Dissonance	Ignore information that conflicts with prior beliefs and decisions	Reduces your ability to evaluate and monitor your investment choices
Representativeness	Think things that seem similar must be alike. So a good company must be a good investment	Purchase overpriced stocks
Familiarity	Think companies that you know seem better and safer	Failure to diversify and put too much faith in the company in which you work

If you want to read more regarding human psychology and how it affects our trading and investment, please read the book “Investment Madness How Psychology Affects Your Investing and What to Do About It” by JOHN R NOFSINGER

http://mystocktrader.blogspot.com/2010/11/investment-madness.html

Knowing about the psychological biases is not enough. You must also have a strategy for overcoming them.

Battling Your Biases

Remember the day-trader cartoon in Chapter 1? The roller coaster called "The Day Trader" represents the modern investment environment. The roller coaster has dramatic highs and lows. As a modern-day investor, you can experience strong emotional highs and lows. This emotional roller coaster has a tendency to enhance your natural psychological biases. Ultimately, this can lead to bad investment decisions.

The previous chapter began the discussion of how to overcome your psychological biases. It introduced two strategies of exerting self-control: rules of thumb and envi­ronment control. This chapter proposes strategies for controlling your environment and gives you specific rules of thumb that focus you on investing for long-term wealth and on avoiding short-term pitfalls caused by decisions based on emotions.

The first strategy was proposed in Chapter 1: Understand the psychological biases. We have discussed many biases in this book. You may not remember each bias and how it affects you (due to cognitive dissonance and other memory biases—see Chapter 10), so reviewing them here should be beneficial. In fact, to help you make wise investments long after reading this book, you should re-familiarize yourself with these biases next month, next year, and every year.

STRATEGY 1: UNDERSTAND YOUR PSYCHOLOGICAL BIASES

In this book, there are three categories of psychological biases: not thinking clearly, letting emotions rule, and functioning of the brain. Let's review the biases in each category.

(a)  Not Thinking Clearly

Your past experiences can lead to specific behaviors that harm your wealth. For example, you are prone to attribute past investment success to your skill at investing. This leads to the psychological bias of overconfidence. Overconfidence causes you to trade too much and to take too much risk. As a consequence, you pay too much in commissions, pay too much in taxes, and are susceptible to big losses.

The attachment bias causes you to become emotionally attached to a security. You are emotionally attached to your parents, siblings, children, and close friends. This attachment causes you to focus on their good traits and deeds. You also tend to discount or ignore their bad traits and deeds. When you become emotionally attached to a stock, you also fail to recognize bad news about the company.

When taking an action is in your best interest, the endowment bias and status quo bias cause you to do nothing. When securities are given to you, you tend to keep them instead of changing them to an investment that meets your needs. You also procrastinate on making important decisions, like contributing to your 401(k) plan.

In the future, you should review these psychological biases.

(b)  Letting Emotions Rule

Emotions get in the way of making good investment decisions. For example, your desire to feel good about yourself—seeking pride— causes you to sell your winners too soon. Trying to avoid regret causes you to hold your losers too long. The consequences are that you sell the stocks that perform well and keep the stocks that perform poorly. This hurts your return and causes you to pay higher taxes.

When you are on a winning streak, you may feel like you are playing with the house's money. The feeling of betting with someone else's money causes you to take too much risk. On the other hand, losing causes emotional pain. The feeling of being snake bit causes you to want to avoid this emotional pain in the future. To do this, you avoid taking risks entirely by not owning any stocks. However, a diversified portfolio of stocks should be a part of everyone's total investment portfolio. Experiencing a loss also causes you to want to get even. Unfortunately, this desire to get even clouds your judgment and induces you to take risks you would not ordinarily take.

And finally, your need for social validation causes you to bring your investing interests into your social life. You like to talk about investing. You like to listen to others talk about investing. Over time, you begin to misinterpret other people's opinions as investment fact. On an individual level, this leads to investment decisions based on rumor and emotions. On a societal level, this leads to price bubbles in our stock market.

(c) Functioning of the Brain

The manner in which the human brain functions can cause you to think in ways that induce problems. For example, people use mental accounting to compartmentalize individual investments and categorize costs and benefits. While mental accounting can help you exert self-control to not spend money you are saving, it also keeps you from properly diversifying. The consequence is that you assume more risk than necessary to achieve your desired return.

To avoid regret about previous decisions that did not turn out well, the brain filters the information you receive. This process, called cognitive dissonance, adjusts your memory about the information and changes how you recall your previous decision. Obviously, this will reduce your ability to properly evaluate and monitor your investment choices.

The brain uses shortcuts to reduce the complexity of analyzing information. These shortcuts allow the brain to generate an estimate of the answer before fully digesting all the available information. For example, the brain makes the assumption that things that share similar qualities are quite alike. Representativeness is judgment based on stereotypes. Furthermore, people prefer things that have some familiarity to them. However, these shortcuts also make it hard for you to correctly analyze new information, possibly leading to inaccurate conclusions. Consequently, you put too much faith in stocks of companies that are familiar to you or represent qualities you desire.

This review of the psychological biases should help you with the first strategy of understanding your psychological biases. However, as Figure 15.1 suggests, knowing about the biases is not enough. You must also have a strategy for overcoming them.

"Y

THE EFFECTS OF YOUR PSYCHOLOGICAL BIASES (CONTINUED).
Psychological	Effect on		Table
Bias	Investment Behavior	Consequence	15.1
Get Even	Take too much risk	Susceptible to big
	trying to break even	losses
Social Validation	Feel that it must be	Participate in a price
	good if others are in-	bubble which ulti-
	vesting in the security	mately causes you to buy high and sell low
Mental	Fail to diversify	Not receiving the
Accounting		highest return possible for the level of risk taken
Cognitive	Ignore information that	Reduces your ability to
Dissonance	conflicts with prior	evaluate and monitor
	beliefs and decisions	your investment choices
Representativeness	Think things that seem	Purchase overpriced
	similar must be alike.	stocks
	So a good company must
	be a goodinvestment.
Familiarity	Think companies that	Failure to diversify
	you know seem better	and put too much
	and safer	faith in the company in which you work

STRATEGY 2: KNOW WHY YOU ARE INVESTING

You should be aware of the reasons you are investing. Most investors largely overlook this simple step of the investing process, having only some vague notion of their investment goals: "I want a lot of money so that I can travel abroad when I retire." "I want to make the money to send my kids to college." Sometimes people think of vague goals in a negative form: "I don't want to be poor when I retire." These vague notions do little to give you investment direction. Nor do they help you avoid the psychological biases that inhibit good decision making. It is time to get specific. Instead of a vague notion of wanting to travel after retirement, be specific. Try

A minimum of $75,000 of income per year in retirement would allow me to make two international trips a year. Since I will receive $20,000 a year in Social Security and retirement benefits, I will need $55,000 in investment income. Investment earnings from $800,000 would generate the desired income. I want to retire in 10 years.

Having specific goals gives you many advantages. For example, by keeping your eye on the reason for the investing, you will

■     Focus on the long term and look at the "big picture"

■     Be able to monitor and measure your progress

■     Be able to determine if your behavior matches your goals

For example, consider the employees of Miller Brewing Company who were hoping to retire early (discussed in Chapter 11). They had all their 401(k) money invested in the company stock, and the price of the stock fell nearly 60%. When you lose 60%, it takes a 150% return to recover the losses. It could easily take the Miller employees many years to recover the retirement assets. What are the conse quences for these employees? Early retirement will probably not be an option.

Investing in only one company is very risky. You can earn great returns or suffer great losses. If the Miller employees had simply compared the specific consequences of their strategy to their specific investment goals, they would have identified the problem. In this type of situation, which option do you think is better?

A.  Invest the assets in a diversified portfolio of stocks and bonds
that will allow a comfortable retirement in two years.

B.   Invest the assets in the company stock, which will either earn
a high return and allow a slightly more comfortable
retirement in two years, or suffer losses which will delay
retirement for seven years.

Whereas option A meets the goals, option B gambles five years of work for a chance to exceed the goal and is not much different than placing the money on the flip of a coin.

STRATEGY 3: HAVE QUANTITATIVE INVESTMENT CRITERIA

Having a set of quantitative investment criteria allows you to avoid investing on emotion, rumor, stories, and other psychological biases. It is not the intent of this book to recommend a specific investment strategy like value investing or growth investing. There are hundreds of books that describe how to follow a specific style of investing. Most of these books have quantitative criteria.

Here are some easy-to-follow investment criteria:

■    Positive earnings

■    Maximum P/E ratio of 50

■    Minimum sales growth of 15%

■    A minimum of five years of being traded publicly

If you are a value investor, then a P/E maximum of 20 may be more appropriate. A growth investor may set the P/E maximum at 80 and increase the sales growth minimum to 25%. You can also use criteria like profit margin and PEG ratio, or you can even look at whether the company is a market share leader in sales.

Just as it is important to have specific investing goals, it is important to write down specific investment criteria. Before buying a stock, compare the characteristics of the company to your criteria. If it doesn't meet your criteria, don't invest!

Consider the Klondike Investment Club of Buffalo, Wyoming, discussed in Chapter 7. The club's number one ranking stems in part from its making buy decisions only after an acceptable research report has been completed. Klondike's criteria have protected its members from falling prey to their psychological biases. On the other hand, the California Investors Club's lack of success is due partially to the lack of criteria. Its decision process leads to buy decisions that are ultimately controlled by emotion.

I am not suggesting that qualitative information is unimportant. Information on the quality of a company's management or the types of new products under development can be useful. If a stock meets your quantitative criteria, then you should next examine these quali tative factors.

STRATEGY 4: DIVERSIFY

The old adage in real estate is that there are three important criteria when buying property: location, location, location. The investment adage should be very similar: diversify, diversify, diversify.

It is not likely that you will diversify in a manner suggested by modern portfolio theory and discussed in Chapter 9. However, if you keep some simple diversification rules in mind, you can do well.

■   Diversify by owning many different types of stocks. You can be reasonably well diversified with 15 stocks that are from different industries and of different sizes. One diversified mutual fund would do it too. However, a portfoilio of 50 technology stocks is not a diversified portfolio, nor is one of five technology mutual funds.

■    Own very little of the company you work for. You already have your human capital invested in your employer—that is, your income is dependent on the company. So diversify your whole self by avoiding that company in your investments.

■    Invest in bonds, too. A diversified portfolio should also have some bonds or bond mutual funds in it.

Diversifying in this way helps you to avoid tragic losses that can truly affect your life. Additionally, diversification is a shield against the psychological biases of attachment and familiarity.

http://www.physcomments.org/THE-INVESTMENT-ENVIRONMENT/functioning-of-investment-choices-the-brain2.html

Bullbear Stock Investing Notes