Avoiding The Avoiding Of Regret
Avoiding the emotional pain of regret causes you to sell winners too soon and hold on to losers too long. This causes a loss of wealth from taxes and a bias toward holding stocks that perform poorly.
How can you avoid this pitfall? The first step is to understand this psychological bias. This chapter should help you accomplish this step. Two other steps are helpful:
1. Make sell decisions before you are emotionally tied to the position.
2. Keep a reminder of the avoiding regret problem.
For example, when buying a stock for $100, you should decide at which price you will sell the stock if the price declines. You may decide to sell if the price falls to $90. However, making this decision before the price actually falls is not enough. You must act. You must act in advance, before the stock actually falls and regret starts to take place. How do you accomplish this? Place a stop-loss order. A stop-loss order is an order that tells the brokerage to sell the stock if it ever falls to a predetermined price. A stop-loss order at $90 will cause the stock to automatically be sold if the price falls to $90. This order is placed when the stock is still at $100 and regret has not had a chance to occur.
Another strategy is to make a point of selling enough losers to offset any gains that you might have incurred during the year. Although this can be done any time during the year, you probably feel most comfortable doing this in December. In fact, December is the most common month to take losses for tax purposes. Investors often use the end-of-the-year tax deadline as motivation to sell losers. However, losers can be sold at any time during the year to achieve the tax benefits. The reason that tax-loss selling usually occurs in December is that the closer you get to the end of the year, the tax-reduction motive has more influence over investors than the disposition effect.
Finally, keep a reminder of the avoiding regret problem. Consider how many futures traders train to do their jobs. Futures traders often take very risky short-term positions in the market. They can gain or lose large sums of money in minutes or even seconds. Some futures traders have told me that they memorized a saying:
You have to love to take losses and hate to take gains.
At first, this saying makes no sense. Why would you hate to take gains? The power of the saying is that it exactly counteracts the disposition effect. The avoidance of regret causes traders to want to hold on to losers too long. "You have to love to take losses" reminds them to sell quickly and get out of a bad position when the market has moved against them. Alternatively, the seeking of pride causes traders to sell their winners too soon. "Hate to take gains" reminds them to not be so quick to take a profit. Hold the winning positions longer than your natural desire for pride would suggest.
IN SUMMARY
To summarize this chapter, you act (or fail to act) to seek pride and avoid regret. This behavior causes you to sell your winners too soon and hold your losers too long. This behavior hurts your wealth in two ways. First, you pay more capital gains taxes because you sell winners. Second, you earn a lower return because the winners you sell and no longer have continue to perform well while the losers you still hold continue to perform poorly.
Thursday, 3 September 2009
Wednesday, 2 September 2009
Winning the Loser’s Game
Winning the Loser’s Game
By Daily Reckoning Contributor
07/14/05
Investing is a loser’s game - good investors do not pull financial rabbits out of their hats or solve difficult scientific problems. They play it safe, avoid errors in judgment - and stick to the basics.
My stepdaughter Rachel is 11 years old.
I’ve been watching her play softball every summer since she was eight. Each game is both tragic and comic…
When the ball is hit in the air, you can bet it’ll hit the ground, occasionally taking a split-second detour into some hopeful little girl’s glove. When the ball is hit on the ground, it is generally hit with pinpoint accuracy, as it nearly always goes right through the legs of the fielder closest to it.
Runs are scored in Rachel’s softball games when somebody drops the ball. There are no homeruns hit over the fence. Many runs are the result of four walks in a row. There are few successful defensive plays of any kind. Balls are thrown but rarely caught. Bases are stolen routinely because the girls are trained to hold onto the ball lest they throw it away, allowing a second base to be stolen.
Loser’s Game: Beating Yourself vs. Beating the Competition
Rachel’s games are nothing like major league baseball games. In the major leagues, home runs are hit out of the park and double plays are thrown in most games. Strikeouts don’t happen because the batting is bad, but because the pitching is so amazingly good. It’s just like in the Ellis book, Winning the Loser’s Game. The little leaguers don’t get beat by the competition; they beat themselves by making errors. The professional ballplayers don’t beat themselves; they are simply outperformed by the competition.
Ellis reports on Dr. Simon Ramo. In his book, Extraordinary Tennis for the Ordinary Tennis Player, Ramo found that, "professional tennis is a winner’s game: The outcome is determined by the actions of the winner. Amateur tennis is a loser’s game: the outcome is determined by the actions of the loser, who defeats himself." War is another loser’s game. According to historian Admiral Samuel Eliot Morison, "the side that makes the fewest strategic errors wins the war." Tommy Armour’s book, How to Play Your Best Golf All the Time, says, "the best way to win is by making fewer bad shots."
Investing is a loser’s game. And it never becomes a winner’s game. It’s like my stepdaughter’s softball league. All you have to do is not make huge mistakes. You never focus on beating a competitor. The greatest investors do not pull financial rabbits out of their hats or solve difficult scientific problems. They mostly just play it safe and avoid big errors. Warren Buffett’s quote on this matter can’t be repeated often enough:
Rule No. 1: Never lose money.
Rule No. 2: Never forget rule No. 1.
Loser’s Game: It’s All About the Basics
I’m beginning to believe that investing is mostly about ruthlessly following basic precepts like, "Never lose money." You never really graduate to the advanced class, because there isn’t one. You simply realize that it’s all about the basics, and then you stop losing money… and start getting rich. Like most of the traits that make a successful investor, this one goes against human nature. We humans love to complicate things. But with investing, the simple answer is the one towards which you should gravitate. As Ben Graham writes on page 147 of The Intelligent Investor, "security analysts today find themselves compelled to become most mathematical and ’scientific’ in the very situations which lend themselves least auspiciously to exact treatment."
Not only do we humans want to complicate things. We also have a bias toward action. This is simply the tendency to want to "do something" and not remain passive. It’s even worse that this bias serves you well in virtually any other business but investing. Tom Peters listed "a bias toward action" as the number one trait of effective managers in his classic work, In Search of Excellence.
Warren Buffett once said something like, "Lethargy bordering on sloth strikes us as intelligent behavior." If I were to recommend more than five or six stocks a year in these pages, maybe you should question the quality of those ideas.
Unlikely as it may sound, I think that if you do nothing but decide right here and now that you’ll make fewer investment decisions and avoid bad ideas, your performance will improve dramatically. This is something you hardly ever read about in newsletters, because newsletter editors have a bias toward feeding the typical reader’s desire for new stock picks. Editors aren’t bad people. It’s just that most readers think they’re paying for the production of a certain number of ideas. Most editors lose subscribers if they don’t recommend a brand new stock every month.
How many stocks should you own at one time? Any amount you want, as long as it’s not too many.
In October 1994, Warren Buffett addressed a room full of graduate students at Kenan Flagler business school in North Carolina. He told them, "I made a study back when I ran a partnership of all our larger investments versus all our smaller investments. The larger investments always did better than the smaller investments. There’s a threshold of examination and criticism and knowledge that has to be overcome or reached in making a big decision. You can get sloppy about small decisions. You’ve all heard about somebody who says, ‘I bought 100 shares of this or that because I heard about it at a party the other night.’ There is that tendency with small decisions to think you can do it for not very good reasons. I think larger decisions are helpful in that regard." During the same talk, Buffett said, "If you have 10 great ideas in your life, you can afford to give away 5 of them, because that’s all you’ll need."
If you simply decide to make fewer investment decisions, you’ll naturally take greater pains to make better decisions. Says Buffett, "Your default position should always be short-term instruments. And whenever you see anything intelligent to do, you should do it." Buffett also said that asset allocation, a Wall Street obsession, is pure nonsense. Asset allocation is Wall Street B.S. for when Abby Jo Cohen announces, in a very pompous way, that now she’s going to recommend that you put 65% of your money in stocks, and 35% in bonds, when before it was 60% in stocks and 40% in bonds. People actually pay a lot of money for that kind of advice. Educated people. People who would otherwise impress us with their connections and money and power.
Jim Rogers is somebody else you ought to listen to on the subject of managing your own money. He used to work with the famous billionaire trader George Soros. Rogers drove around the world twice, once on a motorcycle and once in a car, and wrote a book about global investing after each trip. Rogers told author John Train in 1989 that you should, "take your money, put it in Treasury bills or a money-market fund. Just sit back, go to the beach, go to the movies, play checkers, do whatever you want to. Then something will come along where you know it’s right. Take all your money out of the money-market fund, put it in whatever it happens to be, and stay with it for three or four or five or ten years, whatever it is. You’ll know when to sell again, because you’ll know more about it than anybody else. Take your money out, put it back in the money-market fund, and wait for the next thing to come along. When it does, you’ll make a whole lot of money."
Of course, a tangible margin of safety isn’t always necessary, but it’s hard to argue with. Making a mistake doesn’t mean the principles are wrong. It means I need to work harder to get them right. I’d encourage you to do the same.
Regards,
Dan Ferris
for The Daily Reckoning
http://dailyreckoning.com/winning-the-losers-game/
By Daily Reckoning Contributor
07/14/05
Investing is a loser’s game - good investors do not pull financial rabbits out of their hats or solve difficult scientific problems. They play it safe, avoid errors in judgment - and stick to the basics.
My stepdaughter Rachel is 11 years old.
I’ve been watching her play softball every summer since she was eight. Each game is both tragic and comic…
When the ball is hit in the air, you can bet it’ll hit the ground, occasionally taking a split-second detour into some hopeful little girl’s glove. When the ball is hit on the ground, it is generally hit with pinpoint accuracy, as it nearly always goes right through the legs of the fielder closest to it.
Runs are scored in Rachel’s softball games when somebody drops the ball. There are no homeruns hit over the fence. Many runs are the result of four walks in a row. There are few successful defensive plays of any kind. Balls are thrown but rarely caught. Bases are stolen routinely because the girls are trained to hold onto the ball lest they throw it away, allowing a second base to be stolen.
Loser’s Game: Beating Yourself vs. Beating the Competition
Rachel’s games are nothing like major league baseball games. In the major leagues, home runs are hit out of the park and double plays are thrown in most games. Strikeouts don’t happen because the batting is bad, but because the pitching is so amazingly good. It’s just like in the Ellis book, Winning the Loser’s Game. The little leaguers don’t get beat by the competition; they beat themselves by making errors. The professional ballplayers don’t beat themselves; they are simply outperformed by the competition.
Ellis reports on Dr. Simon Ramo. In his book, Extraordinary Tennis for the Ordinary Tennis Player, Ramo found that, "professional tennis is a winner’s game: The outcome is determined by the actions of the winner. Amateur tennis is a loser’s game: the outcome is determined by the actions of the loser, who defeats himself." War is another loser’s game. According to historian Admiral Samuel Eliot Morison, "the side that makes the fewest strategic errors wins the war." Tommy Armour’s book, How to Play Your Best Golf All the Time, says, "the best way to win is by making fewer bad shots."
Investing is a loser’s game. And it never becomes a winner’s game. It’s like my stepdaughter’s softball league. All you have to do is not make huge mistakes. You never focus on beating a competitor. The greatest investors do not pull financial rabbits out of their hats or solve difficult scientific problems. They mostly just play it safe and avoid big errors. Warren Buffett’s quote on this matter can’t be repeated often enough:
Rule No. 1: Never lose money.
Rule No. 2: Never forget rule No. 1.
Loser’s Game: It’s All About the Basics
I’m beginning to believe that investing is mostly about ruthlessly following basic precepts like, "Never lose money." You never really graduate to the advanced class, because there isn’t one. You simply realize that it’s all about the basics, and then you stop losing money… and start getting rich. Like most of the traits that make a successful investor, this one goes against human nature. We humans love to complicate things. But with investing, the simple answer is the one towards which you should gravitate. As Ben Graham writes on page 147 of The Intelligent Investor, "security analysts today find themselves compelled to become most mathematical and ’scientific’ in the very situations which lend themselves least auspiciously to exact treatment."
Not only do we humans want to complicate things. We also have a bias toward action. This is simply the tendency to want to "do something" and not remain passive. It’s even worse that this bias serves you well in virtually any other business but investing. Tom Peters listed "a bias toward action" as the number one trait of effective managers in his classic work, In Search of Excellence.
Warren Buffett once said something like, "Lethargy bordering on sloth strikes us as intelligent behavior." If I were to recommend more than five or six stocks a year in these pages, maybe you should question the quality of those ideas.
Unlikely as it may sound, I think that if you do nothing but decide right here and now that you’ll make fewer investment decisions and avoid bad ideas, your performance will improve dramatically. This is something you hardly ever read about in newsletters, because newsletter editors have a bias toward feeding the typical reader’s desire for new stock picks. Editors aren’t bad people. It’s just that most readers think they’re paying for the production of a certain number of ideas. Most editors lose subscribers if they don’t recommend a brand new stock every month.
How many stocks should you own at one time? Any amount you want, as long as it’s not too many.
In October 1994, Warren Buffett addressed a room full of graduate students at Kenan Flagler business school in North Carolina. He told them, "I made a study back when I ran a partnership of all our larger investments versus all our smaller investments. The larger investments always did better than the smaller investments. There’s a threshold of examination and criticism and knowledge that has to be overcome or reached in making a big decision. You can get sloppy about small decisions. You’ve all heard about somebody who says, ‘I bought 100 shares of this or that because I heard about it at a party the other night.’ There is that tendency with small decisions to think you can do it for not very good reasons. I think larger decisions are helpful in that regard." During the same talk, Buffett said, "If you have 10 great ideas in your life, you can afford to give away 5 of them, because that’s all you’ll need."
If you simply decide to make fewer investment decisions, you’ll naturally take greater pains to make better decisions. Says Buffett, "Your default position should always be short-term instruments. And whenever you see anything intelligent to do, you should do it." Buffett also said that asset allocation, a Wall Street obsession, is pure nonsense. Asset allocation is Wall Street B.S. for when Abby Jo Cohen announces, in a very pompous way, that now she’s going to recommend that you put 65% of your money in stocks, and 35% in bonds, when before it was 60% in stocks and 40% in bonds. People actually pay a lot of money for that kind of advice. Educated people. People who would otherwise impress us with their connections and money and power.
Jim Rogers is somebody else you ought to listen to on the subject of managing your own money. He used to work with the famous billionaire trader George Soros. Rogers drove around the world twice, once on a motorcycle and once in a car, and wrote a book about global investing after each trip. Rogers told author John Train in 1989 that you should, "take your money, put it in Treasury bills or a money-market fund. Just sit back, go to the beach, go to the movies, play checkers, do whatever you want to. Then something will come along where you know it’s right. Take all your money out of the money-market fund, put it in whatever it happens to be, and stay with it for three or four or five or ten years, whatever it is. You’ll know when to sell again, because you’ll know more about it than anybody else. Take your money out, put it back in the money-market fund, and wait for the next thing to come along. When it does, you’ll make a whole lot of money."
Of course, a tangible margin of safety isn’t always necessary, but it’s hard to argue with. Making a mistake doesn’t mean the principles are wrong. It means I need to work harder to get them right. I’d encourage you to do the same.
Regards,
Dan Ferris
for The Daily Reckoning
http://dailyreckoning.com/winning-the-losers-game/
Ego investing
Ego investing
FE Investor Bureau
Posted online: Aug 03, 2009 at 0006 hrs
Gamblers and mathematicians maybe familiar with what is known as the Martingale probability theory or the Martingale betting strategy and the theory is simple and works on the assumption that a gambler with infinite wealth will never loose. This assumption leads many to take disproportionate risks.
All one needs to do is say in simple games of heads or tails or any other gamble, is to keep doubling his bet after every loss. This will ensure that as and when you do win a bet, you will not only recover all your losses but also make a profit of the original sum you invested. Say for example you bet Rs. 1,000 on heads and loose. Then you double your bet to Rs. 2,000 and loose again. Then you continue playing and double your bet to Rs. 4,000 and loose yet again. Now, you bet yet again, and this time you bet Rs. 8,000.
Having, this time finally won you get Rs. 8,000 and have hence, not only recovered the loss of Rs. 7,00 you had previously incurred, but also make a profit of Rs. 1,000 (the original sum bet).
No, this is not a fool proof or sure shot method to always making money in a casino nor is it a gambling tip. The interesting point to be noted for those who practice this theory is that one’s risk aversion pattern contradicts financial prudence and relies more on emotions.
It is for this reason itself that gamblers often keep on playing even after loosing all the money they decided they could afford to loose, simply in the hope of winning. The reason he/she does not get up and leave the casino is not because they cannot afford that loss sustained, but simply the fact that their ego has been bruised and hurt, and no one likes to end up losing. Hence, in the hope of turning things around one keeps at it till, more often then not they are completely wiped out.
This kind of emotional gambling or making of financial decisions is seen in two extremes, one is when you’re losing and one is when you’re winning heavily. If human financial stupidity were to be depicted in a bell curve, one would see it having a very heavy tail and a very small head. The tail represents the losers which are far greater in number than the winners, and, both have ended up there due to their irrational decisions. In investing they are often termed as greed and fear, with greed making most people follow the madness of the mob, in the hope of making some profits, while fear is what often causes people to try and convert a loss into a profit no matter how slim the odds, often ending up with a bigger loss than needed. "Markets invariably move to undervalued and overvalued extremes because human nature falls victim to greed and/or fear" said William Gross, in his book, “Everything You've Heard About Investing is Wrong!”
Prospect theory
This is a theory that believes people value gains and losses differently and, as such, will base decisions on perceived gains rather than perceived losses. Hence, if a person were given two choices, one expressed in terms of possible gains and the other in possible losses, even though both amount to the same, people would choose the former. It is also known as "loss-aversion theory".
Tversky and Kahneman originally described, "Prospect Theory" in 1979. They found that contrary to expected utility theory, people placed different weights on gains and losses and on different ranges of probability. They found that individuals are much more distressed by prospective losses than they are happy by equivalent gains.
Some economists have concluded that investors typically consider the loss of Rs.1,000 twice as painful as the pleasure received from a gain of the same amount. They also found that individuals will respond differently to equivalent situations depending on whether it is presented in the context of losses or gains. Researchers have also found that people are willing to take more risks to avoid losses than to realize gains. Faced with sure gain, most investors are risk-averse, but faced with sure loss, investors become risk-takers.
--------------------------------------------------------------------------------
Here is an example from Tversky and Kahneman's 1979 article. Kahneman and Tversky presented groups of subjects with a number of problems. One group of subjects was presented with this problem:
In addition to whatever you own, you have been given $1,000. You are now asked to choose between:
a. A sure gain of $500
b. A 50% change to gain $1,000 and a 50% chance to gain nothing.
Another group of subjects was presented with another problem.
In addition to whatever you own, you have been given $2,000. You are now asked to choose between:
a. A sure loss of $500
b. A 50% chance to lose $1,000 and a 50% chance to lose nothing.
In the first group 84% chose A. In the second group 69% chose (b). The two problems are identical in terms of net cash to the subject, however the phrasing of the question causes the problems to be interpreted differently.
--------------------------------------------------------------------------------
Peter L Bernstein in “Against the Gods states that the evidence "reveals repeated patterns of irrationality, inconsistency, and incompetence in the ways human beings arrive at decisions and choices when faced with uncertainty."
Prospect theory also explains why investors hold onto losing stocks: people often take more risks to avoid losses than to realize gains. For this reason, investors willingly remain in a risky stock position, hoping the price will bounce back. The loss-aversion theory points to another reason why investors might choose to hold their losers and sell their winners: they may believe that today's losers may soon outperform today's winners. Investors often make the mistake of chasing market action by investing in stocks or funds which garner the most attention. Research shows that money flows into high-performance mutual funds more rapidly than money flows out from funds that are underperforming.
Regret theory
People tend to feel sorrow and grief after having made an error in judgment. Investors deciding whether to sell a security are typically emotionally affected by whether the security was bought for more or less than the current price. One theory is that investors avoid selling stocks that have gone down in order to avoid the pain and regret of having made a bad investment. The embarrassment of having to report the loss to the accountants, family, friends and others may also contribute to the tendency not to sell losing investments.
Regret, theory deals with the emotional reaction people experience after realising they've made an error in judgment. Faced with the prospect of selling a stock, investors become emotionally affected by the price at which they purchased the stock. Some researchers theorise that investors follow the crowd to avoid the possibility of feeling regret in the event that their decisions prove to be incorrect. Many investors find it easier to buy a popular stock and rationalise it going down since everyone else owned it and thought so highly of it. Buying a stock with a bad image is harder to rationalise if it goes down. Additionally, many believe that money managers and advisors favor well known and popular companies because they are less likely to be fired if they underperform.
What investors should really ask themselves when contemplating selling a stock is, “If this stock was already liquidated, would I but it again?” And, if the answer is “no” then it is time to sell the stock.
Perceiving risk
As per prospect theory, investors really want to know is not just how much an asset deviates from its expected outcome, but how bad things can get. Value at risk (VaR) attempts to provide an answer to this question. The idea behind VaR is to quantify how bad a loss on an investment could be with a given level of confidence over a defined period of time. For example, the following statement would be an example of VaR: "With about a 95% level of confidence, the most you stand to lose on this Rs10,000 investment over a two-year time horizon is Rs 2,000." The confidence level is a probability statement based on the statistical characteristics of the investment and the shape of its distribution curve, it is also known as standard deviation in statistics. However, this is not necessarily the worse case scenario as after all, 95% confidence allows that 5% of the time results may be much worse than what VaR calculates.
Mental accounting
John Allen Paulos states in his book Innumeracy, "There is a strong general tendency to filter out the bad and the failed and to focus on the good and the successful.”
Humans have a tendency to place particular events into mental compartments, and the difference between these compartments sometimes impacts our behavior more than the events themselves. Say, for example, you aim to catch a show at the local theater, and tickets are Rs. 200. When you get there you realize you've lost the Rs. 200 in your wallet. Do you buy a Rs. 200 worth ticket for the show anyway? Behaviour finance has found that roughly 88% of people in this situation would do so. Now, let's say you paid for the Rs 200 ticket in advance. When you arrive at the door, you realise your ticket is at home. Would you pay Rs 200 to purchase another? Only 40% of respondents would buy another. Notice, however, that in both scenarios you're spending Rs 400. An investing example of mental accounting is best illustrated by the hesitation to sell an investment that once had monstrous gains and now has a modest gain. During an economic boom and bull market, people get accustomed to healthy paper gains. When the market correction deflates investor's net worth, they're more hesitant to sell at the smaller profit margin. They create mental compartments for the gains they once had, causing them to wait for the return of that gainful period.
Finally
Many researchers believe that the study of psychology and other social sciences can shed considerable light on the efficiency of financial markets as well as explain many stock market anomalies, market bubbles, and crashes. As an example, some believe that the out performance of value investing results from investor's irrational overconfidence in exciting growth companies and from the fact that investors generate pleasure and pride from owning growth stocks. Many researchers (not all) believe that these human flaws are consistent, predictable, and can be exploited for profit.
The theory that most overtly opposes behavioural finance is the efficient market hypothesis (EMH), associated with Eugene Fama & Ken French (MIT). Their theory that market prices efficiently incorporate all available information depends on the premise that investors are rational. EMH proponents argue that events like those dealt with in behavioural finance are just short-term anomalies, or chance results, and that over the long term these anomalies disappear with a return to market efficiency.
Thus, there may not be enough evidence to suggest that market efficiency should be abandoned since empirical evidence shows that markets tend to correct themselves over the long term. In his book "Against the Gods: The Remarkable Story of Risk", Peter Bernste tells us. "While it is important to understand that the market doesn't work the way classical models think - there is a lot of evidence of herding, the behavioral finance concept of investors irrationally following the same course of action - but I don't know what you can do with that information to manage money. I remain unconvinced anyone is consistently making money out of it."
However, whether these behavioural finance theories can be used to manage your money effectively and economically is still a question mark. That said, investors can be their own worst enemies.
http://www.financialexpress.com/printer/news/497155/
FE Investor Bureau
Posted online: Aug 03, 2009 at 0006 hrs
Gamblers and mathematicians maybe familiar with what is known as the Martingale probability theory or the Martingale betting strategy and the theory is simple and works on the assumption that a gambler with infinite wealth will never loose. This assumption leads many to take disproportionate risks.
All one needs to do is say in simple games of heads or tails or any other gamble, is to keep doubling his bet after every loss. This will ensure that as and when you do win a bet, you will not only recover all your losses but also make a profit of the original sum you invested. Say for example you bet Rs. 1,000 on heads and loose. Then you double your bet to Rs. 2,000 and loose again. Then you continue playing and double your bet to Rs. 4,000 and loose yet again. Now, you bet yet again, and this time you bet Rs. 8,000.
Having, this time finally won you get Rs. 8,000 and have hence, not only recovered the loss of Rs. 7,00 you had previously incurred, but also make a profit of Rs. 1,000 (the original sum bet).
No, this is not a fool proof or sure shot method to always making money in a casino nor is it a gambling tip. The interesting point to be noted for those who practice this theory is that one’s risk aversion pattern contradicts financial prudence and relies more on emotions.
It is for this reason itself that gamblers often keep on playing even after loosing all the money they decided they could afford to loose, simply in the hope of winning. The reason he/she does not get up and leave the casino is not because they cannot afford that loss sustained, but simply the fact that their ego has been bruised and hurt, and no one likes to end up losing. Hence, in the hope of turning things around one keeps at it till, more often then not they are completely wiped out.
This kind of emotional gambling or making of financial decisions is seen in two extremes, one is when you’re losing and one is when you’re winning heavily. If human financial stupidity were to be depicted in a bell curve, one would see it having a very heavy tail and a very small head. The tail represents the losers which are far greater in number than the winners, and, both have ended up there due to their irrational decisions. In investing they are often termed as greed and fear, with greed making most people follow the madness of the mob, in the hope of making some profits, while fear is what often causes people to try and convert a loss into a profit no matter how slim the odds, often ending up with a bigger loss than needed. "Markets invariably move to undervalued and overvalued extremes because human nature falls victim to greed and/or fear" said William Gross, in his book, “Everything You've Heard About Investing is Wrong!”
Prospect theory
This is a theory that believes people value gains and losses differently and, as such, will base decisions on perceived gains rather than perceived losses. Hence, if a person were given two choices, one expressed in terms of possible gains and the other in possible losses, even though both amount to the same, people would choose the former. It is also known as "loss-aversion theory".
Tversky and Kahneman originally described, "Prospect Theory" in 1979. They found that contrary to expected utility theory, people placed different weights on gains and losses and on different ranges of probability. They found that individuals are much more distressed by prospective losses than they are happy by equivalent gains.
Some economists have concluded that investors typically consider the loss of Rs.1,000 twice as painful as the pleasure received from a gain of the same amount. They also found that individuals will respond differently to equivalent situations depending on whether it is presented in the context of losses or gains. Researchers have also found that people are willing to take more risks to avoid losses than to realize gains. Faced with sure gain, most investors are risk-averse, but faced with sure loss, investors become risk-takers.
--------------------------------------------------------------------------------
Here is an example from Tversky and Kahneman's 1979 article. Kahneman and Tversky presented groups of subjects with a number of problems. One group of subjects was presented with this problem:
In addition to whatever you own, you have been given $1,000. You are now asked to choose between:
a. A sure gain of $500
b. A 50% change to gain $1,000 and a 50% chance to gain nothing.
Another group of subjects was presented with another problem.
In addition to whatever you own, you have been given $2,000. You are now asked to choose between:
a. A sure loss of $500
b. A 50% chance to lose $1,000 and a 50% chance to lose nothing.
In the first group 84% chose A. In the second group 69% chose (b). The two problems are identical in terms of net cash to the subject, however the phrasing of the question causes the problems to be interpreted differently.
--------------------------------------------------------------------------------
Peter L Bernstein in “Against the Gods states that the evidence "reveals repeated patterns of irrationality, inconsistency, and incompetence in the ways human beings arrive at decisions and choices when faced with uncertainty."
Prospect theory also explains why investors hold onto losing stocks: people often take more risks to avoid losses than to realize gains. For this reason, investors willingly remain in a risky stock position, hoping the price will bounce back. The loss-aversion theory points to another reason why investors might choose to hold their losers and sell their winners: they may believe that today's losers may soon outperform today's winners. Investors often make the mistake of chasing market action by investing in stocks or funds which garner the most attention. Research shows that money flows into high-performance mutual funds more rapidly than money flows out from funds that are underperforming.
Regret theory
People tend to feel sorrow and grief after having made an error in judgment. Investors deciding whether to sell a security are typically emotionally affected by whether the security was bought for more or less than the current price. One theory is that investors avoid selling stocks that have gone down in order to avoid the pain and regret of having made a bad investment. The embarrassment of having to report the loss to the accountants, family, friends and others may also contribute to the tendency not to sell losing investments.
Regret, theory deals with the emotional reaction people experience after realising they've made an error in judgment. Faced with the prospect of selling a stock, investors become emotionally affected by the price at which they purchased the stock. Some researchers theorise that investors follow the crowd to avoid the possibility of feeling regret in the event that their decisions prove to be incorrect. Many investors find it easier to buy a popular stock and rationalise it going down since everyone else owned it and thought so highly of it. Buying a stock with a bad image is harder to rationalise if it goes down. Additionally, many believe that money managers and advisors favor well known and popular companies because they are less likely to be fired if they underperform.
What investors should really ask themselves when contemplating selling a stock is, “If this stock was already liquidated, would I but it again?” And, if the answer is “no” then it is time to sell the stock.
Perceiving risk
As per prospect theory, investors really want to know is not just how much an asset deviates from its expected outcome, but how bad things can get. Value at risk (VaR) attempts to provide an answer to this question. The idea behind VaR is to quantify how bad a loss on an investment could be with a given level of confidence over a defined period of time. For example, the following statement would be an example of VaR: "With about a 95% level of confidence, the most you stand to lose on this Rs10,000 investment over a two-year time horizon is Rs 2,000." The confidence level is a probability statement based on the statistical characteristics of the investment and the shape of its distribution curve, it is also known as standard deviation in statistics. However, this is not necessarily the worse case scenario as after all, 95% confidence allows that 5% of the time results may be much worse than what VaR calculates.
Mental accounting
John Allen Paulos states in his book Innumeracy, "There is a strong general tendency to filter out the bad and the failed and to focus on the good and the successful.”
Humans have a tendency to place particular events into mental compartments, and the difference between these compartments sometimes impacts our behavior more than the events themselves. Say, for example, you aim to catch a show at the local theater, and tickets are Rs. 200. When you get there you realize you've lost the Rs. 200 in your wallet. Do you buy a Rs. 200 worth ticket for the show anyway? Behaviour finance has found that roughly 88% of people in this situation would do so. Now, let's say you paid for the Rs 200 ticket in advance. When you arrive at the door, you realise your ticket is at home. Would you pay Rs 200 to purchase another? Only 40% of respondents would buy another. Notice, however, that in both scenarios you're spending Rs 400. An investing example of mental accounting is best illustrated by the hesitation to sell an investment that once had monstrous gains and now has a modest gain. During an economic boom and bull market, people get accustomed to healthy paper gains. When the market correction deflates investor's net worth, they're more hesitant to sell at the smaller profit margin. They create mental compartments for the gains they once had, causing them to wait for the return of that gainful period.
Finally
Many researchers believe that the study of psychology and other social sciences can shed considerable light on the efficiency of financial markets as well as explain many stock market anomalies, market bubbles, and crashes. As an example, some believe that the out performance of value investing results from investor's irrational overconfidence in exciting growth companies and from the fact that investors generate pleasure and pride from owning growth stocks. Many researchers (not all) believe that these human flaws are consistent, predictable, and can be exploited for profit.
The theory that most overtly opposes behavioural finance is the efficient market hypothesis (EMH), associated with Eugene Fama & Ken French (MIT). Their theory that market prices efficiently incorporate all available information depends on the premise that investors are rational. EMH proponents argue that events like those dealt with in behavioural finance are just short-term anomalies, or chance results, and that over the long term these anomalies disappear with a return to market efficiency.
Thus, there may not be enough evidence to suggest that market efficiency should be abandoned since empirical evidence shows that markets tend to correct themselves over the long term. In his book "Against the Gods: The Remarkable Story of Risk", Peter Bernste tells us. "While it is important to understand that the market doesn't work the way classical models think - there is a lot of evidence of herding, the behavioral finance concept of investors irrationally following the same course of action - but I don't know what you can do with that information to manage money. I remain unconvinced anyone is consistently making money out of it."
However, whether these behavioural finance theories can be used to manage your money effectively and economically is still a question mark. That said, investors can be their own worst enemies.
http://www.financialexpress.com/printer/news/497155/
Talent without soul
Talent without soul
by Dave C from live comments
It's usually not the class presidents or those with higher intellect that make it in this world. It's those that struggle in school and when entering the workplace. Those that have to work hard to make their way are the ones that become the millionaires and business owners, a lot of times employing those that fared much better than they themselves did during school. It's those seventeen year old kids that work nights and weekends after school, learning that hard work and pride in one's work are the future millionaires and business owners. It took the reading of two books to wake me up and show me where I had gone wrong. Both books are by Thomas J. Stanley, entitled The Millionaire Next Door and The Millionaire Mind
How many artists who have showed great talent, some even being labeled as "naturals," have struggled because their work, while showing lots of talent, displayed no life or soul? How many of these artists feel that all they have to do is drip a little paint on a canvas or draw half a dozen lines with a piece of charcoal and the world will be falling down at their feet, ready to proclaim them the next Wyeth or Pollock? I've attended art events and have run into this type of artist who, if you question their art, act as if you are beneath contempt, that their art needs no explanation or justification. It is what it is.
Some of us are labeled "winner" early on and it's the worst thing that can happen to us. Others get the "loser" tag affixed to them and, if they can survive it and look past it, they become some of the most successful in whatever field of endeavor they choose. Maybe, some day, we'll stop all this nonsense of teaching our children that they are special and they are winners without even lifting a finger, and get back to teaching them how to take pride in hard work and craftsmanship, leading them to much more fulfilling and useful lives.
http://clicks.robertgenn.com/winners-losers.php
by Dave C from live comments
It's usually not the class presidents or those with higher intellect that make it in this world. It's those that struggle in school and when entering the workplace. Those that have to work hard to make their way are the ones that become the millionaires and business owners, a lot of times employing those that fared much better than they themselves did during school. It's those seventeen year old kids that work nights and weekends after school, learning that hard work and pride in one's work are the future millionaires and business owners. It took the reading of two books to wake me up and show me where I had gone wrong. Both books are by Thomas J. Stanley, entitled The Millionaire Next Door and The Millionaire Mind
How many artists who have showed great talent, some even being labeled as "naturals," have struggled because their work, while showing lots of talent, displayed no life or soul? How many of these artists feel that all they have to do is drip a little paint on a canvas or draw half a dozen lines with a piece of charcoal and the world will be falling down at their feet, ready to proclaim them the next Wyeth or Pollock? I've attended art events and have run into this type of artist who, if you question their art, act as if you are beneath contempt, that their art needs no explanation or justification. It is what it is.
Some of us are labeled "winner" early on and it's the worst thing that can happen to us. Others get the "loser" tag affixed to them and, if they can survive it and look past it, they become some of the most successful in whatever field of endeavor they choose. Maybe, some day, we'll stop all this nonsense of teaching our children that they are special and they are winners without even lifting a finger, and get back to teaching them how to take pride in hard work and craftsmanship, leading them to much more fulfilling and useful lives.
http://clicks.robertgenn.com/winners-losers.php
Why The Rich Get Richer And How You Can Do So Too
Why The Rich Get Richer And How You Can Do So Too
By: Joel Teo
The Italian once said “There are only three ways to make money – you can steal it, marry it, or inherit it." Many would argue that they missed one very important method – investment. In fact it is why the rich get richer and how you can do so too.
Just ask the young man who invested his last nickel during the Great Depression. He invested in an apple doubled his money the same day and repeated the process slowly building a small fortune. Of course the two million dollars his parents left him certainly allowed him to invest even more seriously. It's why the rich get richer and how you can do so too.
What about Bill Gates who took great personal risks that gave him an industry monopoly. Of course the fact that his grandparents left him a million dollar trust fund and that his mother personally knew the CEO at IBM who would eventually seal the deal doesn't really make for a fair playing field. So is why the rich get richer and how you can do so too really doable?
Let's have a look at Donald Trump who inherited millions of dollars from his father so no matter what success he's had over the years he would have been wealthy anyway. It's why the rich get richer and how you can do so too – that is if you can pick your parents.
Since most of us can't pick our parents we'd better have a look at investing is some common stocks. If you are investing long term stocks are a good start. And it is why the rich get richer and how you can do so too. It doesn't favor rich or poor as long as you have the money for the stocks.
Mutual funds are also a good choice for long term with a lot less risk. Use a funds manager and you're going to deal with a funds load which is a percentage they take each year. But why not be your own manager and eliminate that cost which can add up. That's why the rich get richer and how you can do so too.
If you haven't figured out why the rich get richer and how you can do so too you need to do just a little more research and reading. You'll figure it out in no time and you will have the formula for why the rich get richer and how you can do so too.
http://www.streetdirectory.com/travel_guide/12761/how_to_grow_wealth/why_the_rich_get_richer_and_how_you_can_do_so_too.html
By: Joel Teo
The Italian once said “There are only three ways to make money – you can steal it, marry it, or inherit it." Many would argue that they missed one very important method – investment. In fact it is why the rich get richer and how you can do so too.
Just ask the young man who invested his last nickel during the Great Depression. He invested in an apple doubled his money the same day and repeated the process slowly building a small fortune. Of course the two million dollars his parents left him certainly allowed him to invest even more seriously. It's why the rich get richer and how you can do so too.
What about Bill Gates who took great personal risks that gave him an industry monopoly. Of course the fact that his grandparents left him a million dollar trust fund and that his mother personally knew the CEO at IBM who would eventually seal the deal doesn't really make for a fair playing field. So is why the rich get richer and how you can do so too really doable?
Let's have a look at Donald Trump who inherited millions of dollars from his father so no matter what success he's had over the years he would have been wealthy anyway. It's why the rich get richer and how you can do so too – that is if you can pick your parents.
Since most of us can't pick our parents we'd better have a look at investing is some common stocks. If you are investing long term stocks are a good start. And it is why the rich get richer and how you can do so too. It doesn't favor rich or poor as long as you have the money for the stocks.
Mutual funds are also a good choice for long term with a lot less risk. Use a funds manager and you're going to deal with a funds load which is a percentage they take each year. But why not be your own manager and eliminate that cost which can add up. That's why the rich get richer and how you can do so too.
If you haven't figured out why the rich get richer and how you can do so too you need to do just a little more research and reading. You'll figure it out in no time and you will have the formula for why the rich get richer and how you can do so too.
http://www.streetdirectory.com/travel_guide/12761/how_to_grow_wealth/why_the_rich_get_richer_and_how_you_can_do_so_too.html
8 Rules of Building Wealth
8 Rules of Building Wealth By: Alan L. Olsen
1. Forget Performance; look at fees
Remember that it’s not what you make, it’s what you keep. When evaluating an investment evaluate the cost to generate an investment return. If you are using an investment manager compare the performance of the investment net of fees. Be careful when entering into non-tradition investment vehicles life limited partnership interest. These type of investments tend to have higher management fees and are often illiquid.
2. Invest when a stock's earnings estimate are being revised upward.
Investing when a stock is strong is often a sign of good management and strong underlying value. Be focused on stocks that are reaching new highs because the management is committed to increasing the stock value. Look for stocks that announce buyback programs. This is often a sign that management feels the stock is undervalued. If the insiders feel that way, its often a great sign that you should be buying the stock too.
3. Monitor cash flow to find the winners
Increased cash flow into a company is a great sign that the company is fundamentally strong. With increased cash flow that company has the ability to pay increased dividends and expand without taking on a lot of debt.
4. Put the right investments in the right places
Don’t just buy an investment because everyone else is. The best investment policy is found in a balanced portfolio and outlines investment objectives. For example, if you are young and starting out your career, you should be heavily weighted into stocks and making investments with greater potential returns. A person in the retirement, should adopt an investment policy that focuses on predictable cash flow and protection of principal.
5. Forget 1 year outlooks; plan at least 5 or 10 years ahead
Even the best professional investment advisors cannot predict what is going to be the best performer for the next year. The best investment policy is reached by taking a long term perspective in mind. When you invest, invest for the long term. Be patience and allow your portfolio to experience volatility. If you are worrying about your investments, then you have too much invested. Only invest what you are afford to lose.
6. Don't be afraid to hold cash
You should set aside some cash outside of the electronic banking system. If you were to experience a disaster your credit cards may no longer work, but your cash will. Hold enough cash to manage your affairs for at least 4 days (or 72 hours).
7. Follow the outstanding shares
When evaluating a company be sure to check who is currently holding the stock. How much institutional shares are invested. Institutional share give more stability to the stock unless bad news is announced. If the stock is quickly dumped by the institution, this will probably result in a large drop on the market. Look for companies that have less than 50% of the outstanding stock in institutions. This may bring a greater up side if you are holding stock and the institutions are looking to acquire large blocks. Also, companies with stock buyback programs are a good sign the companies stock is undervalued.
8. Don't rely on your instincts; they're probably wrong
Most people learn this lesson the hard way. If everyone is dumping a stock, that doesn’t mean that you should also be buying. Do no try to time the market in a stock. Remember the saying: “Lows hit new lows and highs hit new highs". The best investment policy is one that adopts a slow steady pace.
http://www.streetdirectory.com/travel_guide/143305/how_to_grow_wealth/8_rules_of_building_wealth.html
1. Forget Performance; look at fees
Remember that it’s not what you make, it’s what you keep. When evaluating an investment evaluate the cost to generate an investment return. If you are using an investment manager compare the performance of the investment net of fees. Be careful when entering into non-tradition investment vehicles life limited partnership interest. These type of investments tend to have higher management fees and are often illiquid.
2. Invest when a stock's earnings estimate are being revised upward.
Investing when a stock is strong is often a sign of good management and strong underlying value. Be focused on stocks that are reaching new highs because the management is committed to increasing the stock value. Look for stocks that announce buyback programs. This is often a sign that management feels the stock is undervalued. If the insiders feel that way, its often a great sign that you should be buying the stock too.
3. Monitor cash flow to find the winners
Increased cash flow into a company is a great sign that the company is fundamentally strong. With increased cash flow that company has the ability to pay increased dividends and expand without taking on a lot of debt.
4. Put the right investments in the right places
Don’t just buy an investment because everyone else is. The best investment policy is found in a balanced portfolio and outlines investment objectives. For example, if you are young and starting out your career, you should be heavily weighted into stocks and making investments with greater potential returns. A person in the retirement, should adopt an investment policy that focuses on predictable cash flow and protection of principal.
5. Forget 1 year outlooks; plan at least 5 or 10 years ahead
Even the best professional investment advisors cannot predict what is going to be the best performer for the next year. The best investment policy is reached by taking a long term perspective in mind. When you invest, invest for the long term. Be patience and allow your portfolio to experience volatility. If you are worrying about your investments, then you have too much invested. Only invest what you are afford to lose.
6. Don't be afraid to hold cash
You should set aside some cash outside of the electronic banking system. If you were to experience a disaster your credit cards may no longer work, but your cash will. Hold enough cash to manage your affairs for at least 4 days (or 72 hours).
7. Follow the outstanding shares
When evaluating a company be sure to check who is currently holding the stock. How much institutional shares are invested. Institutional share give more stability to the stock unless bad news is announced. If the stock is quickly dumped by the institution, this will probably result in a large drop on the market. Look for companies that have less than 50% of the outstanding stock in institutions. This may bring a greater up side if you are holding stock and the institutions are looking to acquire large blocks. Also, companies with stock buyback programs are a good sign the companies stock is undervalued.
8. Don't rely on your instincts; they're probably wrong
Most people learn this lesson the hard way. If everyone is dumping a stock, that doesn’t mean that you should also be buying. Do no try to time the market in a stock. Remember the saying: “Lows hit new lows and highs hit new highs". The best investment policy is one that adopts a slow steady pace.
http://www.streetdirectory.com/travel_guide/143305/how_to_grow_wealth/8_rules_of_building_wealth.html
Has the stock market rise disturbed your portfolio?
Has the stock market rise disturbed your portfolio?
Consider this, suppose the prices of potato, ghee and sugar dropped to half, would you double your consumption and reduce that of the other food stuffs? Unlikely! You eat a balanced diet and a sudden price change does not make you change your diet drastically. Why then, should you behave differently with your money life and increase the proportion of an asset just because its price has taken its value higher? Rebalancing is a smart way to keep the portfolio suited to your risk and return needs.
Every portfolio has a mix of different instruments - debt, equity and cash. Debt, or interest-bearing instruments like bonds, income mutual funds and deposits, give low risk moderate returns, equity, or shares and stock market mutual funds, is risky and can give higher returns. Cash is the emergency and opportunity fund that gives very low returns, but is liquid and safe. Ideally, as a person ages, he should reduce the equity part of his portfolio and increase the lower risk debt since the risk-taking capacity goes down with age.
At each age and stage in life, each person will have his own unique asset allocation that works for his risk and return needs. For example, a 38 year old person may have an asset allocation of 60 per cent in equity and 40 per cent in debt and a 60 year old could have 20 per cent in equity and 80 per cent in debt. The idea is to stay at the chosen asset allocation at a particular age, even if the markets keep changing. Therefore the need for rebalancing.
Rebalancing the portfolio means coming back to the original asset allocation at least once a year, as markets take the value of the portfolio up or down. Consider this: in April 2003, a 38 year old with a 60:40 asset allocation in equity and debt has Rs 10 lakh in his portfolio. This means he has Rs 6 lakh worth of shares and equity mutual funds and Rs 4 lakh worth of debt paper like bank fixed deposits, debentures, bonds and funds. Now, almost a year later, the rising stock market has taken the collected value of his equity portfolio to Rs 12 lakh - his State Bank shares rose sharply, the index funds went up and so on, but his debt did not gain since interest rates did not fall and there was no capital gain on his bond funds. Now his asset allocation is Rs 12 lakh: Rs 4 lakh or 75:25 without him making any fresh investments or changing any older investments simply because the market took the equity value of his portfolio higher.
But this person had been comfortable with a 60:40 asset allocation, should he be at 75:25? No, he should go back to his original asset allocation, if he feels he cannot expose his portfolio to this higher level of risk. He can do two things:
Sell a part of his equity holdings to book profit and buy debt. It is difficult to sell the winner to buy the loser, specially when it looks as if the markets will keep rising. But remember, that if you don't rebalance, the market may do it for you and you will lose the profit you could have booked. Don't sell your entire holding of a favourite stock, sell a part of it and use the money to buy into debt instruments.
Make all fresh investments in debt. This may be difficult as such a large amount of money may not be available to bring the asset allocation back to the original level. It also prevents the person from booking profit, but it is an option for a person reluctant to sell in a rising market and yet needing to rebalance.
Booking profit to come back to your original equity-debt split is a smart strategy as it allows you to enjoy the gains and yet keep the desired proportion between assets intact. Remember to check on the tax angle before you sell. Sometimes it may be better wait a couple of months to become eligible for the lower long term capital gains tax. Sometimes it may be good to sell some stocks that have lost along with some winners to offset the losses to the gains.
How often should you rebalance?
Rebalance your portfolio once a year. Do it around tax investment time as your focus is already on money matters. Rebalance in the interim, if you feel that one asset class has suddenly shot up alarmingly. For example, the stock market vroom since April 2003 should be making you re-look at your portfolio now. But don't micromanage and churn for every percentage change in the asset allocation. A sustained 10 to 15 per cent change is the trigger to rebalance.
Is there some way to automatically rebalance?
If you find the job of managing your portfolio too heavy and rebalancing is a word you don't even want to hold, look at mutual funds. The newly launched fund of funds category is the most efficient way to follow the rebalancing strategy. A fund of fund invests in other mutual fund schemes. Fund houses like Birla Sun Life Mutual Fund and Prudential ICICI are offering different asset allocations to suit investment needs that will automatically rebalance according to the chosen asset allocation.
When should you not rebalance?
If you feel that your risk profile has changed and you can take higher risk, you can let your portfolio run on and not book profits. This is a high risk strategy, be aware of the risk and then do it, if it suits your profile.
http://www.indianexpress.com/oldStory/39393/
Consider this, suppose the prices of potato, ghee and sugar dropped to half, would you double your consumption and reduce that of the other food stuffs? Unlikely! You eat a balanced diet and a sudden price change does not make you change your diet drastically. Why then, should you behave differently with your money life and increase the proportion of an asset just because its price has taken its value higher? Rebalancing is a smart way to keep the portfolio suited to your risk and return needs.
Every portfolio has a mix of different instruments - debt, equity and cash. Debt, or interest-bearing instruments like bonds, income mutual funds and deposits, give low risk moderate returns, equity, or shares and stock market mutual funds, is risky and can give higher returns. Cash is the emergency and opportunity fund that gives very low returns, but is liquid and safe. Ideally, as a person ages, he should reduce the equity part of his portfolio and increase the lower risk debt since the risk-taking capacity goes down with age.
At each age and stage in life, each person will have his own unique asset allocation that works for his risk and return needs. For example, a 38 year old person may have an asset allocation of 60 per cent in equity and 40 per cent in debt and a 60 year old could have 20 per cent in equity and 80 per cent in debt. The idea is to stay at the chosen asset allocation at a particular age, even if the markets keep changing. Therefore the need for rebalancing.
Rebalancing the portfolio means coming back to the original asset allocation at least once a year, as markets take the value of the portfolio up or down. Consider this: in April 2003, a 38 year old with a 60:40 asset allocation in equity and debt has Rs 10 lakh in his portfolio. This means he has Rs 6 lakh worth of shares and equity mutual funds and Rs 4 lakh worth of debt paper like bank fixed deposits, debentures, bonds and funds. Now, almost a year later, the rising stock market has taken the collected value of his equity portfolio to Rs 12 lakh - his State Bank shares rose sharply, the index funds went up and so on, but his debt did not gain since interest rates did not fall and there was no capital gain on his bond funds. Now his asset allocation is Rs 12 lakh: Rs 4 lakh or 75:25 without him making any fresh investments or changing any older investments simply because the market took the equity value of his portfolio higher.
But this person had been comfortable with a 60:40 asset allocation, should he be at 75:25? No, he should go back to his original asset allocation, if he feels he cannot expose his portfolio to this higher level of risk. He can do two things:
Sell a part of his equity holdings to book profit and buy debt. It is difficult to sell the winner to buy the loser, specially when it looks as if the markets will keep rising. But remember, that if you don't rebalance, the market may do it for you and you will lose the profit you could have booked. Don't sell your entire holding of a favourite stock, sell a part of it and use the money to buy into debt instruments.
Make all fresh investments in debt. This may be difficult as such a large amount of money may not be available to bring the asset allocation back to the original level. It also prevents the person from booking profit, but it is an option for a person reluctant to sell in a rising market and yet needing to rebalance.
Booking profit to come back to your original equity-debt split is a smart strategy as it allows you to enjoy the gains and yet keep the desired proportion between assets intact. Remember to check on the tax angle before you sell. Sometimes it may be better wait a couple of months to become eligible for the lower long term capital gains tax. Sometimes it may be good to sell some stocks that have lost along with some winners to offset the losses to the gains.
How often should you rebalance?
Rebalance your portfolio once a year. Do it around tax investment time as your focus is already on money matters. Rebalance in the interim, if you feel that one asset class has suddenly shot up alarmingly. For example, the stock market vroom since April 2003 should be making you re-look at your portfolio now. But don't micromanage and churn for every percentage change in the asset allocation. A sustained 10 to 15 per cent change is the trigger to rebalance.
Is there some way to automatically rebalance?
If you find the job of managing your portfolio too heavy and rebalancing is a word you don't even want to hold, look at mutual funds. The newly launched fund of funds category is the most efficient way to follow the rebalancing strategy. A fund of fund invests in other mutual fund schemes. Fund houses like Birla Sun Life Mutual Fund and Prudential ICICI are offering different asset allocations to suit investment needs that will automatically rebalance according to the chosen asset allocation.
When should you not rebalance?
If you feel that your risk profile has changed and you can take higher risk, you can let your portfolio run on and not book profits. This is a high risk strategy, be aware of the risk and then do it, if it suits your profile.
http://www.indianexpress.com/oldStory/39393/
Some Investing Principles which cannot be disputed
While it may be true that in the online investing world there is no rule without an exception, there are some principles which cannot be disputed. These principles can help investors get a better grasp of how to approach online investments and nurture them to maturity.
Sell the losers and let the winners keep riding
For long term investing success it is important to ride a winner. Ever so often, investors make profits by selling their appreciated online stocks, but hold onto stocks that have declined in hopes of a rebound. If an investor doesn't know when it's time to let go of hopeless stocks, he or she can, in the worst-case scenario, see the stock sink to the point where it is almost worthless. Of course, the idea of holding onto high-quality investments while selling the poor ones is great in theory, but hard to put into practice.
If you have a personal preference to sell after a stock has increased by a certain multiple - say three, for instance - you may never fully ride out a winner. No one in the history of investing with a "sell-after-I-have-tripled-my-money" mentality has ever succeeded.. Don't underestimate a stock that is performing well by sticking to some rigid personal rule - if you don't have a good understanding of the potential of your investments, your personal rules may end up being arbitrary and too limiting.
While riding a winner is important, you also should sell the losers. There is no guarantee that an online stock will bounce back after a long period of decline. While it is important not to underestimate good stocks, it is equally important to be realistic about investments that are performing badly. Recognizing your losers is hard because it's also an acknowledgment of your mistake. But it's important to be honest when you realize that a stock is not performing as well as you expected it to. Don't be afraid to swallow your pride and move on before your losses become even greater.
In both cases, the point is to judge companies on their merits according to your research. In each situation, you still have to decide whether a price justifies future potential. Just remember not to let your fears limit your returns or inflate your losses.
Learn to give a cold shoulder to hot tips
Whether the tip comes from your brother, cousin, neighbor or even online broker, no one can ever guarantee what online stocks will do. When you make an investment, it's important you know the reasons for doing so. Conduct your own research and analysis of any company before you even consider investing your hard earned money. Relying on a hot tip from someone else is not only an attempt at taking the easy way out, it is also a big gamble. Sure, with some luck, tips may sometimes pan out. But they will never make you an informed investor, which is what you need to be to be successful in the long run.
Don't panic when shares experience short-term movements
As a long term online investing strategy, you should not panic when your online investments experience short-term movements. When tracking the activities of your investments, you should look at the big picture. Remember to be confident in the quality of your investments rather than nervous about the inevitable volatility of the short term.
Day traders will use these day-to-day and even minute-to-minute fluctuations as a way to make gains. But the gains of a long-term investor come from a completely different market movement - the one that occurs over many years - so keep your focus on developing your overall investment philosophy by educating yourself.
Do not overemphasize the P/E ratio
Investors often place too much importance on the price-to-earning (P/E) ratio in their online investing strategy. It is one key tool among many. Using only this ratio to make buy or sell decisions is dangerous and ill-advised. The P/E ratio must be interpreted within a context, and it should be used in conjunction with other analytical processes. So, a low P/E ratio doesn't necessarily mean a security is undervalued, nor does a high P/E ratio necessarily mean a company is over valued.
Resist the temptation of penny stocks
A common misconception is that there is less to lose in buying a low-priced stock. But whether you buy a $5 stock that plunges to $0 or a $75 stock that does the same, either way you'd still have a 100% loss of your initial investment. A penny stock is probably riskier than a company with a higher share price, which would have more regulations placed on it.
Stick to your strategy
Online stock investors use different methods to pick stocks and fulfill investing goals. There are many ways to be successful and no one strategy is inherently better than any other. However, once you find your style, stick to it. An investor who switches between different stock-picking strategies will probably experience the worst, rather than the best, of each. Constantly switching strategies effectively makes you a market timer, and this is definitely territory most investors aiming at long term strategies should avoid.
While these suggestions cover some critical strategies for long-term online investments there is an exception to every rule. Depending on your circumstances, use these principles within the framework of your overall investment strategy, and reap the benefits of long term online investments.
http://www.1einvestonline.com/online-stock-investors.html
Sell the losers and let the winners keep riding
For long term investing success it is important to ride a winner. Ever so often, investors make profits by selling their appreciated online stocks, but hold onto stocks that have declined in hopes of a rebound. If an investor doesn't know when it's time to let go of hopeless stocks, he or she can, in the worst-case scenario, see the stock sink to the point where it is almost worthless. Of course, the idea of holding onto high-quality investments while selling the poor ones is great in theory, but hard to put into practice.
If you have a personal preference to sell after a stock has increased by a certain multiple - say three, for instance - you may never fully ride out a winner. No one in the history of investing with a "sell-after-I-have-tripled-my-money" mentality has ever succeeded.. Don't underestimate a stock that is performing well by sticking to some rigid personal rule - if you don't have a good understanding of the potential of your investments, your personal rules may end up being arbitrary and too limiting.
While riding a winner is important, you also should sell the losers. There is no guarantee that an online stock will bounce back after a long period of decline. While it is important not to underestimate good stocks, it is equally important to be realistic about investments that are performing badly. Recognizing your losers is hard because it's also an acknowledgment of your mistake. But it's important to be honest when you realize that a stock is not performing as well as you expected it to. Don't be afraid to swallow your pride and move on before your losses become even greater.
In both cases, the point is to judge companies on their merits according to your research. In each situation, you still have to decide whether a price justifies future potential. Just remember not to let your fears limit your returns or inflate your losses.
Learn to give a cold shoulder to hot tips
Whether the tip comes from your brother, cousin, neighbor or even online broker, no one can ever guarantee what online stocks will do. When you make an investment, it's important you know the reasons for doing so. Conduct your own research and analysis of any company before you even consider investing your hard earned money. Relying on a hot tip from someone else is not only an attempt at taking the easy way out, it is also a big gamble. Sure, with some luck, tips may sometimes pan out. But they will never make you an informed investor, which is what you need to be to be successful in the long run.
Don't panic when shares experience short-term movements
As a long term online investing strategy, you should not panic when your online investments experience short-term movements. When tracking the activities of your investments, you should look at the big picture. Remember to be confident in the quality of your investments rather than nervous about the inevitable volatility of the short term.
Day traders will use these day-to-day and even minute-to-minute fluctuations as a way to make gains. But the gains of a long-term investor come from a completely different market movement - the one that occurs over many years - so keep your focus on developing your overall investment philosophy by educating yourself.
Do not overemphasize the P/E ratio
Investors often place too much importance on the price-to-earning (P/E) ratio in their online investing strategy. It is one key tool among many. Using only this ratio to make buy or sell decisions is dangerous and ill-advised. The P/E ratio must be interpreted within a context, and it should be used in conjunction with other analytical processes. So, a low P/E ratio doesn't necessarily mean a security is undervalued, nor does a high P/E ratio necessarily mean a company is over valued.
Resist the temptation of penny stocks
A common misconception is that there is less to lose in buying a low-priced stock. But whether you buy a $5 stock that plunges to $0 or a $75 stock that does the same, either way you'd still have a 100% loss of your initial investment. A penny stock is probably riskier than a company with a higher share price, which would have more regulations placed on it.
Stick to your strategy
Online stock investors use different methods to pick stocks and fulfill investing goals. There are many ways to be successful and no one strategy is inherently better than any other. However, once you find your style, stick to it. An investor who switches between different stock-picking strategies will probably experience the worst, rather than the best, of each. Constantly switching strategies effectively makes you a market timer, and this is definitely territory most investors aiming at long term strategies should avoid.
While these suggestions cover some critical strategies for long-term online investments there is an exception to every rule. Depending on your circumstances, use these principles within the framework of your overall investment strategy, and reap the benefits of long term online investments.
http://www.1einvestonline.com/online-stock-investors.html
When To Sell Your Stocks
When To Sell Your Stocks
David Serchuk 03.04.09, 6:00 PM ET
We sell our winners too early and ride the losers straight into the ground. This self-destructive pattern even has a name. It's called the "disposition effect."
Why do we do it? Ravi Dhar and Ning Zhu of the Yale School of Management believe that the disposition effect is real but that professional investors are less prone to it. One reason is because such investors are more able to confront bad news and admit error. But the madding crowd seems to lack this armor. Basically, we can't handle the truth.
To deal with such messy, emotional, but real issues we convened a special, more intimate meeting of the Forbes.com Investor Team. On one side of the table we have Michael Ervolini, the head of Cabot Research, which applies behavioral finance to its mostly institutional client base. Behavioral finance applies the lens of psychology to the seemingly cold, rational world of business and investing. On the other side of the discussion we have Marc Lowlicht, the head of the wealth management division of Further Lane Asset Management. Lowlicht is on the front lines, dealing with unhappy, stressed customers who feel panicked and powerless as their portfolios shrink.
What Ervolini has found is that many of our seemingly rational decisions--good or bad--are based on emotions hard-wired into us. Greed, embarrassment and shame are often in the driver's seat, no matter how much we would like to think otherwise.
In the case of stock sales, here's the problem: it's been documented that the pain of losing money is twice greater than the joy of making it. So if you buy a stock and it goes up $2, you're tempted to sell. Investors love to take small gains off the table. If it goes down $1, most investors will refuse to take the loss. They will hang onto the loser in the hopes of making that dollar back. That $1 loss has as strong an effect on the brain as a $2 gain.
"As long as the loss is hanging in the portfolio it has a chance of coming back," Ervolini says. "But once you sell a position, that position is a loser forever and a little bit of you is a loser forever."
Another problem Ervolini has found is that the same part of the brain that reacts with horror to death and disease is the one that's affected by financial losses. This stretches far back in our evolutionary history. In less civilized times, a financial loss, or the loss of a source of gathered or hoarded food, could lead quickly to death. We react the same way to the nest egg that's meant to see us through retirement.
There is very little research on the subject of stock sales. Ervolini found just one paper. But as shown by the recent market meltdown, selling is often the more critical skill.
Another issue Lowlicht confronts is that his customers often don't understand that there can be no real growth without some risk. The problem, Ervolini counters, is that so few of us truly know how much loss we can bear. Often it is much less than we initially believe. "Know Thyself" might be a classic ideal but for many it remains just that.
Why We Can't Sell
Forbes: Mike, one thing you've mentioned is the anti-selling bias. You can be a good buyer of securities or a good seller, but usually people aren't both. Why is there this anti-selling bias?
Michael Ervolini: Well, I can relate it to [mutual fund] managers and then we can try to then relate it to individuals. From managers, there's a technical and an emotional explanation. The technical one is that for the past 30 years virtually every dollar invested in studying the strategic part of investing has been about buying. It's research for ranking stocks. It's portfolio risk management. It's optimizers. It's tools that do attribution analysis and on and on. It's all looking at what you own and what you're going to buy today. We did some extensive work on this and we found one academic article on selling.
Forbes: One? Was it a good article?
Ervolini: It was pretty good.
Marc Lowlicht: Compared to the others, it was great.
Ervolini: And there are no real heavy books on the subject. Everybody's oriented toward buying in terms of the profession. We talked to the people at Tower Research who do financial research. They agreed that 80% or more of the dollars that they see invested are on buying. In terms of research, capital, etc. So selling has just been under-served from the industry's perspective.
Our academic adviser, Terrance Odean [the Willis H. Booth Professor of Banking and Finance at the Haas School of Business at the University of California, Berkeley] has expressed a behavioral approach this way: When you buy something--and we're looking at long portfolios for a second--it's out of hope. What can this position do for me? It's a pretty nice place to be. When you sell, it's because of what the position did to you. And maybe there's just some natural inclination to want to spend more time thinking about buying because it's just a more pleasant thought process as opposed to selling. But, I can tell you we've looked at just scores and scores and scores of funds and we see it over and over again.
And when we talk to professional managers, it resonates. "Yeah, I have some concerns about my selling and I'm glad to be able to have a really thorough examination of just my selling. Because I know I can make it better." And it's they don't have in their organization feedback mechanisms to help them do it.
Lowlicht: Can I add something else in there that I've observed? Part of my business is to understand how people think because I have to guide them based on that. I think another reason people are better buyers than sellers is because when you buy, there's no tally to how you did. If you lose, it's a paper loss. "It's still a good company. It's going to come back." But when you finally sell something, if it goes higher, you sold too soon. If it goes lower, you made the right decision. If you outperformed, you did great. So, people like to be winners. People like to be right. That's why people argue. And when you buy, there is no weighing system as to whether you're right or wrong until the sale is made. So, it's much easier not to second guess a purchase.
And even if you bought Citigroup at $12, you can make a hundred excuses why you think it's going to $20. You still made the right decision. And right now, it's just a paper loss … But once you make a sale, your decision has been final and there's an accounting for the decision you made.
Ervolini: In behavioral finance, exactly what Marc's talking about is known as the disposition effect. And what we see repeatedly is that people love to take small gains off the table. We see it repeatedly, retail and institutional. People love to take gains for two reasons. Ten $1 gains make us feel better than one $10 gain. That's just the way our brains work. We like lots of small rewards as opposed to one big one. And once the gain starts to get up there, like $3-$4, we get fearful that the market will take it away. So, those two motivations cause us to take gains early.
And with losses it's what Marc was saying. As long as the loss is hanging in the portfolio, it has a chance of coming back. And we can postpone the self recrimination. But once you sell a position, that position is a loser forever and a little bit of you is a loser forever.
The other thing to keep in mind is that studies have shown that the emotional high we get from a dollar of win is only half the emotional low we get from losing a dollar. So a loss is twice as impactful as a win in money. We hate to lose and it's something primitive.
Forbes: Do investors really believe there is no reward without risk?
Ervolini: Oh, there's always a trade-off. When you allay someone's fears by changing their investment strategy, you're giving up return. And there's no way around that. The problem is the general investing public is misled into believing that return is magically created with no risk.
Lowlicht: And I think one of the problems is people want something for nothing almost. I don't know if that's the right terminology, but they have expectations of receiving, but don't consider what they give up. And they want to believe that there's a free lunch, that there's an easier way to do it. Or that somebody else has figured it out. Nobody else has figured it out. You've got a certain amount of return for the amount of risk you take. The more risk you take, the greater the return. The less risk you take, the less the return.
Ervolini: This is tough because one of the things we're not good at appreciating today is what a future outcome will feel like. And so, if Marc's interviewing me and he says to me, "Mike, can you handle a 5% draw down on your account?" I say, "Yeah, sure." And he says, "How about 10%?" I say, "Yeah, sure." And then he keeps going on and on. And he finally gets to a number where I say ouch. Let's say it's 40%. So now, based on his interview, Marc has a sense of one dimension of my risk tolerance. And then what happens is we're running down the road and my account gets drawn down 12% and I'm on the phone begging him to help me. Because I can't really appreciate what a 10% or 15% draw down feels like until I get there.
See More Intelligent Investing Features.
http://www.forbes.com/2009/03/04/psychology-selling-stocks-intelligent-investing_psychology.html
David Serchuk 03.04.09, 6:00 PM ET
We sell our winners too early and ride the losers straight into the ground. This self-destructive pattern even has a name. It's called the "disposition effect."
Why do we do it? Ravi Dhar and Ning Zhu of the Yale School of Management believe that the disposition effect is real but that professional investors are less prone to it. One reason is because such investors are more able to confront bad news and admit error. But the madding crowd seems to lack this armor. Basically, we can't handle the truth.
To deal with such messy, emotional, but real issues we convened a special, more intimate meeting of the Forbes.com Investor Team. On one side of the table we have Michael Ervolini, the head of Cabot Research, which applies behavioral finance to its mostly institutional client base. Behavioral finance applies the lens of psychology to the seemingly cold, rational world of business and investing. On the other side of the discussion we have Marc Lowlicht, the head of the wealth management division of Further Lane Asset Management. Lowlicht is on the front lines, dealing with unhappy, stressed customers who feel panicked and powerless as their portfolios shrink.
What Ervolini has found is that many of our seemingly rational decisions--good or bad--are based on emotions hard-wired into us. Greed, embarrassment and shame are often in the driver's seat, no matter how much we would like to think otherwise.
In the case of stock sales, here's the problem: it's been documented that the pain of losing money is twice greater than the joy of making it. So if you buy a stock and it goes up $2, you're tempted to sell. Investors love to take small gains off the table. If it goes down $1, most investors will refuse to take the loss. They will hang onto the loser in the hopes of making that dollar back. That $1 loss has as strong an effect on the brain as a $2 gain.
"As long as the loss is hanging in the portfolio it has a chance of coming back," Ervolini says. "But once you sell a position, that position is a loser forever and a little bit of you is a loser forever."
Another problem Ervolini has found is that the same part of the brain that reacts with horror to death and disease is the one that's affected by financial losses. This stretches far back in our evolutionary history. In less civilized times, a financial loss, or the loss of a source of gathered or hoarded food, could lead quickly to death. We react the same way to the nest egg that's meant to see us through retirement.
There is very little research on the subject of stock sales. Ervolini found just one paper. But as shown by the recent market meltdown, selling is often the more critical skill.
Another issue Lowlicht confronts is that his customers often don't understand that there can be no real growth without some risk. The problem, Ervolini counters, is that so few of us truly know how much loss we can bear. Often it is much less than we initially believe. "Know Thyself" might be a classic ideal but for many it remains just that.
Why We Can't Sell
Forbes: Mike, one thing you've mentioned is the anti-selling bias. You can be a good buyer of securities or a good seller, but usually people aren't both. Why is there this anti-selling bias?
Michael Ervolini: Well, I can relate it to [mutual fund] managers and then we can try to then relate it to individuals. From managers, there's a technical and an emotional explanation. The technical one is that for the past 30 years virtually every dollar invested in studying the strategic part of investing has been about buying. It's research for ranking stocks. It's portfolio risk management. It's optimizers. It's tools that do attribution analysis and on and on. It's all looking at what you own and what you're going to buy today. We did some extensive work on this and we found one academic article on selling.
Forbes: One? Was it a good article?
Ervolini: It was pretty good.
Marc Lowlicht: Compared to the others, it was great.
Ervolini: And there are no real heavy books on the subject. Everybody's oriented toward buying in terms of the profession. We talked to the people at Tower Research who do financial research. They agreed that 80% or more of the dollars that they see invested are on buying. In terms of research, capital, etc. So selling has just been under-served from the industry's perspective.
Our academic adviser, Terrance Odean [the Willis H. Booth Professor of Banking and Finance at the Haas School of Business at the University of California, Berkeley] has expressed a behavioral approach this way: When you buy something--and we're looking at long portfolios for a second--it's out of hope. What can this position do for me? It's a pretty nice place to be. When you sell, it's because of what the position did to you. And maybe there's just some natural inclination to want to spend more time thinking about buying because it's just a more pleasant thought process as opposed to selling. But, I can tell you we've looked at just scores and scores and scores of funds and we see it over and over again.
And when we talk to professional managers, it resonates. "Yeah, I have some concerns about my selling and I'm glad to be able to have a really thorough examination of just my selling. Because I know I can make it better." And it's they don't have in their organization feedback mechanisms to help them do it.
Lowlicht: Can I add something else in there that I've observed? Part of my business is to understand how people think because I have to guide them based on that. I think another reason people are better buyers than sellers is because when you buy, there's no tally to how you did. If you lose, it's a paper loss. "It's still a good company. It's going to come back." But when you finally sell something, if it goes higher, you sold too soon. If it goes lower, you made the right decision. If you outperformed, you did great. So, people like to be winners. People like to be right. That's why people argue. And when you buy, there is no weighing system as to whether you're right or wrong until the sale is made. So, it's much easier not to second guess a purchase.
And even if you bought Citigroup at $12, you can make a hundred excuses why you think it's going to $20. You still made the right decision. And right now, it's just a paper loss … But once you make a sale, your decision has been final and there's an accounting for the decision you made.
Ervolini: In behavioral finance, exactly what Marc's talking about is known as the disposition effect. And what we see repeatedly is that people love to take small gains off the table. We see it repeatedly, retail and institutional. People love to take gains for two reasons. Ten $1 gains make us feel better than one $10 gain. That's just the way our brains work. We like lots of small rewards as opposed to one big one. And once the gain starts to get up there, like $3-$4, we get fearful that the market will take it away. So, those two motivations cause us to take gains early.
And with losses it's what Marc was saying. As long as the loss is hanging in the portfolio, it has a chance of coming back. And we can postpone the self recrimination. But once you sell a position, that position is a loser forever and a little bit of you is a loser forever.
The other thing to keep in mind is that studies have shown that the emotional high we get from a dollar of win is only half the emotional low we get from losing a dollar. So a loss is twice as impactful as a win in money. We hate to lose and it's something primitive.
Forbes: Do investors really believe there is no reward without risk?
Ervolini: Oh, there's always a trade-off. When you allay someone's fears by changing their investment strategy, you're giving up return. And there's no way around that. The problem is the general investing public is misled into believing that return is magically created with no risk.
Lowlicht: And I think one of the problems is people want something for nothing almost. I don't know if that's the right terminology, but they have expectations of receiving, but don't consider what they give up. And they want to believe that there's a free lunch, that there's an easier way to do it. Or that somebody else has figured it out. Nobody else has figured it out. You've got a certain amount of return for the amount of risk you take. The more risk you take, the greater the return. The less risk you take, the less the return.
Ervolini: This is tough because one of the things we're not good at appreciating today is what a future outcome will feel like. And so, if Marc's interviewing me and he says to me, "Mike, can you handle a 5% draw down on your account?" I say, "Yeah, sure." And he says, "How about 10%?" I say, "Yeah, sure." And then he keeps going on and on. And he finally gets to a number where I say ouch. Let's say it's 40%. So now, based on his interview, Marc has a sense of one dimension of my risk tolerance. And then what happens is we're running down the road and my account gets drawn down 12% and I'm on the phone begging him to help me. Because I can't really appreciate what a 10% or 15% draw down feels like until I get there.
See More Intelligent Investing Features.
http://www.forbes.com/2009/03/04/psychology-selling-stocks-intelligent-investing_psychology.html
Warren Buffett On Sex
Published in Investing on 22 July 2009
Buffett's analogies frequently involve sex. Here are our favourite Buffett thoughts and quotes on sex.
Besides being the world's greatest investor, Warren Buffett is a Michelangelo when it comes to drawing analogies.
He is a master at distilling complex concepts into humorous one-liners that we can understand. And we tend to trust him because he only invests and speaks about what he knows.
He develops decades-long relationships with portfolio holdings including Coca-Cola, Wells Fargo and American Express and while he's been known to sneak a peek at companies outside his circle of competence, you'll never see him stray to Google or even Microsoft.
What does all this have to do with sex, you ask? Well, we already know that Buffett tends to stick to stuff he understands in and out. We also know that his analogies frequently involve sex. Ahem. You can connect the dots yourself. To help you, here are our favourite Warren Buffett thoughts on sex!
Buffett's advice seems to be to start early ... and we ain't talkin' retirement planning:
On being active: "It's nice to have a lot of money, but you know, you don't want to keep it around forever. I prefer buying things. Otherwise, it's a little like saving sex for your old age."
On career advice: "A few months ago I was talking to another MBA student, a very talented man, about 30 years old from a great school with a great resume. I asked him what he wanted to do for his career, and he replied that he wanted to go into a particular field, but thought he should work for McKinsey for a few years first to add to his resume. To me that's like saving sex for your old age. It makes no sense."
On loving your job: "You want to have a passion for what you are doing. You don't want to wait until 80 to have sex."
All this bedroom talk may have you wondering if Buffett is straying too far outside his primary circle of competence. Not to worry:
On ninja-like focus: "You know, if I'm playing bridge and a naked woman walks by, I don't ever see her."
On due diligence: "Other guys read Playboy, I read annual reports."
On over-diversification: "If you have a harem of 40 women, you never get to know any of them very well."
Of course, maybe we're underestimating how large his circle is:
On internal yardsticks: "Would you prefer to be the greatest lover in the world and known as the worst, or would you prefer to be the worst lover and known as the greatest?"
Sometimes opportunity knocks -- gather ye rosebuds while ye may:
On investing in 1973: "I feel like an oversexed guy on a desert island. I can't find anything to buy."
On investing in 1974: "I feel like an oversexed man in a harem. This is the time to start investing."
An Indecent Proposal:
On selling your business to Berkshire Hathaway vs. private equity: "You can sell it to Berkshire, and we'll put it in the Metropolitan Museum; it'll have a wing all by itself; it'll be there forever. Or you can sell it to some porn shop operator, and he'll take the painting and he'll make the boobs a little bigger and he'll stick it up in the window, and some other guy will come along in a raincoat, and he'll buy it.''
On becoming a true investor: "We believe that according the name 'investors' to institutions that trade actively is like calling someone who repeatedly engages in one-night stands a 'romantic.'"
Some insights into the current economic situation that make us wonder which of these he's tried:
On the first stimulus package: "[It was like] half a tablet of Viagra and then having also a bunch of candy mixed in -- it doesn't have really quite the wallop."
Solicited to buy Bear Stearns, and asked if he wanted more information (from the book Street Fighters): "It was sort of like having a woman standing in front of you who had taken half her clothes off and then asked whether she should continue, [Buffett] thought. Just as he'd want the woman to finish the job, he was certainly curious to hear what was happening that weekend with the embattled Bear."
On the speed of economic recovery: "You can't produce a baby in one month by getting nine women pregnant. It just doesn't work that way."
Buffett knew a girl who knew a guy who knew a credit default swap:
On financially transmitted diseases: "Derivatives are like sex. It's not who we're sleeping with, it's who they're sleeping with that's the problem."
> A version of this article was originally published on Fool.com. It has been updated by Bruce Jackson, who has an interest in Berkshire Hathaway.
http://www.fool.co.uk/news/investing/2009/07/22/warren-buffett-on-sex.aspx
Buffett's analogies frequently involve sex. Here are our favourite Buffett thoughts and quotes on sex.
Besides being the world's greatest investor, Warren Buffett is a Michelangelo when it comes to drawing analogies.
He is a master at distilling complex concepts into humorous one-liners that we can understand. And we tend to trust him because he only invests and speaks about what he knows.
He develops decades-long relationships with portfolio holdings including Coca-Cola, Wells Fargo and American Express and while he's been known to sneak a peek at companies outside his circle of competence, you'll never see him stray to Google or even Microsoft.
What does all this have to do with sex, you ask? Well, we already know that Buffett tends to stick to stuff he understands in and out. We also know that his analogies frequently involve sex. Ahem. You can connect the dots yourself. To help you, here are our favourite Warren Buffett thoughts on sex!
Buffett's advice seems to be to start early ... and we ain't talkin' retirement planning:
On being active: "It's nice to have a lot of money, but you know, you don't want to keep it around forever. I prefer buying things. Otherwise, it's a little like saving sex for your old age."
On career advice: "A few months ago I was talking to another MBA student, a very talented man, about 30 years old from a great school with a great resume. I asked him what he wanted to do for his career, and he replied that he wanted to go into a particular field, but thought he should work for McKinsey for a few years first to add to his resume. To me that's like saving sex for your old age. It makes no sense."
On loving your job: "You want to have a passion for what you are doing. You don't want to wait until 80 to have sex."
All this bedroom talk may have you wondering if Buffett is straying too far outside his primary circle of competence. Not to worry:
On ninja-like focus: "You know, if I'm playing bridge and a naked woman walks by, I don't ever see her."
On due diligence: "Other guys read Playboy, I read annual reports."
On over-diversification: "If you have a harem of 40 women, you never get to know any of them very well."
Of course, maybe we're underestimating how large his circle is:
On internal yardsticks: "Would you prefer to be the greatest lover in the world and known as the worst, or would you prefer to be the worst lover and known as the greatest?"
Sometimes opportunity knocks -- gather ye rosebuds while ye may:
On investing in 1973: "I feel like an oversexed guy on a desert island. I can't find anything to buy."
On investing in 1974: "I feel like an oversexed man in a harem. This is the time to start investing."
An Indecent Proposal:
On selling your business to Berkshire Hathaway vs. private equity: "You can sell it to Berkshire, and we'll put it in the Metropolitan Museum; it'll have a wing all by itself; it'll be there forever. Or you can sell it to some porn shop operator, and he'll take the painting and he'll make the boobs a little bigger and he'll stick it up in the window, and some other guy will come along in a raincoat, and he'll buy it.''
On becoming a true investor: "We believe that according the name 'investors' to institutions that trade actively is like calling someone who repeatedly engages in one-night stands a 'romantic.'"
Some insights into the current economic situation that make us wonder which of these he's tried:
On the first stimulus package: "[It was like] half a tablet of Viagra and then having also a bunch of candy mixed in -- it doesn't have really quite the wallop."
Solicited to buy Bear Stearns, and asked if he wanted more information (from the book Street Fighters): "It was sort of like having a woman standing in front of you who had taken half her clothes off and then asked whether she should continue, [Buffett] thought. Just as he'd want the woman to finish the job, he was certainly curious to hear what was happening that weekend with the embattled Bear."
On the speed of economic recovery: "You can't produce a baby in one month by getting nine women pregnant. It just doesn't work that way."
Buffett knew a girl who knew a guy who knew a credit default swap:
On financially transmitted diseases: "Derivatives are like sex. It's not who we're sleeping with, it's who they're sleeping with that's the problem."
> A version of this article was originally published on Fool.com. It has been updated by Bruce Jackson, who has an interest in Berkshire Hathaway.
http://www.fool.co.uk/news/investing/2009/07/22/warren-buffett-on-sex.aspx
3 Really Bad Reasons Not To Sell
3 Really Bad Reasons Not To Sell
By Bruce JacksonPublished in Investing Strategy on 24 July 2009
Selling shares really is much easier than you think. You should do more of it.
Investors often find it difficult to sell their shares. If I had a pound for every time someone said to me "selling is the hardest investing decision", I'd be a rich person.
What hogwash. Selling is easy. Just click the sell button. Poof. Shares out, cash in.
It can't get much easier than that. And with trading commissions so low, there really is no reason not to sell.
Yet people still struggle to sell. Why?
Bad Reason #1 -- Laziness
The easy option is to do nothing. The same goes in business. Most businesses simply keep doing things the way they've always done them, "because we've always done it that way."
Why change? I'll tell you why. There is always a better way of doing things. You need to constantly challenge yourself, and challenge the status quo.
When it comes to investing, people don't challenge their investments. They don't look at them and say "this one is overvalued now" or "that one is struggling to grow its market share" or "I think there's trouble ahead for this sector".
Unfortunately, there are precious few "buy and hold forever" companies. Just ask the people who thought Royal Bank of Scotland (LSE: RBS) and Lloyds Banking Group (LSE: LLOY) were large, stable, high yielding and cheap companies.
Bad Reason #2 -- Boring
Buying is far more exciting. It's always fun looking for the "next big winner", the share that is going to make your investing fortune. People spend most of their time looking for this illusive company, the next Tullow Oil (LSE: TLW) or the next GlaxoSmithKline (LSE: GSK).
Whilst there is nothing wrong with looking for tomorrow's big winners, I'd suggest investors should spend much more time monitoring their existing portfolio stocks.
Things they need to keep an eye on include…
■The competitive environment. If you own shares in J Sainsbury (LSE: SBRY), you might want to think about whether the resurgence of Wm. Morrison (LSE: MRW) might impact on their future sales growth.
■The economy. In the past 12 months, as we all found out to our cost, ignoring the economy can be wealth destroying. If you think the economy is in for a rough time over the next few years, you might want to think about selling your shares in companies selling discretionary goods, like DSG International (LSE: DSGI) and Carpetright (LSE: CPR).
■Valuation. When a company reaches your estimate of fair value, you should start selling. It's as simple as that. So why don't people sell on valuation grounds? Read on…
Bad Reason #3 - Fear
People fail to sell because they fear of missing out on a huge winner. Fear and greed are the two most powerful emotions investors have to deal with, almost on a daily basis. Fear can come in many guises, but is most powerful when people fear losing money. How else do you explain the massive and indiscriminate selling spree witnessed in March this year? It was based on fear alone.
But there's another thing investors fear almost as much. They fear of selling too early. The stock market is littered with tales of people who bought Tesco (LSE: TSCO) shares in the early days and hung on all the way through to now, or Domino's Pizza (LSE: DOM), one of the best performing shares of the last decade.
The stories usually recount how these great performers were, at various times over the years, over-valued. Yet the companies kept growing, kept beating market expectations, and the share price ended up providing these canny investors with returns in the thousands of percentage points.
This is very much the exception rather than the rule. The intensely competitive environment usually puts a cap on the long-term growth prospects of most companies. For example, although Domino's Pizza dominates the takeaway pizza environment today, it wasn't too many years ago when many thought PizzaExpress would open hundreds of takeaway outlets and rule the world of ham, cheese, tomato, pineapple and anchovies.
Fear not. If a company in your portfolio is highly valued, just click and sell. You'll most likely get the chance to buy it back at a cheaper price anyway.
The Best Parts About Selling
If this choppy market has taught us anything, it should be that you need to sell at the right time. It's not that difficult. And you know the best parts about selling? 1) It's cheap and easy, and 2) you can't lose cash!
http://www.fool.co.uk/news/investing/investing-strategy/2009/07/24/3-really-bad-reasons-not-to-sell.aspx
By Bruce JacksonPublished in Investing Strategy on 24 July 2009
Selling shares really is much easier than you think. You should do more of it.
Investors often find it difficult to sell their shares. If I had a pound for every time someone said to me "selling is the hardest investing decision", I'd be a rich person.
What hogwash. Selling is easy. Just click the sell button. Poof. Shares out, cash in.
It can't get much easier than that. And with trading commissions so low, there really is no reason not to sell.
Yet people still struggle to sell. Why?
Bad Reason #1 -- Laziness
The easy option is to do nothing. The same goes in business. Most businesses simply keep doing things the way they've always done them, "because we've always done it that way."
Why change? I'll tell you why. There is always a better way of doing things. You need to constantly challenge yourself, and challenge the status quo.
When it comes to investing, people don't challenge their investments. They don't look at them and say "this one is overvalued now" or "that one is struggling to grow its market share" or "I think there's trouble ahead for this sector".
Unfortunately, there are precious few "buy and hold forever" companies. Just ask the people who thought Royal Bank of Scotland (LSE: RBS) and Lloyds Banking Group (LSE: LLOY) were large, stable, high yielding and cheap companies.
Bad Reason #2 -- Boring
Buying is far more exciting. It's always fun looking for the "next big winner", the share that is going to make your investing fortune. People spend most of their time looking for this illusive company, the next Tullow Oil (LSE: TLW) or the next GlaxoSmithKline (LSE: GSK).
Whilst there is nothing wrong with looking for tomorrow's big winners, I'd suggest investors should spend much more time monitoring their existing portfolio stocks.
Things they need to keep an eye on include…
■The competitive environment. If you own shares in J Sainsbury (LSE: SBRY), you might want to think about whether the resurgence of Wm. Morrison (LSE: MRW) might impact on their future sales growth.
■The economy. In the past 12 months, as we all found out to our cost, ignoring the economy can be wealth destroying. If you think the economy is in for a rough time over the next few years, you might want to think about selling your shares in companies selling discretionary goods, like DSG International (LSE: DSGI) and Carpetright (LSE: CPR).
■Valuation. When a company reaches your estimate of fair value, you should start selling. It's as simple as that. So why don't people sell on valuation grounds? Read on…
Bad Reason #3 - Fear
People fail to sell because they fear of missing out on a huge winner. Fear and greed are the two most powerful emotions investors have to deal with, almost on a daily basis. Fear can come in many guises, but is most powerful when people fear losing money. How else do you explain the massive and indiscriminate selling spree witnessed in March this year? It was based on fear alone.
But there's another thing investors fear almost as much. They fear of selling too early. The stock market is littered with tales of people who bought Tesco (LSE: TSCO) shares in the early days and hung on all the way through to now, or Domino's Pizza (LSE: DOM), one of the best performing shares of the last decade.
The stories usually recount how these great performers were, at various times over the years, over-valued. Yet the companies kept growing, kept beating market expectations, and the share price ended up providing these canny investors with returns in the thousands of percentage points.
This is very much the exception rather than the rule. The intensely competitive environment usually puts a cap on the long-term growth prospects of most companies. For example, although Domino's Pizza dominates the takeaway pizza environment today, it wasn't too many years ago when many thought PizzaExpress would open hundreds of takeaway outlets and rule the world of ham, cheese, tomato, pineapple and anchovies.
Fear not. If a company in your portfolio is highly valued, just click and sell. You'll most likely get the chance to buy it back at a cheaper price anyway.
The Best Parts About Selling
If this choppy market has taught us anything, it should be that you need to sell at the right time. It's not that difficult. And you know the best parts about selling? 1) It's cheap and easy, and 2) you can't lose cash!
http://www.fool.co.uk/news/investing/investing-strategy/2009/07/24/3-really-bad-reasons-not-to-sell.aspx
Getting Out While the Getting's Good
Getting Out While the Getting's Good
By WALTER HAMILTON
September 18, 1998
When should you sell a stock? If you're bargain hunting in today's dicey market, the answer is sooner rather than later--that is, if the stock moves against you.
The market's summer plunge has made for some good buying opportunities. But it has also made for a risky investment climate in which it's easy to lose money quickly, experts note.
To protect against that, some investment pros say individual investors should take the bold step of jettisoning any stock that falls as little as 8% from the price at which they bought it.
The reasoning: For most of the 1990s' bull market, stocks often bounced back quickly from trouble as a rising tide lifted most boats. But today, a stock that begins to sink may quickly crash--and stay down.
"The very best investors I know have very set parameters for losses," said Jonathan Lee, managing partner at Hollister Asset Management, a money management firm in Century City. "They say: 'I'm going to buy and have very tight risk parameters. If it goes down 5%, I'm out.' "
Dumping a stock that drops 8% or so from your entry price may sound drastic. Even in a good market, prices naturally ebb and flow, and an investor who sells after a small loss could subsequently watch the stock rebound.
Indeed, conventional wisdom is that an investor needn't reexamine a stock unless it declines 15% or more. If a stock has fallen simply because of market sentiment--rather than because of a fundamental change in the company's prospects--traditional thinking says an investor should hold on.
But in a high-risk market like this one, one or two sizable losses can crush a portfolio.
Think about this: If an investor waits to sell a falling stock until the loss is 20%, and then reinvests the proceeds in another stock, that new holding must rise 25% just to recoup the original amount. After a loss of 30%, a fresh holding must climb 43% to get the investor back to even.
*
Some pros take a more basic view of why losers should quickly be sold.
"The best reason why you should not hold [a losing] stock is . . . you've made a mistake," said David Ryan, head of Ryan Capital Management, a Santa Monica-based hedge fund.
Ryan is a onetime protege of William O'Neil, an investment legend and founder of Investor's Business Daily newspaper. O'Neil has long been one of the more vocal proponents of the "8%-loss-and-out" sell rule.
Note that this rule applies only to newly purchased stocks--not to price moves in shares that an investor has owned for a while and that have appreciated in value.
In those cases, assuming you're holding the stock as a long-term investment, interim moves that may erase some of your gain (without reducing your original principal) are OK to ride out, so long as they reflect overall market weakness rather than problems specific to the company.
The conventional thinking about sticking with a stock that falls sharply from your purchase level also misses another point: A stock often turns down before an erosion in the company's fundamentals is readily apparent.
Even the most diligent investors have trouble getting access to the best information. They may not know exactly why a stock is going down, but they can often infer from the action in the shares that the company's outlook is dimming.
"Many times a stock will tell you something bad about the company before anyone else will," said Tom Barry, investment chief at George D. Bjurman & Associates in Century City, which manages $1 billion.
*
But what about the practical issues involved in quickly selling stocks that move against you? True, there are commission costs. And depending on market conditions, an investor may end up taking a large number of losses.
Still, better to take smaller losses than risk that they become major losses, many pros say.
Investment legend Peter Lynch has long noted that investors are likely to make the bulk of their profits in a relative handful of stocks that rise dramatically over time. Most stocks in a portfolio, Lynch has said, will be mediocre or poor performers. Thus, keeping losses to a minimum assures that your few big gainers aren't watered down by big losers.
Indeed, many pros insist that small investors' prime mistake usually is to hold losers too long, hoping to at least break even.
"There are too many companies where things are going great. Why not switch?" Barry said. "There are so many people who don't want to admit a loss, so they hold their losers. We do the opposite. We sell the losers and keep the winners."
Psychologically, the 8%-loss sell rule may be easiest to observe in the case of higher-priced stocks. An 8% drop in a $50 stock is $4, while for a $25 stock it's only $2.
Still, investors should remember to focus on the percentage loss, not the dollar amount.
*
To see the benefit of the 8% sell rule in action, imagine you bought Chase Manhattan at its July 31 peak of $77.56. Let's say you disregarded the sell rule, which would have gotten you out a mere two days later at about $71, as the stock slumped.
You might have figured that Chase, as a blue-chip stock, would be insulated from a sharp drop.
But amid deepening worries about U.S. banks' potential trading and loan losses overseas, Chase shares have plunged to $47.88 now--a drop of 38% from the peak.
It's entirely possible that the fears are overdone and that Chase will emerge unscathed from the current global turmoil.
But it remains to be seen whether an investor who has ridden the stock down will be able to claim the same thing.
*
Times staff writer Walter Hamilton can be reached by e-mail at walter.hamilton@latimes.com.
http://articles.latimes.com/1998/sep/18/business/fi-23902
By WALTER HAMILTON
September 18, 1998
When should you sell a stock? If you're bargain hunting in today's dicey market, the answer is sooner rather than later--that is, if the stock moves against you.
The market's summer plunge has made for some good buying opportunities. But it has also made for a risky investment climate in which it's easy to lose money quickly, experts note.
To protect against that, some investment pros say individual investors should take the bold step of jettisoning any stock that falls as little as 8% from the price at which they bought it.
The reasoning: For most of the 1990s' bull market, stocks often bounced back quickly from trouble as a rising tide lifted most boats. But today, a stock that begins to sink may quickly crash--and stay down.
"The very best investors I know have very set parameters for losses," said Jonathan Lee, managing partner at Hollister Asset Management, a money management firm in Century City. "They say: 'I'm going to buy and have very tight risk parameters. If it goes down 5%, I'm out.' "
Dumping a stock that drops 8% or so from your entry price may sound drastic. Even in a good market, prices naturally ebb and flow, and an investor who sells after a small loss could subsequently watch the stock rebound.
Indeed, conventional wisdom is that an investor needn't reexamine a stock unless it declines 15% or more. If a stock has fallen simply because of market sentiment--rather than because of a fundamental change in the company's prospects--traditional thinking says an investor should hold on.
But in a high-risk market like this one, one or two sizable losses can crush a portfolio.
Think about this: If an investor waits to sell a falling stock until the loss is 20%, and then reinvests the proceeds in another stock, that new holding must rise 25% just to recoup the original amount. After a loss of 30%, a fresh holding must climb 43% to get the investor back to even.
*
Some pros take a more basic view of why losers should quickly be sold.
"The best reason why you should not hold [a losing] stock is . . . you've made a mistake," said David Ryan, head of Ryan Capital Management, a Santa Monica-based hedge fund.
Ryan is a onetime protege of William O'Neil, an investment legend and founder of Investor's Business Daily newspaper. O'Neil has long been one of the more vocal proponents of the "8%-loss-and-out" sell rule.
Note that this rule applies only to newly purchased stocks--not to price moves in shares that an investor has owned for a while and that have appreciated in value.
In those cases, assuming you're holding the stock as a long-term investment, interim moves that may erase some of your gain (without reducing your original principal) are OK to ride out, so long as they reflect overall market weakness rather than problems specific to the company.
The conventional thinking about sticking with a stock that falls sharply from your purchase level also misses another point: A stock often turns down before an erosion in the company's fundamentals is readily apparent.
Even the most diligent investors have trouble getting access to the best information. They may not know exactly why a stock is going down, but they can often infer from the action in the shares that the company's outlook is dimming.
"Many times a stock will tell you something bad about the company before anyone else will," said Tom Barry, investment chief at George D. Bjurman & Associates in Century City, which manages $1 billion.
*
But what about the practical issues involved in quickly selling stocks that move against you? True, there are commission costs. And depending on market conditions, an investor may end up taking a large number of losses.
Still, better to take smaller losses than risk that they become major losses, many pros say.
Investment legend Peter Lynch has long noted that investors are likely to make the bulk of their profits in a relative handful of stocks that rise dramatically over time. Most stocks in a portfolio, Lynch has said, will be mediocre or poor performers. Thus, keeping losses to a minimum assures that your few big gainers aren't watered down by big losers.
Indeed, many pros insist that small investors' prime mistake usually is to hold losers too long, hoping to at least break even.
"There are too many companies where things are going great. Why not switch?" Barry said. "There are so many people who don't want to admit a loss, so they hold their losers. We do the opposite. We sell the losers and keep the winners."
Psychologically, the 8%-loss sell rule may be easiest to observe in the case of higher-priced stocks. An 8% drop in a $50 stock is $4, while for a $25 stock it's only $2.
Still, investors should remember to focus on the percentage loss, not the dollar amount.
*
To see the benefit of the 8% sell rule in action, imagine you bought Chase Manhattan at its July 31 peak of $77.56. Let's say you disregarded the sell rule, which would have gotten you out a mere two days later at about $71, as the stock slumped.
You might have figured that Chase, as a blue-chip stock, would be insulated from a sharp drop.
But amid deepening worries about U.S. banks' potential trading and loan losses overseas, Chase shares have plunged to $47.88 now--a drop of 38% from the peak.
It's entirely possible that the fears are overdone and that Chase will emerge unscathed from the current global turmoil.
But it remains to be seen whether an investor who has ridden the stock down will be able to claim the same thing.
*
Times staff writer Walter Hamilton can be reached by e-mail at walter.hamilton@latimes.com.
http://articles.latimes.com/1998/sep/18/business/fi-23902
Learning from a 10-bagger
Learning from a 10-bagger
Posted Aug 30 2009, 11:57 PM
by AllStar Portfolio Rating: Filed under: investing, CAPS
Since I'm sure you're just as tired as I am with blogs about “calling” Sirius (SIRI) at 5 cents, and since I'm equally sure you don't want to hear someone bragging about how great of an investor they are, especially if your portfolio is still down from the recent carnage, let me be clear that you won't find that in this post! (I’ll leave that for when I score my 10th or so 10-bagger, not my first, especially when I have some serious losses to more than help balance my ego).
An investor who wants to be successful (and don't we all!), should spend some time and effort examining the stocks in their portfolio, both the winners and the losers to see what they can learn from the investment. I think investors DO spend a great deal of time considering those stocks that didn't perform as as they had hoped.
They are either angry at themselves, blaming company management, blaming the economy, blaming "Mr. Market" for being foolish or contrary, or blaming their third grade teacher for not doing a better job of teaching them basic math. Rather than blaming anyone, a thorough analysis of what they may have left out would be a better use of their time if they want to avoid similar mistakes.
Less obvious: We should study our winners. This could be equally as beneficial, but I suspect we rarely take this route either. A ten bagger -- a stock that has gone up 10 times its purchase price -- can happen without a great deal of investment skills, especially in the current market.
Pharmaceuticals
Whether it's a ride on a pharmaceutical that gets good news or a stock that Mr. Market has left for dead, 10-baggers can be found, especially in this economy, without having to ride them up for decades.
While being savvy enough, (or lucky enough), to jump on Human Genome Sciences (HGSI) soon after it plummeted to 50 cents on March 11th and riding it up to $20 on August 26th would have been a thrilling ride, and a great “trade”, it’s not quite the investing multi-bagger I’m referring to.
Pharmaceuticals are certainly an area where you might have a chance for a 10+ bagger in quick order. If one trades these, however, they should understand that the losers will outnumber the winners. (The FDA is more fickle than pretty much anything else you can think of, including.....well, I'll let you finish that sentence, I'm not sure if my relatives will read this).
Having held Dendreon (DNDN) for the longer leg up, I can relate that it’s easy to day dream. This might be acceptable if you’re willing to risk a small part of your portfolio, but such trading should not be your plan for an early retirement. Likewise in this market, taking a chance on a stock that Mr. Market priced for bankruptcy in the 60-cent range and riding it up to $8 is another way to “trade” your way into a 10-bagger, (examples being TRW Automotive (TRW), Dollar Thrifty (DTO), Las Vegas Sands (LVS), Tenneco (TEN) and many others).
For me, those would be good trades, but not quite what I consider an investment-grade 10-bagger. For me, it’s the home-grown, getting in when the equity is fair-valued by fundamental standards, and riding it up as it grows in earnings and potential.
This type of 10-bagger use to be more prevalent back in the tech days of the 90’s. In fact it was only a fraction of what EMC (EMC), Dell (DELL), Amazon (AMZN), and other Internet potential stocks achieved. Of course the bubble bursting shows you can ride a 10-bagger back down as fast or faster as you rode it up. You can also grow a 10-bagger over decades such as General Electric (GE) or Wal-Mart (WMT).
My first 10-bagger goes more along the lines of the tech bubble stocks, achieving the 10-bagger status for me in just under a year.
STEC (STEC) spent the eight years of its relatively young history often cycling between $2 and $12. As a designer and manufacturer of computer memory modules, it was at the whim of the tech industry to keep it's product "current" with each new computer technology. Each new memory generation was a source of renewed sales, but a nightmare controlling the inventory on now obsolete parts. Supply and demand controlled the earnings reports.
Enter the year of solid state disk drives. Most disk drive companies had decided that solid state hard drives, made entiredly from memory modules, were too expensive and would not be embraced by the market for several years. In the area of disruptive technology, STEC decided that there would be some cases where data-intensive applications might be make the user willing to pay a premium for speed and reliability, with no moving parts. There were also technical challenges, especially in regard to static memory being subjected to many thousands of writes and erasures.
STEC's share price has gone from $3.55, when I purchased a small stake, to $39.90 on Aug. 28. While development took a great deal of time, STEC did find willing partners to help evaluate the technology. When EMC validated that the technology was sound and the time IS NOW, (in limited quantities and specific applications), the major disk drive vendors were left flat-footed. It can take a year or more for a company to qualify technology. IBM (IBM) , Sun Microsystems (JAVA), Hitachi (HIT), and other storage companies soon certified the STEC drive. Other drive manufacturers are struggling to catch up, but for now, STEC dominates the market.
So what have I learned from my 10-bagger?
•Buy what you know. This old adage tells us that we should have some understanding of what we invest in. It doesn’t mean that we need to be an aeronautics engineer to buy Boeing. It doesn’t mean that we need to be a doctor to buy HGSI. It does mean that we should understand something about the industry. The more the better so we can make intelligent decisions about how wide someone’s moat is, how competition will affect our thesis, how regulation or environment rules might restrict bring a product to market, or how a recession might affect our potential.
•It’s NOT all in the Fundamentals: I still see people shorting STEC. Each month, there is a fresh round of shorts whose only thesis appears to be “too far too fast”, “overvalued”, “P/E over 100”, “bad five-year chart”. Yes, a rapidly growing company can look a little “scary” as the stock price climbs and the P/E looks out of whack. Yes, current P/E does “seem” high, but what about the forward P/E, 18, not bad in the tech field. Quarterly growth was1,269%, not bad in any industry. Toss in market domination, no serious competition, no debt, expanded manufacturing capabilities, and you have a recipe for growth that can’t be measured on past data.
•Ride your winners: This is a lesson that I’m still struggling with as STEC exceeds my target ratio of any individual stock in my portfolio. For some, selling a third or half is a good compromise to lock in gains, especially if one isn’t sure why the stock rose so high, or what the real upside might be. The “ride your winners” may be the hardest thing to do to score that elusive 10-bagger as you will have ample time to talk yourself out of “risking” that new found gain, especially in this type of market. The key is to reevaluate your thesis, why you bought the stock in the first place. If I feel a stock got beaten down too far by Mr. Market and the stock rises back to a new five year high, and then some, all while having earnings that are topped off well below historical highs, then it might be time to sell. Having a hard target to sell without reevaluating can be an easy way to play the stock, but certainly doesn’t give you an opportunity to ride winners that have a fresh outlook. Rebalancing is an issue that investors need to determine based on their own risk/reward.
•Small Cap stocks have the best chance to have rapid returns: Plenty of larger companies have show the way to stellar gains, but it's a little harder to double when you're market cap is $1 Billion than it is when it's $100 Million, and if you want to grow a 10-bagger, it's harder still for big companies. There is nothing wrong with the large companies, giving you steady growth, value, and dividends. Every portfolio should have a good mix. From my reflections, however, I will always have a few small caps in my portfolio. Do expect volitility to be higher, and do plan on reevaluating them more often. Companies with "disruptive technology" and a wide moat can give you the most growth and best chance of holding the growth. These terms are oft used and while some people think disruptive technology can only happen in the tech world, like STEC, there can be disruption, or wide moats in many industries.
• I never buy enough of my winners: No explanation needed here, but the lesson is that we can't get greedy, and we'll never be totally happy, even with 10-baggers! I learned this lesson well with Dendreon, but as a high risk “trade”, I’m not sorry. By the same token, having a plan when you go into a stock, an initial thesis for why you would sell, and your own definition of diversity in your portfolio means that you should be less likely to waste valuable self reflection second guessing yourself! I try hard not to spend my time playing the “if”, “should have, could have” game. Although I do play the “glad I didn’t” game! It would be nice if our biggest problem was when to sell our winners, but yes, we do need to learn from our losers as well, however, I’ll save that for another day.
May all of you learn some lessons from your own 10-bagger investment.
VISIT Allstarportfolio at WallStreetSurvivor.com
BLOG entry by Motley Fool, Allstarportfolio contributor TSIF on Caps.
Allstarportfolio is a collection of investors using community intelligence as one tool for investing. STEC is a holding in the allstarportfolio wallstreetsurvivor portfolio. At the time of this posting, the author is LONG on STEC, and believes it has room to grow. The writer also is also long EMC and GE and has long options in Dell. The writer has no holdings in any other stock referenced in this article, including WDC, STX, DNDN, IBM, DTO, TRW, JAVA, HIT, HGSI, LVS, TEN, or WMT
http://blogs.moneycentral.msn.com/topstocks/archive/2009/08/30/learning-from-our-winners-what-i-learned-from-a-10-bagger.aspx
Posted Aug 30 2009, 11:57 PM
by AllStar Portfolio Rating: Filed under: investing, CAPS
Since I'm sure you're just as tired as I am with blogs about “calling” Sirius (SIRI) at 5 cents, and since I'm equally sure you don't want to hear someone bragging about how great of an investor they are, especially if your portfolio is still down from the recent carnage, let me be clear that you won't find that in this post! (I’ll leave that for when I score my 10th or so 10-bagger, not my first, especially when I have some serious losses to more than help balance my ego).
An investor who wants to be successful (and don't we all!), should spend some time and effort examining the stocks in their portfolio, both the winners and the losers to see what they can learn from the investment. I think investors DO spend a great deal of time considering those stocks that didn't perform as as they had hoped.
They are either angry at themselves, blaming company management, blaming the economy, blaming "Mr. Market" for being foolish or contrary, or blaming their third grade teacher for not doing a better job of teaching them basic math. Rather than blaming anyone, a thorough analysis of what they may have left out would be a better use of their time if they want to avoid similar mistakes.
Less obvious: We should study our winners. This could be equally as beneficial, but I suspect we rarely take this route either. A ten bagger -- a stock that has gone up 10 times its purchase price -- can happen without a great deal of investment skills, especially in the current market.
Pharmaceuticals
Whether it's a ride on a pharmaceutical that gets good news or a stock that Mr. Market has left for dead, 10-baggers can be found, especially in this economy, without having to ride them up for decades.
While being savvy enough, (or lucky enough), to jump on Human Genome Sciences (HGSI) soon after it plummeted to 50 cents on March 11th and riding it up to $20 on August 26th would have been a thrilling ride, and a great “trade”, it’s not quite the investing multi-bagger I’m referring to.
Pharmaceuticals are certainly an area where you might have a chance for a 10+ bagger in quick order. If one trades these, however, they should understand that the losers will outnumber the winners. (The FDA is more fickle than pretty much anything else you can think of, including.....well, I'll let you finish that sentence, I'm not sure if my relatives will read this).
Having held Dendreon (DNDN) for the longer leg up, I can relate that it’s easy to day dream. This might be acceptable if you’re willing to risk a small part of your portfolio, but such trading should not be your plan for an early retirement. Likewise in this market, taking a chance on a stock that Mr. Market priced for bankruptcy in the 60-cent range and riding it up to $8 is another way to “trade” your way into a 10-bagger, (examples being TRW Automotive (TRW), Dollar Thrifty (DTO), Las Vegas Sands (LVS), Tenneco (TEN) and many others).
For me, those would be good trades, but not quite what I consider an investment-grade 10-bagger. For me, it’s the home-grown, getting in when the equity is fair-valued by fundamental standards, and riding it up as it grows in earnings and potential.
This type of 10-bagger use to be more prevalent back in the tech days of the 90’s. In fact it was only a fraction of what EMC (EMC), Dell (DELL), Amazon (AMZN), and other Internet potential stocks achieved. Of course the bubble bursting shows you can ride a 10-bagger back down as fast or faster as you rode it up. You can also grow a 10-bagger over decades such as General Electric (GE) or Wal-Mart (WMT).
My first 10-bagger goes more along the lines of the tech bubble stocks, achieving the 10-bagger status for me in just under a year.
STEC (STEC) spent the eight years of its relatively young history often cycling between $2 and $12. As a designer and manufacturer of computer memory modules, it was at the whim of the tech industry to keep it's product "current" with each new computer technology. Each new memory generation was a source of renewed sales, but a nightmare controlling the inventory on now obsolete parts. Supply and demand controlled the earnings reports.
Enter the year of solid state disk drives. Most disk drive companies had decided that solid state hard drives, made entiredly from memory modules, were too expensive and would not be embraced by the market for several years. In the area of disruptive technology, STEC decided that there would be some cases where data-intensive applications might be make the user willing to pay a premium for speed and reliability, with no moving parts. There were also technical challenges, especially in regard to static memory being subjected to many thousands of writes and erasures.
STEC's share price has gone from $3.55, when I purchased a small stake, to $39.90 on Aug. 28. While development took a great deal of time, STEC did find willing partners to help evaluate the technology. When EMC validated that the technology was sound and the time IS NOW, (in limited quantities and specific applications), the major disk drive vendors were left flat-footed. It can take a year or more for a company to qualify technology. IBM (IBM) , Sun Microsystems (JAVA), Hitachi (HIT), and other storage companies soon certified the STEC drive. Other drive manufacturers are struggling to catch up, but for now, STEC dominates the market.
So what have I learned from my 10-bagger?
•Buy what you know. This old adage tells us that we should have some understanding of what we invest in. It doesn’t mean that we need to be an aeronautics engineer to buy Boeing. It doesn’t mean that we need to be a doctor to buy HGSI. It does mean that we should understand something about the industry. The more the better so we can make intelligent decisions about how wide someone’s moat is, how competition will affect our thesis, how regulation or environment rules might restrict bring a product to market, or how a recession might affect our potential.
•It’s NOT all in the Fundamentals: I still see people shorting STEC. Each month, there is a fresh round of shorts whose only thesis appears to be “too far too fast”, “overvalued”, “P/E over 100”, “bad five-year chart”. Yes, a rapidly growing company can look a little “scary” as the stock price climbs and the P/E looks out of whack. Yes, current P/E does “seem” high, but what about the forward P/E, 18, not bad in the tech field. Quarterly growth was1,269%, not bad in any industry. Toss in market domination, no serious competition, no debt, expanded manufacturing capabilities, and you have a recipe for growth that can’t be measured on past data.
•Ride your winners: This is a lesson that I’m still struggling with as STEC exceeds my target ratio of any individual stock in my portfolio. For some, selling a third or half is a good compromise to lock in gains, especially if one isn’t sure why the stock rose so high, or what the real upside might be. The “ride your winners” may be the hardest thing to do to score that elusive 10-bagger as you will have ample time to talk yourself out of “risking” that new found gain, especially in this type of market. The key is to reevaluate your thesis, why you bought the stock in the first place. If I feel a stock got beaten down too far by Mr. Market and the stock rises back to a new five year high, and then some, all while having earnings that are topped off well below historical highs, then it might be time to sell. Having a hard target to sell without reevaluating can be an easy way to play the stock, but certainly doesn’t give you an opportunity to ride winners that have a fresh outlook. Rebalancing is an issue that investors need to determine based on their own risk/reward.
•Small Cap stocks have the best chance to have rapid returns: Plenty of larger companies have show the way to stellar gains, but it's a little harder to double when you're market cap is $1 Billion than it is when it's $100 Million, and if you want to grow a 10-bagger, it's harder still for big companies. There is nothing wrong with the large companies, giving you steady growth, value, and dividends. Every portfolio should have a good mix. From my reflections, however, I will always have a few small caps in my portfolio. Do expect volitility to be higher, and do plan on reevaluating them more often. Companies with "disruptive technology" and a wide moat can give you the most growth and best chance of holding the growth. These terms are oft used and while some people think disruptive technology can only happen in the tech world, like STEC, there can be disruption, or wide moats in many industries.
• I never buy enough of my winners: No explanation needed here, but the lesson is that we can't get greedy, and we'll never be totally happy, even with 10-baggers! I learned this lesson well with Dendreon, but as a high risk “trade”, I’m not sorry. By the same token, having a plan when you go into a stock, an initial thesis for why you would sell, and your own definition of diversity in your portfolio means that you should be less likely to waste valuable self reflection second guessing yourself! I try hard not to spend my time playing the “if”, “should have, could have” game. Although I do play the “glad I didn’t” game! It would be nice if our biggest problem was when to sell our winners, but yes, we do need to learn from our losers as well, however, I’ll save that for another day.
May all of you learn some lessons from your own 10-bagger investment.
VISIT Allstarportfolio at WallStreetSurvivor.com
BLOG entry by Motley Fool, Allstarportfolio contributor TSIF on Caps.
Allstarportfolio is a collection of investors using community intelligence as one tool for investing. STEC is a holding in the allstarportfolio wallstreetsurvivor portfolio. At the time of this posting, the author is LONG on STEC, and believes it has room to grow. The writer also is also long EMC and GE and has long options in Dell. The writer has no holdings in any other stock referenced in this article, including WDC, STX, DNDN, IBM, DTO, TRW, JAVA, HIT, HGSI, LVS, TEN, or WMT
http://blogs.moneycentral.msn.com/topstocks/archive/2009/08/30/learning-from-our-winners-what-i-learned-from-a-10-bagger.aspx
Loss Aversion versus Risk Aversion
http://www.ppfas.com/media/articles/how-the-wish.pdf
"It makes sense to ride the winners and sell the losers, but loss aversion makes people do the exact opposite."
Why do most portfolios have a few winners but a long list of losers? Why are your profits from your winners smaller than your losses from your losers? Due to loss aversion, investors sell their winners fast and hold on to the losers. Investors behave as if the loss occurs when the sale is made, when in fact the loss has already occurred, with the depreciation in price. Offsetting a loss against other income has tax benefits, too - it makes good sense to ride the winners and sell the losers. But loss aversion makes people do the exact opposite.
"It makes sense to ride the winners and sell the losers, but loss aversion makes people do the exact opposite."
Why do most portfolios have a few winners but a long list of losers? Why are your profits from your winners smaller than your losses from your losers? Due to loss aversion, investors sell their winners fast and hold on to the losers. Investors behave as if the loss occurs when the sale is made, when in fact the loss has already occurred, with the depreciation in price. Offsetting a loss against other income has tax benefits, too - it makes good sense to ride the winners and sell the losers. But loss aversion makes people do the exact opposite.
Emodons Rule
Seeking Pride and Avoiding Regret
People avoid actions that create regret and seek actions that cause pride. Regret is the emotional pain that comes with realizing that a previous decision has turned out badly. Pride is the emotional joy of realizing that a decision has turned out to be a good decision.
Say you've been playing the lottery.
You have been selecting the same lottery ticket numbers every week for months. Not surprisingly, you have not won. A friend suggests a different set of numbers. Do you change numbers?
Clearly, the likelihood of the old set of numbers winning is the same as the likelihood of the new set of numbers winning. There are two possible sources of regret in this example. Regret may be felt if you stick with the old numbers and the new numbers win, called the regret of omission (not taking an action).
Alternatively, regret would also be felt if you switch to the new numbers and the old numbers win. The regret of an action you took is the regret of commission. In which case would the pain of regret be stronger? The stronger regret is most likely from switching to the new numbers because you have a lot of emotional capital in the old numbers - after all, you have been selecting them for months. A regret of commission is more painful than a regret of omission.
DISPOSITION EFFECT
Avoiding regret and seeking pride affects people's behavior, but how does it affect investment decisions? This is called the disposition effect.
Consider the situation in which you wish to invest in a particular stock, Lucent. However, you have no cash and must sell a position in another stock in order to buy the purchase it in the nrst place. You enjoy pride at locking in your profit. Selling Microsoft at a loss means realizing that your decision to purchase it was bad. You would feel the pain of regret. The disposition effect predicts that you will sell the winner, IBM. Selling IBM triggers the feeling of pride and avoids the feeling of regret.
It's common sense that because of this you may sell your winners more frequently than your losers. Why is this a problem? One reason that this is a problem is because of the U.S. tax code. The taxation of capital gains causes the selling of losers to be the wealth-maximizing strategy. Selling a winner causes the realization of a capital gain and thus the payment of taxes. Those taxes reduce your profit. Selling the losers gives you a chance to reduce your taxes, thus decreasing the amount of the loss. Reconsider the IBM/Microsoft example and assume that capital gains are taxed at the 20% rate. If your positions in Microsoft and IBM are each valued at $1,000, then the original purchase price of IBM must have been $833 to have earned a 20% return. Likewise, the purchase price of Microsoft must have been $1,250 to have experienced a 20% loss. Table 5.1 shows which stock would be more advantageous to sell when you look at the total picture.
If you sell IBM, you receive $1,000, but you pay taxes of $33, so your net gain is $967. Alternatively, you could sell Microsoft and receive $1,000, plus gain a tax credit of $50 to be used against other capital gains in your portfolio; so your net gain is $1,050. If the tax rate is higher than 20% (as in the case of gains realized within one year of the stock purchase), then the advantage of selling the loser is even greater. The disposition effect predicts the selling of winners. However, it is the selling of losers that is the wealth-maximizing strategy!
This is not a recommendation to sell a stock as soon as it goes down in price - stock prices do frequently fluctuate. Instead, the disposition effect refers to hanging on to stocks that have fallen during the past six or nine months, when you really should be considering selling them. This is a psychological bias that affects you over a fairly long period of time. We'll discuss a similar, but opposite behavior in the next chapter, one that happens very quickly - where there is a quick drop in price and the "snake-bit" investor dumps the stocks quickly.
SELLING TO MAXIMIZE WEALTH
SEEKING PRIDE AND AVOIDING REGRET
DO WE REALLY SELL WINNERS?
So, do you behave in a rational manner and predominately sell losers, or are you affected by your psychology and have a tendency to sell your winners? Several studies provide insight into what investors really do.
One study examined 75,000 round-trip trades of a national brokerage house. A round-trip trade is a stock purchase followed later by the sale of the stock. Which stocks did investors sell - the winners or the losers? The study examined the length of time the stock was held and the return that was received. Are investors quick to close out a position when it has taken a loss or when it has a gain? Figure 5.1 shows the average annualized return for positions held 0-30 days, 31-182 days, 183-365 days, and over 365 days. Figure 5.1 indicates that investors are quick to realize their gains. The average annualized return for stocks purchased and then sold within the first 30 days was 45%. The returns for stocks held 31-182 days, 183-365 days, and over 365 days were 7.8%, 5.1%, and 4.5%, respectively.
It is apparent that investors are quick to sell winners. If you buy a stock and it quickly jumps in price, you become tempted to sell it and lock in the profit. You can now go out and seek pride by telling your neighbors about your quick profit. On the other hand, if you buy a stock and it goes down in price, you wait. Later, if it goes back up, you may sell or wait longer. However, selling the winner creates tax payments!
ANNUALIZED RETURN FOR DIFFERENT INVESTOR HOLDING PERIODS.
This behavior can be seen after initial public offering (IPO) shares hit the market. Shares of the IPO are first sold to the clients of the investment banks and brokerage firms helping the company go public. As we will discuss in detail in the next chapter, the price paid by these initial shareholders is often substantially less than the initial sales price of the stock on the stock exchange. These original shareholders often quickly sell the stock on the stock market for a quick profit - so often, in fact, that it has a special name: flipping IPOs. There are times, however, that the IPO does not start trading at a higher price on the stock exchange. Sometimes the price falls. The volume of shares traded is lower for these declining-price IPOs than for the increasing-price IPOs. The original investors are quick to flip increasing-price IPOs, but they tend to hold the declining-price IPOs hoping for a rebound.
Another study by Terrance Odean examined the trades of 10,000 accounts from a nationwide discount brokerage. He found that, when investors sell winners, the sale represents 23% of the total gains of the investor's portfolio. In other words, investors sell the big winners - one stock representing one quarter of the profits. He also found that, on average, investors are 50% more likely to sell a winner than a loser. Investors are prone to letting their losses ride.
Do you avoid selling losers? If you hear yourself in any of the following comments, you hold on to losers.
SEEKING PRIDE AND AVOIDING REGRET
■ The stock price has dropped so much, I can't sell it now!
■ I will hold this stock because it can't possibly fall any farther.
Sound familiar? Many investors will not sell anything at a loss because they don't want to give up the hope of making their money back. Meanwhile, they could be making money somewhere else.
Selling Winners Too Soon and Holding Losers Too Long
Not only does the disposition effect predict the selling of winners, it also suggests that the winners are sold too soon and the losers are held too long*.
What does selling too soon or holding too long imply? Selling a winner too soon suggests that it would have continued to perform well for you if you had not sold it. Holding losers too long suggests that your stocks with price declines will continue to perform poorly and will not rebound with the speed you hope for.
Do investors sell winners too soon and hold losers too long, as suggested by the disposition effect? Odean's study found that, when an investor sold a winner stock, the stock beat the market during the next year by an average of 2.35%. In other words, it continued to perform pretty well. During this same year, the loser stocks that the investor kept underperformed the market by -1.06%. In short, you tend to sell the stock that ends up providing a high return and keep the stock that provides a lower return.
So we've seen that the fear of regret and the seeking of pride hurts your wealth in two ways:
■ You are paying more in taxes because of the disposition to sell winners instead of losers.
■ You earn a lower return on your portfolio because you sell the winners too early and hold on to poorly performing stocks that continue to perform poorly.
React to a news story? Buy, sell, hold? I examined the trades of individual investors with holdings in 144 New York Stock Exchange companies in relation to news reports.5 I specifically studied investor reaction either to news about the company or to news about the economy. News about a company mostly affects the price of just that company's stock, whereas economic news affects the stock prices of all companies. The results are interesting. Good news about a company resulting in an increase in the stock price induces investors to sell (selling winners). Bad news about a company does not induce investors to sell (holding losers). This is consistent with avoiding regret and seeking pride.
However, news about the economy does not induce investor trading. Although good economic news increases stock prices and bad economic news lowers stock prices, this does not cause individual investors to sell. In fact, investors are less likely than usual to sell winners after good economic news. Investor reaction to economic news is not consistent with the disposition effect.
This illustrates an interesting characteristic of regret. After taking a stock loss, investors feel stronger regret if the loss can be tied to their own decision. However, if the investor can attribute the loss to things out of his or her control, then the feeling of regret is weaker. For example, if the stock you hold declines in price when the stock market itself is advancing, then you have made a bad choice and regret is strong. In this case, you would avoid selling the stock because you want to avoid the strong regret feelings. Alternatively, if the stock you hold drops in price during a general market decline, then this is divine intervention and out of your control. The feeling of regret is weak and you may be more inclined to sell.
In the case of news about a company, your actions are consistent with the disposition effect because the feeling of regret is strong. In the case of economic news, you have a weaker feeling of regret because the outcome is considered out of your control. This leads to actions that are not consistent with the predictions of the disposition effect.
http://www.wdc-econdev.com/THE-INVESTMENT-ENVIRONMENT/emodons-rule-investment-banks.html
People avoid actions that create regret and seek actions that cause pride. Regret is the emotional pain that comes with realizing that a previous decision has turned out badly. Pride is the emotional joy of realizing that a decision has turned out to be a good decision.
Say you've been playing the lottery.
You have been selecting the same lottery ticket numbers every week for months. Not surprisingly, you have not won. A friend suggests a different set of numbers. Do you change numbers?
Clearly, the likelihood of the old set of numbers winning is the same as the likelihood of the new set of numbers winning. There are two possible sources of regret in this example. Regret may be felt if you stick with the old numbers and the new numbers win, called the regret of omission (not taking an action).
Alternatively, regret would also be felt if you switch to the new numbers and the old numbers win. The regret of an action you took is the regret of commission. In which case would the pain of regret be stronger? The stronger regret is most likely from switching to the new numbers because you have a lot of emotional capital in the old numbers - after all, you have been selecting them for months. A regret of commission is more painful than a regret of omission.
DISPOSITION EFFECT
Avoiding regret and seeking pride affects people's behavior, but how does it affect investment decisions? This is called the disposition effect.
Consider the situation in which you wish to invest in a particular stock, Lucent. However, you have no cash and must sell a position in another stock in order to buy the purchase it in the nrst place. You enjoy pride at locking in your profit. Selling Microsoft at a loss means realizing that your decision to purchase it was bad. You would feel the pain of regret. The disposition effect predicts that you will sell the winner, IBM. Selling IBM triggers the feeling of pride and avoids the feeling of regret.
It's common sense that because of this you may sell your winners more frequently than your losers. Why is this a problem? One reason that this is a problem is because of the U.S. tax code. The taxation of capital gains causes the selling of losers to be the wealth-maximizing strategy. Selling a winner causes the realization of a capital gain and thus the payment of taxes. Those taxes reduce your profit. Selling the losers gives you a chance to reduce your taxes, thus decreasing the amount of the loss. Reconsider the IBM/Microsoft example and assume that capital gains are taxed at the 20% rate. If your positions in Microsoft and IBM are each valued at $1,000, then the original purchase price of IBM must have been $833 to have earned a 20% return. Likewise, the purchase price of Microsoft must have been $1,250 to have experienced a 20% loss. Table 5.1 shows which stock would be more advantageous to sell when you look at the total picture.
If you sell IBM, you receive $1,000, but you pay taxes of $33, so your net gain is $967. Alternatively, you could sell Microsoft and receive $1,000, plus gain a tax credit of $50 to be used against other capital gains in your portfolio; so your net gain is $1,050. If the tax rate is higher than 20% (as in the case of gains realized within one year of the stock purchase), then the advantage of selling the loser is even greater. The disposition effect predicts the selling of winners. However, it is the selling of losers that is the wealth-maximizing strategy!
This is not a recommendation to sell a stock as soon as it goes down in price - stock prices do frequently fluctuate. Instead, the disposition effect refers to hanging on to stocks that have fallen during the past six or nine months, when you really should be considering selling them. This is a psychological bias that affects you over a fairly long period of time. We'll discuss a similar, but opposite behavior in the next chapter, one that happens very quickly - where there is a quick drop in price and the "snake-bit" investor dumps the stocks quickly.
SELLING TO MAXIMIZE WEALTH
SEEKING PRIDE AND AVOIDING REGRET
DO WE REALLY SELL WINNERS?
So, do you behave in a rational manner and predominately sell losers, or are you affected by your psychology and have a tendency to sell your winners? Several studies provide insight into what investors really do.
One study examined 75,000 round-trip trades of a national brokerage house. A round-trip trade is a stock purchase followed later by the sale of the stock. Which stocks did investors sell - the winners or the losers? The study examined the length of time the stock was held and the return that was received. Are investors quick to close out a position when it has taken a loss or when it has a gain? Figure 5.1 shows the average annualized return for positions held 0-30 days, 31-182 days, 183-365 days, and over 365 days. Figure 5.1 indicates that investors are quick to realize their gains. The average annualized return for stocks purchased and then sold within the first 30 days was 45%. The returns for stocks held 31-182 days, 183-365 days, and over 365 days were 7.8%, 5.1%, and 4.5%, respectively.
It is apparent that investors are quick to sell winners. If you buy a stock and it quickly jumps in price, you become tempted to sell it and lock in the profit. You can now go out and seek pride by telling your neighbors about your quick profit. On the other hand, if you buy a stock and it goes down in price, you wait. Later, if it goes back up, you may sell or wait longer. However, selling the winner creates tax payments!
ANNUALIZED RETURN FOR DIFFERENT INVESTOR HOLDING PERIODS.
This behavior can be seen after initial public offering (IPO) shares hit the market. Shares of the IPO are first sold to the clients of the investment banks and brokerage firms helping the company go public. As we will discuss in detail in the next chapter, the price paid by these initial shareholders is often substantially less than the initial sales price of the stock on the stock exchange. These original shareholders often quickly sell the stock on the stock market for a quick profit - so often, in fact, that it has a special name: flipping IPOs. There are times, however, that the IPO does not start trading at a higher price on the stock exchange. Sometimes the price falls. The volume of shares traded is lower for these declining-price IPOs than for the increasing-price IPOs. The original investors are quick to flip increasing-price IPOs, but they tend to hold the declining-price IPOs hoping for a rebound.
Another study by Terrance Odean examined the trades of 10,000 accounts from a nationwide discount brokerage. He found that, when investors sell winners, the sale represents 23% of the total gains of the investor's portfolio. In other words, investors sell the big winners - one stock representing one quarter of the profits. He also found that, on average, investors are 50% more likely to sell a winner than a loser. Investors are prone to letting their losses ride.
Do you avoid selling losers? If you hear yourself in any of the following comments, you hold on to losers.
SEEKING PRIDE AND AVOIDING REGRET
■ The stock price has dropped so much, I can't sell it now!
■ I will hold this stock because it can't possibly fall any farther.
Sound familiar? Many investors will not sell anything at a loss because they don't want to give up the hope of making their money back. Meanwhile, they could be making money somewhere else.
Selling Winners Too Soon and Holding Losers Too Long
Not only does the disposition effect predict the selling of winners, it also suggests that the winners are sold too soon and the losers are held too long*.
What does selling too soon or holding too long imply? Selling a winner too soon suggests that it would have continued to perform well for you if you had not sold it. Holding losers too long suggests that your stocks with price declines will continue to perform poorly and will not rebound with the speed you hope for.
Do investors sell winners too soon and hold losers too long, as suggested by the disposition effect? Odean's study found that, when an investor sold a winner stock, the stock beat the market during the next year by an average of 2.35%. In other words, it continued to perform pretty well. During this same year, the loser stocks that the investor kept underperformed the market by -1.06%. In short, you tend to sell the stock that ends up providing a high return and keep the stock that provides a lower return.
So we've seen that the fear of regret and the seeking of pride hurts your wealth in two ways:
■ You are paying more in taxes because of the disposition to sell winners instead of losers.
■ You earn a lower return on your portfolio because you sell the winners too early and hold on to poorly performing stocks that continue to perform poorly.
React to a news story? Buy, sell, hold? I examined the trades of individual investors with holdings in 144 New York Stock Exchange companies in relation to news reports.5 I specifically studied investor reaction either to news about the company or to news about the economy. News about a company mostly affects the price of just that company's stock, whereas economic news affects the stock prices of all companies. The results are interesting. Good news about a company resulting in an increase in the stock price induces investors to sell (selling winners). Bad news about a company does not induce investors to sell (holding losers). This is consistent with avoiding regret and seeking pride.
However, news about the economy does not induce investor trading. Although good economic news increases stock prices and bad economic news lowers stock prices, this does not cause individual investors to sell. In fact, investors are less likely than usual to sell winners after good economic news. Investor reaction to economic news is not consistent with the disposition effect.
This illustrates an interesting characteristic of regret. After taking a stock loss, investors feel stronger regret if the loss can be tied to their own decision. However, if the investor can attribute the loss to things out of his or her control, then the feeling of regret is weaker. For example, if the stock you hold declines in price when the stock market itself is advancing, then you have made a bad choice and regret is strong. In this case, you would avoid selling the stock because you want to avoid the strong regret feelings. Alternatively, if the stock you hold drops in price during a general market decline, then this is divine intervention and out of your control. The feeling of regret is weak and you may be more inclined to sell.
In the case of news about a company, your actions are consistent with the disposition effect because the feeling of regret is strong. In the case of economic news, you have a weaker feeling of regret because the outcome is considered out of your control. This leads to actions that are not consistent with the predictions of the disposition effect.
http://www.wdc-econdev.com/THE-INVESTMENT-ENVIRONMENT/emodons-rule-investment-banks.html
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