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Should I stay or should I go?

By Dave Thrifty

Remember the song? It was recorded in 1981 by the Clash featuring Mick Jones. It reminds me that I’m getting older. The song goes on “If I go there will be trouble, if I stay it will be double”.

How does this relate to the investment world? Well it doesn’t directly but the sentiment does. Recently many investors have seen valuations plummet, especially over the last six months. What had been great gains in the past few years have suddenly been wiped out by market crashes all over the world and nest eggs have started to look a lot smaller. Panic sets in and the decisions have to be made. Should I stay where I am in the hope that the markets will recover and when I am back to where I was six months ago then move? Am I courting double trouble as the song says with this attitude?

If you’re like most investors you will behave irrationally and that’s not a surprise to anyone who watches the markets. There are ways to answer this question and isn’t there always ways to make money in the markets?

Let me introduce you to a theory known as behavioral finance which posits that investors behave irrationally in systematic and predictable ways because of human psychology.

A major mistake and one of the biggest made by individual investors, is to hold losers until they break even or make a little money, and then sell them.

There are few things in life more emotionally satisfying than closing out a winning stock trade-and few things more painful than selling a loser.

One study found that investors are nearly twice as likely to sell winners as losers. The result: a lot of times you end up watering your weeds and cutting your flowers.

Another big mistake investors tend to make is to be overly optimistic about past winners and overly pessimistic about past losers.

Everyone knows investors who have piled into glamour stocks after their best years are behind them. A variant of that behavior is to buy a great company even though its stock is overpriced. The antidote to this is to hunt for undervalued stocks. Cheap stocks do outperform expensive ones.

Another common investment mistake is to under react to changes in companies’ fortunes. This can be seen on CNBC and Bloomberg TV by the behavior of brokerage analysts. They set an estimate for what they think companies per share earnings will be for the year. The company subsequently releases much better quarterly earnings than the analyst expected and raises its outlook for the year dramatically.

What does the analyst normally do? He raises his estimate for the year. But more often than not he doesn’t raise it enough. Almost inevitably he and his fellow analysts later issue more upward earnings revisions.

I keep wondering why this happens. I have discovered that psychologists call it “the confirmation effect”. That means that people tend to look for evidence that confirms what they already believe. They move only slowly to embrace new thinking which contradicts their preconceived views.

While there is little doubt that financial behavior is motivated and driven by human psychology there is still the skeptic in me that whispers-So what, my personal fortune has taken a big hit and all the smart investment jargon in the world won’t bring it back. I have great sympathy with this viewpoint but in adopting it I am steadily progressing toward the closed mind and blaming others for my predicament, which is always the easier softer option, instead of taking steps to improve my situation.

We have read that the biggest mistake individual investors make is to hold losers until they break even or make a profit.

If as an investor you are sitting with big losers and you want to move forward from here and find the shares and funds that are doing well now, and can prosper in the future then there is only one thing to do. Change your current losers yourself or sit down with your broker and let him assist you in picking these new funds and stocks.

Try and avoid “double trouble”

David.thrifty@yahoo.com