Forum Archive Index - June 2001

["Peter" <pmaiden@xtra.co.nz>]

Disciplined Investment Decisions

 

Don't let the human psyche rule

 

By Peter Maiden

June 2001

 

So you have finally taken the plunge and got some shares in your favourite companies!

 

Now comes the hard part. How does one get the best overall return from the investments you have made.

 

One school of thought is that you should hold the shares through both the good and bad times. The reason being that over time a widely diversified portfolio of shares generally return, over time,  more than investments like government stock and bank deposits. .

 

If you wish your investments to make a return in line with the general performance of the sharemarket it is probably a better idea to put your money in a managed fund. That way you are letting professionals do your investing for you without all the hassles of managing your own portfolio.

 

However, seeing you have put your hard earned money into buying shares your intention is obviously to achieve a better return than a managed fund. This does not mean you need to regularly trade your shares each time the price rises or falls. Rather it is a matter of timing the sale of shares to make the most of your investments.

 

Do you want to see good gains made not being realised? Do you want to lose more than you need to by holding on to losing shares?

 

The answer to both questions is no.

 

However the human psyche makes us do some some funny things.

 

Most investors have a fear of making mistakes. Even deeper is the fear of actually taking losses on some investments.

 

If the price of a share falls from $1.00 to 80 cents some investors will hold the share - because they will regret it more if they sell and the price goes back to $1.00 than if they hold and the share price drops another 20 cents.

 

Conversely regret can also motivate some investors to sell a winning share at $1.20 (instead of waiting for it to increase further) for fear of it falling back to $1.00

 

The fear of making mistakes also leads to procrastination when it comes to selling losing stocks. Because some investors fear making a loss, they sometimes hang on for years to these losing stocks. Even worse is when this fear is combined with an emotional attachment to the company involved.

 

A recent book 'You Only Make A Profit When You Sell' by Charles Beelaerts and Kevin Forde mentioned studies of shareholder's physchological  behaviour which showed that some investors also fear success, and will not sell to realise a gain. The authors' answer to this was 'to overcome the fear of success, aim to treat success as an imposter which will not last - then take full advantage of it'

 

What's the answer?  To get the best overall returns why not adopt a stop-loss strategy. One that restricts losses on losing shares - and locks in gains on winning shares.

 

For any share you purchase put a floor price below which you will not own that share. You could set this stop-loss at 15% below the purchase price. When the price falls below that stop-loss level you sell the share.

 

The stop-loss is not the only trigger to sell a share. You will  usually sell for other reasons but use this stop-loss strategy as a discipline to restrict losses and capture some benefits on winning shares. That way you are not letting the human psyche drive the decision making process.

 

For shares increasing in price you should regularly raise the stop-loss level as a means of keeping some of the profits. When a share price goes up 20%  put a new stop-loss at 15% below the new price - and so on at each 20% increase in the share price.

 

These parameters are ideal for a longer term investor... 

 

This is how it works. Say last June you bought some Sky City shares at $6.10. The original stop-loss would have been $5.19. When the price went to $7.32 ( $6.10 + 20%) a new stop-loss on this share would have been $6.22. When the price got to $8.78 ( $7.32 + 20%) the new stop-loss would have been $7.46. The current stop-loss  (based on a price of $10.53) will be $8.95.

 

If the Sky City price drifts back to $8.95 you should sell - you will retain $2.85 in profits. Hopefully the Sky City share price will continue to rise. When it does and the price gets to $12.63 you impose a new stop-loss level of $10.75.     

 

Using such a strategy is a discipline. This strategy will restrict losses and allow most of the gains you make to be locked away.

 

Above all no investor should regret making the odd loss - I am sure that your losses will be be out numbered by the gains you make.

 

It really is a case of mind over matter. We all need to put some rules in place so the human psyche does not win out in all cases

 

Good investing

 

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(Publishing Note:  The  LEARNING TO INVEST series is a concept developed by Gerry Stolwyk.   This post has been produced at his invitation)