Why do clever investors make big money mistakes?

(This post was originally published at Malaysia-FInance Blogspot)
Statistics show that most equity investors including professionals cannot beat the stock index. Studies have also shown that more than 80 % of day traders lose money mainly due to transaction costs and they select shares based on hot tips. There are several reasons for their poor performance but the most frequent mistake is ‘loss aversion’.  This is a psychological obstacle which has been consistently affecting their performance especially in view of the ups and downs that is the normal behavior of the stock market.
How to select shares?
It is easy to master all the basic fundamental principles in stock selection. The most important criterion, in my opinion is that the stock must be ‘Undervalued and with good profit growth prospect’. I will not buy a stock which does not have this quality. In other words – buy on solid evidence of value and good profit growth  – not on the basis of speculation or hot tips!
After you have bought some stock that you think can perform well, you will have to decide when and which stock to sell. Often many investors make the mistake of selling the good ones to lock in profit early but retain those that are not performing because of their aversion to taking losses on these. Some regret their action later and may even jump back into the market to buy the same stock that they had just sold but at a higher price. Most of them do not jump back into the market for the stock and they can only watch the stock go higher and higher.
Loss Aversion:
Some investors may object to the implication that loss aversion is a bad thing. After all, it is a very natural behavior. They might justifiably point out that the tendency to weigh losses more heavily than gains is a net positive attitude. After all, investors who care too much about possible gains and too little about potential losses, run a great risk that can threaten their portfolios. It may appear better to care more about the share price falling than hoping for it to climb higher.
True enough; loss aversion can be helpful and is part of a conservative strategy. But an over sensitivity to loss can also have negative consequences. One of the most obvious and most important areas in which loss aversion skews judgment is in selling too early and missing the additional profit if you dare to hold it longer. Very often even clever investors who are well versed in stock selection cannot overcome this psychological fear.
What is tricky about this concept of loss aversion is that it can often lead us in the opposite direction- to hold on to a losing investment for longer than we should. I asked one of my friends why he sold a particular stock instead of selling his other holdings that he bought at higher prices? He said that he did not want to recognize the losses but preferred to lock in the profit. This is the most common mistake committed by investors because they do not want to admit their mistake of picking the wrong stock. Moreover, the profit from the sale could easily cover the losses.
Studies have shown that on average, it is easier for well managed companies to continue their good performance than for bad companies to improve their poor position. That is why we should not sell good shares too early and retain the bad shares.
Why invest in public listed shares?
Statistics show that our Malaysian Stock Index has an average annual growth rate of about 10% which is more than most other forms of investment. You can make more than 10% if you buy really undervalued stocks with good profit growth prospect.
There is a classic saying ‘you can still buy the winning horse after the race in the stock market’. It means that you can still buy shares of really good companies after they have announced their good results.
Moreover, profit from share investment is tax free in Malaysia. You do not have to deal with people which is the most difficult from my experience, as you can never satisfy everybody. You do not have to consult anybody if you want to buy, sell or hold. Another advantage is that there is no bad debt, all cash deal.
When to sell?
After having said all that about selling too early due to the loss aversion phenomenon, we must not forget that no share can keep climbing up and up indefinitely for whatever reasons. In other words, we must not be too greedy and wait for the bubble to burst. Hence the time to sell is when the reasons you bought the share – undervalued  and good profit growth prospect – are no longer there or valid. Sometimes you have to sell to raise cash to buy another stock which is better.
Note: The writer, a retired Chartered Civil Engineer, was one of the founders of IJM Corporation Bhd and was one of the major shareholders of Kaiser Stocks and Shares Co. Ltd. Hong Kong.
I wrote this article in September 2010 when Supermax shot up from Rm 1.00 to Rm 6.50 within 18 months due to the HINI fear and my friends and followers sold too early.

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