Investment Myths

Investment Myths

by Thomas L. Hardin

There are many old sayings related to the stock market. Some are true; most are not. Most are harmless, but some can be quite dangerous. Here are two sayings related to individual stocks that have cost people money:

  1. You haven't lost money until you sell.
  2. You can never lose money taking a profit.

Let's take a look at these one at a time.

People who believe they haven't lost money until they sell sometimes hang onto losing stocks long after they should have sold. When a security goes down, they're reluctant to admit that they made a mistake or to face the fact that, for whatever reason, the stock is going down. Rather than selling when they should, they hang on tight, hoping the stock will make a comeback or thinking they'll get out when the stock breaks even. They firmly believe they haven't lost anything yet, but that's where they're wrong. They have lost because a stock is only worth what it's trading for today. If you don't believe me, try telling holders of Enron or Conseco ( whose stock has essentially gone to zero) that they haven't lost money because they haven't sold. I'm sure they'd disagree!

In reality, it's important to cut your losses short on individual positions. If something moves away from you, cut it short. Having a strong "sell discipline" - a well-defined plan for when you or your portfolio manager will get out of a stock that's not moving - is even more important than having a strong "buy discipline."

The second saying that can cost you money is, "You can never lose money taking a profit." This one causes people to feel more comfortable taking a profit quickly. When a stock starts to go up, they're ready to sell and run with the money, even though the stock may continue to climb.

As I said at the beginning, not all of the old sayings are false or dangerous. One saying I like is "The trend is your friend." When a stock is trending upward, the smart investor takes advantage of the trend and lets it run. Since good portfolio management technique requires you to take money off the table as positions begin to go up, the smart investor "trims" the position instead of selling it all for the quick profit. In other words, if a stock goes from $20 to $40, the smart investor trims it back by 25"50%, taking a partial profit, keeping the upward-moving stock in hopes of additional profits, but bringing the position back to its normal size within the portfolio.

In the portfolios I manage, many of the stocks I sell are the ones that have gone down. In a portfolio of 15 or 20 stocks, there will always be some underperformers. As a result, I always want to cut those losses short. Why? To avoid disasters like Enron, WorldCom, and Global Crossing. All three of those stocks were touted by big-name fundamental analysts at major brokerage firms. Then they continued to go down, down, down. Finally, when the true fundamentals were known, it was too late; most of the money had been lost. Had investors implemented a stop-loss process or sell discipline that required them to sell when the stock began to underperform, they could have gotten out before the damage was done.

That's why I emphasize over and over again the need for a rules-based system and the discipline to stick with it. Instead of listening to the messages and myths about buying and selling, smart investors know which rules make sense and which to ignore. They follow their system and leave the "old wives tales" behind.