The First Step to Getting Help Is Admitting You Have a Problem
Jason is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
If you are like many individual investors, you are losing to the market.
Your earnings aren't keeping up with the S&P 500, or any of the other indexes out there. And it's frustrating, especially when The Motley Fool's Morgan Housel publishes another article that shows how, in the long-term, stocks outperform all other investments.
But here's the rub. It takes decades of ownership to guarantee getting ahead -- and the numbers are based on a total stock market index, which may not match up with your portfolio if you aren't diversified. But let's put that aside for now, and assume that you are diversified in your portfolio.
The bottom line is that it's the most powerful of human traits -- emotion -- that causes us as individual investors to self-destruct. As stated in this paper (opens PDF) by Coval, Hirshleifer, and Shumway, published by Harvard School of Finance:
"Individual traders are regarded at best, uninformed, at worst, fools.... [I]ndividual traders appear to trade too much."
To put the above quote in my own words, individual investors (that would be you and me) don't know what we are buying. We buy and sell too often, except when we don't sell early enough.
So what's an investor to do? Buy index funds?
Actually, that's probably a good idea, at least as part of a smart long-term strategy for diversification:
As the chart above shows, the SPDR index fund (NYSEMKT: SPY), which tracks the S&P 500, has grown in value by over 70% over the past decade, even with the painful losses of the Great Recession. So yes, buying index funds is a viable part of a smart strategy. However, if one is trying to beat the market, an index fund won't get you there, since it is the market.
So what's an investor to do?
Honestly, the key to beating the market is beating yourself. It's the urges to buy and sell, "going with your gut," that does the damage. Here's proof, straight from my own portfolio.
I bought shares of "Company A" at $10.89, and then sold them later at $30.09, good for a 176% return. Not bad, right? Well, I also bought shares of "Company B" at $27.47, and then sold them later at $64.35, giving me a 134%.
Looks like I did a great job of taking my earnings and getting out ahead, right?
Yep, not so much.
I bought shares in both of these companies within months of each other, and sold within days -- in September of 2011, which will let you see how much I left on the table (with what looks to be years more for both yet to come). My one saving grace is that I kept half my position in Whole Foods while I liquidated all of my shares of Liquidity Services.
To make sure that this is abundantly clear, I sold shares of not just Whole Foods, which is continuing to dominate its industry while also delighting its customers, employees, suppliers and shareholders, but also sold my stake in a company that has taken a massively fragmented business and consolidated and expanded in leaps and bounds, right when the growth story is just getting going.
My mistake was a simple one: I had to "take my profits." My decision had nothing to do with the fundamentals of the companies I was selling, or the (powerfully bright) future opportunities. I only sold because the stocks had gone up in price, relative to what I had paid. That's truly the height of foolishness.
I have learned that selling shares in a company should have very little to do with either the share price, or how much it has gone up in your portfolio. Selling shares should be viewed through the same set of analysis tools as buying shares. Think about it this way -- if you would buy shares at that price, you probably shouldn't be selling them. It's really that simple.
But you're cherry picking!
Yes. But that's precisely the point -- it's our cherry-picking behaviors that lead down this path to not outperforming the market, or even, heaven forbid, actually losing money. Here's another example.
I purchased my shares in Rosetta Stone (NYSE: RST) for $27.37. You see that valley in January 2012? Yep. That's where I cashed out. $7.60 per share. And as you can see, shares have rebounded to recent highs in the low teens. And here's what's most important: Rosetta Stone still has a bright future, with plenty of upside potential. Frankly, there's just not another language learning company that comes close to offering the level or product that Rosetta Stone does, and with recent shakeups in leadership, I probably walked away from a big winner in a decade.
But I sold on a number, that, had I not been burned, I would have jumped at if I was looking to buy shares. And think about the fact that Rosetta Stone has gone up 57% since I sold. But that's all based on what I know today, right? Sure it is.
Hindsight and all that, right?
It's easy to armchair quarterback, and say, "If I only had...." But that misses the point. Using the mistakes of the past is an important way to improve as an investor. It's not looking back and trying to change the past. It's taking the past and applying it to future decisions, not repeating the same mistakes. And the clear lesson for me (and I hope, for you as well) is that buying and selling on a number is not a strategy. My lack of focus on the long-term opportunities of these three companies, and only looking at a share price (and the relative performance in my portfolio), led me to leaving money on the table and walking away from holdings in three companies that have great futures in front of them.
I hope you learn from my mistakes. I know I have.
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elihpaudio owns shares of Whole Foods Market. The Motley Fool owns shares of Rosetta Stone and Whole Foods Market. Motley Fool newsletter services recommend Liquidity Services, Rosetta Stone, and Whole Foods Market. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.