Human Nature

We have had another poor week with distribution days continuing to show up. The major indexes are now back below their 50 day moving averages as the stock market continues to act poorly. More bad news on the economy this week as the Philadelphia Report showed unexpected higher unemployment and poor economic numbers. Having said this we have to remain on watch for accumulation days since the stock market will turn around long before we see it in the economy.

I would like to discuss human nature today since it is the biggest enemy of successful investing. It is human nature to want to take profits yet when we own losing stocks we tend to stay with them sometimes for years if not forever. Let me walk you through a scenario you may see yourself as having done many times (I certainly have). I will explain it in three parts.

1. You find this great company (company A) that has a fantastic future, or so you believe. You buy the stock and it hesitates and maybe drops down a little. You stay with the company after all it has a great future. It recovers and now your back to break even, feeling great you know it will go up. The stock goes up 10% you knew all along this would be a winner. The stock rises more it’s now up 15%, gosh you’re a genius, you tell all your friends. You now feel a little nervous and want to lock in that profit. It now rises again to an 18% or 20% gain then hesitates a little perhaps falls back to a 15% gain. You sell out worried it will continue to fall and tell all your friends what a genius you are with this profit. You found a winner and made some nice cheese from it. Emboldened you look for another company.

2. You find another great company (company B) that also has a great future or so you believe. The company goes up a little, falls back a little. Couple of weeks later it is still around your purchase price. After a month you get bored and sell the stock. Oh well no big deal, you didn’t lose or gain so let’s find another.

3. Yet again you identify a third great company (company C) and buy the stock. It does nothing for a few days then falls 5%. Oh well no big deal it will recover it’s a great company with great prospects. Next week it’s down a total of 10% but you know it will recover. The next week the Dow has a few bad days pulling all stocks down, your stock is now down 20%. The stock recovers a little over the next few days so now it’s down only 10%, you knew it was a good company. Oh dear suddenly it’s down 20% again and you say I have had enough of this, as soon as it get back to break even I am going to sell. Suddenly the stock is down 30% and you think to yourself no way am I taking a 30% loss I am going to wait for it to recover then consider selling. Oh my goodness just before vacation you notice it’s down 40%. I don’t care any more so I leave for a good vacation. Well the story goes on and the stock keeps falling. Your ego refuses to take a loss then one day perhaps a year down the road you still own it and its down 80%. Most people I know at this point will either hold stock C forever or sell it to take a “tax loss”. Your pride now justifies the sale after all it’s a tax write off.

Now let’s look at this statistically we buy all three stocks with returns of 20%, 0% and -80%. Of course I don’t know what will happen to those three stocks but we do know that statistically those three things could happen (up, down and sideways). In practice because of human nature we cut our gains short yet we let our losses ride. I can assure you that’s what most people will do.

DO NOT do that you must work against your human nature and do exactly the OPPOSITE. Cut your losses quickly at 10% or even better and let your winners continue to win. You are in a much better position if you take the 10% losses and collect the 100% gains. If you let human nature control you then you are destined to large losses but only small gains since you always sell your winners. I have already given you the tools on how to know when to sell your winners, remember the high volume falls as an indicator and/or the crossing of the 50 day moving average. Remember winners tend to continue to go up and losers tend to continue to go down.

Human nature is so hard to overcome but when investing you must do the opposite of human nature.