You're not as smart as you think. How do I know? Because you keep selling your best stock ideas and buying ideas that, well, aren't quite as good. How do I know that too? Thanks to a study by Berkeley's Terrance Odean, who looked at thousands of real-life transactions and found that when investors sold a stock and buy another with better prospects, that new stock trailed the old stock by more than 3 percentage points over the following 12 months. That's right, trailed. As in worse.
So why are we leaving good investments too soon? My guess is that we're way too impatient.
"Slow down, you move too fast"
Take me, for example. Whenever I hear a new stock being touted, I feel like I need to go out and buy shares. And if I don't and the stock starts going up, then I really want to buy shares.
Of course, if I sell existing shares to buy new shares, then according to Odean, that impatience just cost me 3 percentage points of return. Ouch.
The way to fight impatience is to take those words from Simon and Garfunkel to heart ... slow down. And do some due diligence. For example, ask yourself these questions:
- What does the company do?
- Is it profitable? If so, what are the margins?
- How do its margins compare to its competitors?
- How big a moat, if any, does the company have?
In other words, get to know the company a bit better before buying. Try to reach the point of being able to give a convincing two-minute summary of your investment thesis, as Peter Lynch urged. He wrote in Beating the Street that "You have to know what you own and why you own it. 'This baby is a cinch to go up!' doesn't count."
And don't worry if a stock starts going up while you're doing your research. I can almost guarantee that it will come back down. As Lynch observed in One Up on Wall Street, there often is a 50% difference between the high and the low prices during a year. If you look at the longer-term price charts for great performers such as Boeing (NYSE: BA ) , Pfizer (NYSE: PFE ) , and Motorola (NYSE: MOT ) , you'll see how true Lynch's statement is.
Taking a profit doesn't profit you
Similarly, just as it pays to be patient when it comes to making buy decisions, it pays to be patient when selling, too. Seriously. Let's go back to Professor Odean. He found that when the motivation for selling was just to "take a profit," the old stock beat the new stock by 5.8 percentage points after one year and 8.9 points after two.
Profit-taking is generally a quick decision made out of fear of losing those paper profits. But if you've got a great company on your hands, the best time to sell is almost never.
Patience pays
If you bought Toyota Motor (NYSE: TM ) in the spring of 2003 for $45, got impatient when the price leveled off in the fall of 2004, and sold near the end of the year at $79, you would have made a 76% return in 19 months. Not too shabby. However, if you had held, you'd be sitting on a 200% gain today.
Suppose you bought Procter & Gamble (NYSE: PG ) in early 2005, right in the middle of that plateau at $55. By the end of 2005, it seemed to be breaking out. Then came last spring, when many stocks -- including Procter & Gamble -- took a tumble. A nervous investor could have sold on the way down with a minor profit of 8%. The patient investor, on the other hand, may have noticed that nothing was wrong with the company and chosen to hold. By not selling, that investor would have an 18% return today.
Here's one more example. Conglomerate Rohm & Haas (NYSE: ROH ) , maker of Morton salt, has been quite volatile over the past few years, experiencing several nerve-racking drops since the beginning of 2003. Yet the company has continued plowing along, and the stock is up more than 80% overall.
What's the key?
Gains don't happen over a few days or even months. Rather, it takes years to build a fortune in the stock market. And while those years can be hair-raising, remember that volatility is your friend, not your foe. It gives you the opportunity, if you've done your due diligence, to build a position in a great company at a lower cost basis. And that's a recipe for huge returns.
At Motley Fool Stock Advisor, Fool co-founders David and Tom Gardner advise their subscribers to be patient when it comes to their stocks and to take a three- to five-year view when assessing their portfolio returns. While it may seem like an eternity, it's that long-term view that will help you do better as a patient investor. And patience pays off, it seems; since 2002, David and Tom's picks are beating the market by an average 36 percentage points.
If you'd like to take a look at the stocks they're recommending today, stocks that you can be patient with, click here to join Stock Advisor free for 30 days. There is no obligation to subscribe.
Fool contributor Jim Mueller is patiently invested in several companies, just none of the ones mentioned here. Pfizer is an Inside Value recommendation. Are you patient enough to read the Fool's disclosure policy?
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