"You know less than you think you do."
That's a conclusion from behavioral economist James Montier. What's he talking about?
He means that whether you know it or not, you're making big mistakes with your money. And over time, those mistakes will cost you.
Dearly.
Stock madness
Think we're exaggerating? Consider this: Performance-chasing in mutual funds has gotten so bad that Morningstar has created an "investor returns" category to account for the problem of investors buying funds when they're hot and selling when they're not. The difference between fund returns and investor returns can be startling -- as much as 20 percentage points.
Abby normal?
Even if you're not into funds, your emotions are costing you money. Ever heard of loss aversion? It's the practice of holding onto losers in the hopes that they'll turn.
Terrance Odean, professor of banking and finance at the Haas School of Business, found that while investors held losing stocks for a median of 124 days, they held winning stocks for just 102 days. Moreover, investors were 1.7 times as likely to sell their winner.
In other words, investors are cutting winners off early and letting losers ride. That's the antithesis of a successful investment formula.
Alas, this madness can be explained. As master fund manager Ron Muhlenkamp puts it, "For most people 'The Game of the Stock Market' is a distraction that prevents them from making money in 'The Business of Investing.'"
That's why you only hear your buddies talk about their winners at cocktail parties. In the "The Game of the Stock Market," losers don't exist. But in "The Business of Investing," they're the reason why those same buddies haven't yet retired.
Small consolation: The pros aren't immune
Professional investors suffer from loss aversion, too, according to research from Andrea Frazzini, a professor of finance at the University of Chicago. Pros were 1.2 times as likely to sell a winning stock rather than a losing stock. While not quite as bad as the 1.7 of the average, these guys and gals supposedly earn their paychecks staying calm, cool, and collected!
So what's the solution? Easy. Enroll in one of those color-coded day-trading workshops coming soon to an airport Sheraton near you.
Not really.
The actual solution is so simple you won't believe it when we tell you. So we won't tell you -- yet.
Let's lead with an example
In the fourth quarter of 2002, 1,214 stocks rose more than 15%. Since then, 592 of them have continued to beat the market. A whopping 544, including Pre-Paid Legal Services (NYSE: PPD), Cisco Systems (Nasdaq: CSCO), and McAfee (NYSE: MFE), have more than doubled since then. And 58, including Monsanto (NYSE: MON), Bankrate (Nasdaq: RATE), and Joy Global (Nasdaq: JOYG), are up an additional 1,000% or more.
You'd sure be shooting yourself today if you'd sold one of those to preserve a 15% gain.
The lesson? Quick trigger fingers aren't rewarded. While any stock may give back gains, the big bucks are made by finding winners like Bankrate or Monsanto early on and letting them ride.
Be brash. Be boring.
So what's the solution? Buy to hold. Of course, be sure to hold the types of stocks that can be bought to hold. Stocks that are:
- Reasonably priced.
- Managed well.
- Poised to grow.
Stocks that meet all these criteria take many shapes, and Fool co-founders David and Tom Gardner endeavor to find them for our Motley Fool Stock Advisor subscribers. Since its inception in 2002, Stock Advisor picks are up 75% on average, versus 29% for the S&P 500. If you'd like to know what David and Tom are recommending today, click here to join Stock Advisor free for 30 days. There's no obligation to subscribe.
This article was originally published on Feb. 1, 2007. It has been updated.
Brian Richards saw what he saw. Tim Hanson would like to take this opportunity to say, "Hi, Cary!" Neither owns shares of any company mentioned. Bankrate is a Motley Fool Rule Breakers recommendation. The Motley Fool has a disclosure policy, outlined here.
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