1 Crucial Strategy to Avoid Awful Investing Mistakes

Investors have seen several high-profile stocks make some pretty ugly moves since the beginning of the year -- SodaStream  (NASDAQ: SODA  )  down more than 19% and off 50% from its 52-week high, Best Buy (NYSE: BBY  ) down 36%, and GameStop  (NYSE: GME  ) now down 21%. These precipitous falls have been the result of updated guidance from holiday sales, and they present investors with a troubling question: To sell or not to sell? This dilemma commonly arises after large price moves, when investors are the most susceptible to making awful decisions.

Awful decisions explained
Below we have two investors, each with a $10,000 portfolio. But one investor has two stocks in his portfolio, while the other has 10. Let's look at what happens when one of their stocks declines by 50%, much like Sodastream.

As you can see, investor No. 1 loses 25% of his portfolio value, while No. 2 loses 5%. This means that after a 50% loss on one stock, investor No. 1 will need to achieve a 33% return just to break even, while investor No. 2 only needs to generate a 5% return to break even.

The real point of the exercise above is to show that having a small number of high-risk stocks in a portfolio exposes investors to powerful psychological forces. The human brain is much less adept at holding on to a particular stock when it causes a 25% drop in that investor's portfolio. This, in turn, can lead to loss-aversion, causing the investor to prematurely sell the stock after a large market decline. The proper allocation of high-risk investments makes it easier to deal with the dramatic ups and downs that come with higher-risk investments and can help to prevent emotional investing decisions.

Foolish takeaway
In my opinion, one of the bigger risks of investing in a small number of companies isn't that a single stock will fall and seriously affect overall returns, but rather that the investor will buy or sell based on an emotional response to dramatic price swings.

In business, success generally doesn't happen overnight, and reacting to limited information can be dangerous to those sitting on large portfolio declines. Instead, it can be much better to appropriately allocate investments so one can comfortably watch a business execute its strategy over the long term.

In the video below, I'll explain these powerful psychological forces and how investors should deal with the large declines they've seen at SodaStream, Best Buy, and RadioShack. 

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4/17/2014 4:00 PM
BBY $24.48 Up +0.01 +0.04%
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