"You know less than you think you do."
That's a conclusion from behavioral economist James Montier. What's he talking about? That whether you know it or not, you're making big mistakes with your money. And that over time, they will cost you.
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.
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 they'll turn.
In another study, Professor Terrance Odean 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 which 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. 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 Joe, these guys and gals supposedly earn their paychecks staying calm, cool, and collected!
So what's the solution? Easy. Simply enroll in one of those color-coded day-trading workshops coming soon to an airport Sheraton near you.
The actual solution is so simple that you won't believe it when we tell you. So we're not going to tell you -- at least, not yet.
Let's lead with an example
In May 2002, 951 stocks rose more than 10%. Since then, 477 of them -- or a little more than half -- have continued to beat the market. A whopping 331, including Evergreen Solar
You'd sure be shooting yourself today if you'd sold one of those to preserve a 10% 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 Sohu.com and Bankrate early on and letting them ride.
Be brash. Be boring.
So what's the solution? Buy to hold. Of course, be sure to buy to hold the types of stocks that can be bought to hold. Stocks that are:
- Reasonably priced.
- Poised to grow.
Stocks that meet those criteria can take many shapes, and Fool co-founders David and Tom Gardner endeavor to find them for our Motley Fool Stock Advisor subscribers. Since inception in 2002, their Stock Advisor picks are up 70% on average, versus 30% for the S&P 500. If you'd like to see the stocks they're currently recommending, 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.