"You know less than you think you do."
That's a conclusion from behavioral economist James Montier. Whether you know it or not, he's saying, 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 that 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 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 more likely to sell a winning stock than a losing stock. While that's 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 the first quarter of 2003, 608 stocks rose more than 15%. Since then, 269 of them have continued to beat the market. A whopping 243, including Abercrombie & Fitch
You'd sure be kicking 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 WellPoint or Arena Resources 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.
- Poised to grow.
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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!" Tim owns shares of International Assets. GameStop is a Stock Advisor pick. The Motley Fool has a disclosure policy, outlined here.