"You'll never go broke taking a profit."
Have you heard that phrase recently? I know I've been hearing it a lot more. And I'll grant that it's true, to some extent.
But, if you use it to justify getting out of a successful investment (pulling the flowers, as some have said), you'll never truly get rich. Why? Because emotion -- I'll tell you which one in a moment -- is ruling your decision. Let me illustrate what I mean.
Suppose you start with $1,000 and your broker charges you $10 in commissions. And suppose you decide to invest it all in one stock and sell once it goes up 20%. Take your profit, reinvest into another idea, and sell again after a 20% gain. Rinse and repeat. How much would you have after just 10 rounds of this? Well it turns out that by following this somewhat reasonable strategy, you would end up with $5,620.65. Not bad, a 460% gain.
But in reality, you've given up $499.17. (And capital gains taxes on all those trades would make it even worse.) That's the difference between doing the above and just buying a single stock that rises 20%, ten times.
The skeptic's speak up
Sure, you say, 20%, 10 times. How often does that happen? Well, putting it another way, that's just a six-bagger and it happens more often than you might think. Check out Wal-Mart Stores
Getting back to our example, $180 of that $500 loss is because of the extra commissions paid to the broker. Kiss that money goodbye. The other $320 is what you did not earn on those commission charges.
Kiss that money goodbye, too.
In other words, trading is hazardous to your wealth, in the words of Brad Barber and Terrance Odean, who's now at the University of California at Berkeley. That's what their research showed from following the records of 60,000 investors. Active traders, people who might use that phrase from above, trailed the least active investors by six percentage points a year. Wow!
Now, compound that over an investing lifetime. How many thousands of dollars would you lose all because of one emotion? "Can't go broke taking a profit?" Uh huh.
Be afraid, very afraid
The emotion behind that phrase, my friends, is fear. Pure and simple. People who use that phrase are afraid that whatever gain they've gotten when the stock price goes up will disappear when the stock price goes down temporarily.
Yes, temporarily. I've written before about how using stop losses to protect gains actually insures losses. Haliburton
My colleague, Joe Magyer, wrote about how a nervous and itchy trigger finger from watching price action too closely on one investment cost him $20,000.
But it's not only fear that will hurt you. Another colleague, Rich Greifner, wrote how falling in love with a stock, such as Apple
Even hate can hurt your performance. If you hate the product, how likely are you to invest in the company? Did hate keep you from profiting from Microsoft
Fear, love, hate. Letting emotions dictate our investing is the mistake that costs us a fortune. Listening to them leads to excessive trading. And those who trade often, as shown by Barber and Odean, trail those who don't -- by a lot. Joe lost $20,000. My little example above shows a loss of over 8%.
Joe's (and my) boss, David Gardner, is the best person I've seen at putting his emotions aside when it comes to investing decisions. Sure, he loves it when a company he picked for Motley Fool Stock Advisor reports great results and the stock price jumps, like Netflix
To learn how to stop letting your emotions get the better of your investing, along with the names of those 18 picks, sign up for a free 30-day trial to the newsletter. There's no obligation, so give it a try today.
Jim Mueller owns shares of Netflix and Apple, and has beneficial ownership in Microsoft. Microsoft and Wal-Mart are Inside Value picks. Ford, Netflix, and Apple are Stock Advisor recommendations. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool's disclosure policy goes where angels, not to mention other disclosure policies, fear to tread.