Of course, I should have known better.
All I wanted was a new camera lens. There are thousands of good places to buy something like that. I chose none of them. Instead, I waltzed into one of those brashly lit rip-off photo stores in New York City. I knew the exact make and model of the lens I wanted. What could go wrong?
Here's what went wrong: Somewhere along the line the store clerk changed both the bill and the lens I paid for to something cheaper. You know the drill -- I paid for a Canon and got a "Camon." Yes, I know, I know. I'm not from around here and all that. So when I take the thing back, the guy offers to buy the lens back from me, but because I had left the store, he would only buy it used. When I explained that I'd paid nearly three times that amount for the lens, I got, surprisingly, an object lesson in investing:
"Nobody gives a [golf word] what you paid."
Ripped off by Lucent
In investing, how many times have you seen someone -- heck, how many times have you been that "someone" -- who said, "I'm going to hold this company until I get back to even. Then I'm selling."
No one likes to lose money on any one investment. When you look at a list of your holdings in an online portfolio, the first thing you notice is whether you've made money on each one. Up is green, down is red. Red numbers are no good.
While your ultimate goal in buying a stock is to make money, let me point out that once you've made your decision to buy, the price you paid at that moment (ignoring, for now, tax considerations) is irrelevant in determining at any future time whether you should continue to hold, sell, or buy more. Instead, there is one -- and only one -- consideration: "Does holding this company at this price offer a reasonable chance of a market-beating risk-adjusted return?"
Oh, sure, you can think about diversification, style points, and all that stuff. But what you should not think about is the fact that you paid $32 for Lucent
You see, what you bought at $32 per share turned out to be a depreciating asset, the same way that your car is. You may not have thought about it that way. Fact is, you'd have to be insane to buy a stock with the expectation that you were going to suffer grievous capital loss because of your decision. And yet, that's what millions of people did in 1999 and 2000.
Some of these companies might not be what you would expect. Certainly, there are Gemstar
But here's the thing. No one -- not the market, not your broker (online or not), not your neighbors or buddies -- no one cares what price you paid for your shares. It is a totally irrelevant piece of information. It is a historical fact, nothing more. The only person to whom it matters is you. And for you, it only matters because it is an anchor that tells you whether you're winning or losing.
In fact, I'd go so far as to wager that hang-ups over the price paid are among the biggest contributors to horrible investing decisions. Yesterday, Andrew Patterson describedMicrosoft as the "mother of all small-cap winners." Yes, it's been a long, long time since Microsoft has been a small cap, but at one point it was, and it had shareholders. Those folks were, in effect, holding winning lottery tickets back in 1990. How many do you think took their double and sold?
I'd put sell stops in the same boat. If I buy a company for $10 that I believe is worth $15, and it drops to $9.20, I'm supposed to automatically sell and run for the hills? The market doesn't know what I paid, nor does it care, but I'm supposed to react to its (many times completely irrational) meanderings? Who thought that piece of wisdom up? "I thought it was cheap, now it's cheaper? Sell!" (Answer: someone who doesn't think very hard about valuing companies, that's who.)
Now that I've got that off my chest...
I'm not suggesting that returns are not of primary importance. One does not (or should not) invest for style. Returns are the ultimate scorecard. What we're talking about here are mental traps that keep you from maximizing your total return.
When you're making the decision to sell or hold, what you paid shouldn't really come into the equation. If 10 years ago you bought a guitar autographed by the rock group Warrant for $25,000, and recently an appraiser valued it at $500, the Warrant memorabilia collector who offers you $1,000 for it is doing you a favor. You're not losing $24,000 on a $25,000 ax, you're gaining $500 on a $500 guitar. Don't wait around for Warrant to come back. Lead-pipe cinch of the day: Warrant is not coming back, and neither is the value of that guitar. Sell it. It's that simple. (And by the way, Warrant? What were you thinking?)
So place this question foremost in your mind, and you'll be better off: "What is this company worth?" If what the market is offering is out of whack with the number you come up with, you have a strong incentive to make a deal. Don't compound an earlier mistake by anchoring your decision on whether you're in the black or not on that position. If the company's condition has materially worsened, or if your analysis was faulty (and you did, after all, buy that guitar, so you've got it in you), waiting it out may just make it worse. Believe me, this is a hard-learned lesson.
Foolish final thoughts
At Motley Fool Hidden Gems, we think of our stocks as being for sale every day. This might seem counterintuitive for folks who tend not to trade and who invest in companies for a minimum of three to five years. These stances are not contradictory, however. If we believe that a company's prospects have changed, or if we believe that its risks far exceed its potential reward at the current price -- even if that price is far lower than where we first entered the position -- we're going to think about selling it. The only two pieces of information that matter are the price at the moment and the potential for the future. Without that sort of mental flexibility, we're susceptible to making suboptimal decisions.
What we don't consider, though, is a company's current price compared to where it was when we first recommended it. Tom Gardner re-recommended FARO Technologies
Of course, Uncle Sam interjects
Naturally, there is a caveat. What I've written above assumes a frictionless market, which Uncle Sam and his orchestra long ago decided was not as important as making sure they get a cut on every transaction. While tax considerations shouldn't drive your decisions, they will make a difference.
But besides nosy Uncle Sam, nobody cares what you paid.
Hidden Gems is the premier small-cap investing newsletter, authored by Tom Gardner and Bill Mann. Afree 30-day trial, as it suggests, costs you nothing.
In consideration of his "Great moments in music history" series, Bill Mann would like to pay tribute to February 2003, when Quiet Riot finally broke up without imposing another album upon the music-listening public. Pfizer and Home Depot are Motley Fool Inside Value recommendations. The Fool has a disclosure policy.