If you play a game before familiarizing yourself with the rules, you are deemed to fail. Most people have a difficult time making money in stocks, because they do not have a proven investing strategy. Most of their methods of investing are based on unsound and unproven “conventional wisdoms” proposed by those “experts” who have actually never got rich by investing themselves. In the following, it will be pointed out the 3 most common misconceptions in investing, and how they might cripple you in your investment decisions.
Myth 1: Buy and hold.
Everyone brings out Warren Buffet, the king of buy-and-hold, when it comes to the appraisal of the method. However, you cannot just copy Buffet’s philosophy directly to yourself, for whereas Buffet is buying the whole company, you are only buying the shares. Buffett can do a lot of things like replacing the underperforming management to ensure its efficiency, and as an individual investor you have very little control over the performance of the stock, so while it is still useful to appreciate the value of a company, you have to find something that works better for you.
Most proponents of buy-and-hold describe themselves as rational “investors” as opposed to crazy “speculators”, but let's see how Bernard Baruch, a famous veteran of the stock market, defined the term “speculator” as follows: “The word speculator comes from the Latin ‘speculari’ which means to spy and observe. A speculator, therefore, is a person who observes and acts before it occurs.” Jesse Livermore, another legendary stock operator, defined “investor” this way: “Investors are the big gamblers. They make a bet, stay with it, and if it goes wrong, they lose it all.” These definitions are different from most “professionals” who wrote books and newspaper columns, but as we know, while Baruch and Livermore made millions in the stock market, we are not sure about those other experts.
The truth is that you should combine the elements of investing and speculation. It is not just about buying the best stocks, but also about doing it at the right time, as well as to sell it whenever your rules tell you it is time. Let your rules and the market decide and determine how long to hold each stock, and as a rule, no portfolio should carry losers for six months or more. Rid your losers to keep the portfolio clean is the first step to success, and holding on to losers is surely not a way to do that.
Myth 2: Diversification.
Diversification was proven a myth in the 1960s conglomerate when many big companies tried to “diversify” their business risk by buying a lot of unrelated business. However, with the few exceptions like Berkshire Hathaway and General Electric, most of them failed, because they are involved in too many businesses to concentrate and creating profitable growth.
As Warren Buffett said, if you have a harem of 40 women, you cannot get to know each of them every well. The jack-of-all-trades and master of none is seldom a dramatic success in any field, as the more you diversify, the less you know about any one area. The best results are achieved through concentration by putting all your eggs in just the very few baskets that you know well, and keep a close eye to them. Most people should consider limiting themselves to 3–4 carefully chosen stocks, and once you want to buy more, you should muster up the discipline to sell your least wanted one in hand.
The way to win the game is to have one or two big winners rather than dozens of very small profits. Have you ever bought a giant winner, yet you had owned too little to make it significant, exactly because your capital was distracted to the more uneventfully performing ones? One way to make concentrated positions is to average up and make additional buys in stocks that have advanced 2%–3% or so above your original purchase price, and at the same time, eliminate those show 5%–10% losses. Using this strategy should result in your having more of your money stashed in just a few of your best stock investments.
Myth 3: Buy low and sell high.
Although Warren Buffet said it is stupid to buy a stock is simply because it is going up, it is even worse to buy it simply because it is going down. Buying low seems to be a bargain, but it turns out to be the most dangerous of all investing mistakes.
A stock declines for a reason, and the reason usually appears on the balance sheet after the decline is completed. For example, a friend of mine bought Yahoo at $17 in May 2010 because it was just down from near $19 and seemed a great bargain, and he thought that it makes sense to buy dips in a household name like Yahoo, but it turned out that the company was in some kind of trouble, and the price was near $13 within half a year. Worse yet, he averaged down in his buying (i.e. he bought a stock at $17 and then more at $15 and averaged out the cost at $16) and ended up following the losers and putting his own good money after bad.
You want to buy right, not to buy low, so you would be better off buying less shares of higher-priced, sounder companies instead of chasing losers and think that it is a bargain. In other words, you must think in terms of the capital you are investing, not the number of shares you are buying. The appeal of penny stocks seems irresistible, but most stocks sell cheap because of either the inferiority of the companies in the past or some recent problems they might have encountered. The stock price is often fair so that you can't buy the best at the cheapest price!
Remember, we are buying for quality instead of bargain, so it is a far better idea to buy high and sell higher.
Victor Chan Wai-To is an active trader in Hong Kong.