How Not To Lose Money On The Stock Market

Published in Investing Strategy on 11 June 2009

Investors always set out with the intention of making money, so how come so many ending up losing it?

BLASH!

No, I'm not about to write about comic book superheroes.

BLASH stands for Buy Low and Sell High. It's the fundamental objective of all investors. Buy when the share price is low and sell when the share price is high. It's pretty simple really. It's what we all aspire to.

So why do many small shareholders manage to do the complete reverse and lose money by buying high and selling low?

The reason is rooted in psychology and human nature. When things are going well, investors, like most humans, feel positive about the future. However the stock market tends to overreact both on the upside and the downside. When the share price is high and analysts and other investors are recommending the company, things must surely be going well, so it seems a good time to buy the shares. Who wants to buy shares that no-one else wants? When the share price falls back and analysts and other investors turn negative, we assume things must be going badly, so it's time to bale out. The result unfortunately is a loss.

How can investors avoid this scenario?

DYOR

It means Do Your Own Research and you'll see it occasionally at the end of posts on the Motley Fool bulletin boards.

It's very easy to get caught up in the euphoria of a rising share. Most bulletin board posters, not unnaturally, are holders of the share and therefore have a positive view of it. They often give little regard to the negatives and risks associated with the company. Furthermore some disreputable bulletin board posters (although not really on Motley Fool, due to its strong community spirit) actually post selectively and repetitively about the share with the specific intention of driving up the share price so they can sell at a profit. It's called RAMPING. Don't be the person that buys their shares.

The way round this is to do your own analysis. Why is the share good value? What are you expecting from it in the future? If you know that, then it makes the decision of when to buy and sell that much easier. If you want to test your analysis then why not post it on the Motley Fool bulletin boards. Some kind soul might point out any mistakes and save you money.

Taking profits

Don't forget to take your profits, especially if your analysis shows the share has become overvalued. It may be a cliché but a profit is not a profit until the shares are sold. It's easy to fall in love with a share and believe it will continue to rise forever. We've all heard tales of the hundred baggers (shares whose prices increased hundred fold) which made their holders wealthy people. I made that mistake with Internet Business Group, now part of TMN (LSE: TMN). Buying at 3p, the share price soared to 35p, with many holders forecasting 100p and more. My dream retirement home in the Caribbean beckoned. Unfortunately, after a series of botched decisions by management, the price is now back effectively to 4p. Oops!

Investors like Warren Buffet may believe the best period to hold a share for is forever, but few shares satisfy that criteria. It's better to miss out on future gains than it is to lose your money.

Cutting losses

If the story about a share changes then the reason for holding it must change. If you didn't hold the share, would you really buy it on the basis of the information available? If the answer is no, then why are you continuing to hold it? Again it's easy to fall into the trap of loss denial -- a loss isn't a loss until you sell the shares. Many investors in banking shares just watched traumatized as the prices fell relentlessly, when clearly the story had changed.

Another misguided technique to recover losses is doubling up; buying more shares to reduce the average acquisition price. That means the share price doesn't have to increase as much to get your money back. It's a lesson I learnt many years ago with Marconi. In the end all that happened was that I doubled the amount of money I lost. Double oops.

Forget your losses and move on.

On the other hand, if the story hasn't changed, don't be scared out of the shares. Many small companies have very volatile share prices. A big seller can drive the share price down. For those who have done their homework this can be an excellent buying opportunity.

The longer term view

If you were offered the opportunity to double or treble your money in two years, would you take it? I believe most investors would.

Too often however, small investors become obsessed by short term considerations. The share looks fantastic value, but it might fall further in the short term. I can't count the number of great opportunities I've missed hanging on for a cheaper entry point. Unless you are incredibly lucky or talented, you'll never get the absolute cheapest price.

Another mistake is avoiding shares because they've risen in price. Why turn your back on a possible 100 percent gain, just because you've missed the first 10 percent?

None of this of course will guarantee you make money, but it may at least help.

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Comments

The opinions expressed here are those of the individual writers and are not representative of The Motley Fool. If you spot any comments that are unsuitable hit the flag to alert our moderators.

lotontech 11 Jun 2009 , 7:53am

Nice article Steve, with a few observations:

I think we agree on Warren Buffett's rules for investing:

1) DON'T LOSE MONEY!
2) Don't forget rule 1.

Not losing money is a function of cutting losses (mentioned in this article) and not staking too much too soon (or position sizing, not mentioned).

The advice to "take profits" is a little dubious though, since most successful investors advise to "cut losses and let profits run". The reason is obvious: unless you have a consistent edge that gives you >50% chance that your investment will go up then the only way to make money over time is to make sure that you make more on each winner than you lose on each loser.

Ok, so it would have been better to "take the profit" from TMN at 35p, but most "profit takers" would have taken the profit prematurely at 6p when it had enjoyed 100% increase. So the question is where to take those profits?

Suppose that at 6p you set a stop order at 4p. The price could have 'corrected' by as much as 33% down without selling you out at 4p, and if the stop order did trigger then you would have secured a 30% profit (from the original 3p). Suppose instead that the price 'corrects' by 20% down from 6p, thereby not triggering your stop order, and then rises to 9p. You move your stop order to 6p thereby securing a minimum 100% profit and allowing another 33% 'correction' before the next rise.

This approach allows you to hold a share 'forever' (Buffett's ideal period) as long as it keeps going up and never corrects too far, but it gets you out automatically (and not emotionally), most likely at a profit, when things turn sour.

And who says that investing is rocket science? ;-)

Stemis3 11 Jun 2009 , 10:38am

Tony,

Thanks for your comments.

I think knowing when to sell is maybe the hardest part of investing. As you say, it certainly ain't rocket science.

I guess all I was recommending in the article is to make the decision to sell on the basis of your views on valuation. Too many investors seem to hang on in the face of the evidence, either because they've fallen in love with the share or they are chasing the dream. Of course as the share price rises, so does the size of the investment, so top slicing also re-balances risk.

I'm not a big fan of stop losses because my focus is mainly on fundamental not sentiment (although I'm not discounting the later). However if they work for you, who am I to criticise.

Cheers

lotontech 11 Jun 2009 , 12:14pm

I agree Steve.

Knowing when to exit, whether based on price action or fundamentals, is key to holding on to profits. You might like my "Exit Strategies" article at http://www.stockbrokers.barclays.co.uk/content/ads/documents/SI16_Exit_strategies.pdf which discusses exiting on fundamentals as well as, or instead of, on price action.

(I hope the moderators don't delete this comment, since I am linking only to a relevant free article -- nothing promotional)

Tony.

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