The Greatest Wall Street Danger of All: You

re: Born Suckers [the broken link was removed] – The greatest Wall Street danger of all: you by Henry Blodget.

Henry Blodget mentions two profoundly (though simple) important factors that lead to poor investment decisions: Prospect Theory and Outcome Bias. He lists 7 factors, I find two profound.

Prospect Theory (more details) essentially states people are eager to “lock in gains” (sell positions with profits to realize gains) and hold losses (deffer selling positions in which they have losses so as not to “realize” the loss). Like many profound ideas the simplicity of the idea undermines the importance. This factor can make a huge difference in investment results. Many of the most successful investors understand the importance of this idea. And they repeat the importance of taking action to avoid falling into the patterns prospect theory predicts.

William O’Neil (founder of Investors Business Daily) – “Remember, 7% to 8% is your absolute loss limit. You must sell without hesitation – no waiting a few days to see what might happen or hoping the stock rallies back; no need to wait for the day’s market close” page 90, How to Make Money in Stocks: a winning system in good times or bad, 3rd Edition, 2002.

From The New Market Wizards: Conversations With America’s Top Traders by Jack Schwager
Schwager: “What else have you learned from Soros?”
Stanley Druckenmiller: “I’ve learned many things from him, but perhaps the most significant is that it’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.” (page 207)
This is obvious, so what value does it offer? As Prospect Theory states peole have a tendency to sell profits and hold losses. Often this means you make less when you are right. It can also mean you loss more when you are wrong (because you are reluctant to sell – I must admit I can still fall into this trap).

Outcome Bias – “We tend to evaluate decisions based on outcomes instead of probabilities. Thus, we congratulate ourselves for stupid choices that happen to turn out well and vow to never again make smart choices that happen to turn out badly.” from Born Suckers [the broken link was removed]. For example, I decide to thrown a dart at the newspaper and move all my portfolio into the one stock that is hit. If that stock is the best performer of the year I will have very good results, however, the that will not be due to my great decision but luck. Luck is a factor in investing, but the way to achieve exceptional performance is to developing investment strategies that give you an advantage in the market.

I have used an online portfolio management and performance tracking tool for several years: Marketocracy [the broken link was removed]. It is a tool that helps me learn, by seeing the real results of my investing decisions. It is also a great way to provide others a view of how my ideas have played out as measured by Marketocracy. My marketocracy fund [the broken link was removed] has beaten the S&P 500 by an average annual rate of 10.32% (as of this posting) since it was started in 2000.

One final thought on investing from Jesse Livermore (as remembered by his sons) – From page 141 How to Trade in Stocks: “the stock market must be studied, not casually either, but deeply, thoroughly. It’s my conclusion that most people pay more care and attention to the purchase of an appliance for their house, or when buying a car, that they do to the purchase of stocks. The stock market, with its allure of easy money and fast action, induces people into foolishness and the careless handling of their hard-earned money, like no other entity.”

Good investing to you in the new year.