Learn To Invest

Secret #5: Stay away from “glitter” stocks
There are many thousands of stocks to choose from: in the USA over 10,000 stocks, in Canada over 3000 and in Australia over 1,500. Faced with these massive numbers and the associated deluge of information, investors get drawn to what I call glitter stocks. These are stocks that have some attention grabbing activity such as high trading volume, extreme movements in the price whether up or down, or when the stocks are in the news.
Even with the best of intentions, it is hard to look at these stocks in a clear and objective manner compared to the remaining stocks. On average, individual investors tended to invest in glitter stocks more than professionals.
Secret #6: Know what is happening behind the scene and what to do with it
When we apply this to investing the message is clear. Wait until everything is in your favor. Nothing makes you buy any particular stock at any particular time. As investors we have the luxury of waiting for the “fat pitch.”
But there are problems. To be able to do this effectively we need to master three steps. The first step to master is to be able to recognize a home-run stock. As we have seen, they are not glitter stocks that have appeared on the front cover of an investment magazine or recommended by a popular share market commentator. Nor are they stocks that have a trader price pattern of breakouts, double bottoms, or candle-stick trend reversals.
The second is to know what to do when a home-run stock comes along. When everything meets your criteria of it being a great business at a fair price, then buy a “meaningful amount of the stock.” Of course, this means that you can only hold a small number of companies in your portfolio.
The more stocks you hold, the more likely your returns will be average and the more time you will have to spend keeping track of the stocks in your portfolio. You also add considerable risk because you can’t study them properly.
The third step concerns knowledge and confidence. You need the knowledge to know approximately how often a home run stock comes along. You won’t make the investors Hall of Fame if your criteria are set so high that you only get to swing every other decade. On the other hand, if they are set too low then, well, they are unlikely to give you the outcome that you desire. You also need to have the confidence to wait.
Secret #7: Calculate how much money you will make, not whether the stock is undervalued or overvalued according to some academic model.
As an investor what is the right question to ask? Most ask whether the stock is undervalued or overvalued. The problem with this is that there is no way of properly determining whether a stock is, in fact, undervalued or overvalued.
There are various academic models for calculating what is called the intrinsic value of a stock. From my extensive experience as a research mathematician all these models, referred to as discount cash flow models, are fatally flawed. There are four areas that bring them down. They are theoretical, contradictory, unstable and untestable.
These problems are a rather technical to explain fully so I will only give the general ideas behind them. Just because some theoretical formula labels a stock as undervalued does not mean that you are going to make money from it. For example, perhaps the price will stay at that level. The models are contradictory since different values are obtained depending on which of the many variations of the models that you use.
They are unstable since insignificantly small changes in the input variables lead to changes of 100 percent or more in the intrinsic value. This means that in instead of the models being objective, they can lead to almost any output that is desired. And finally the models are impractical because they are untestable. Some of the input variables require verification over an infinite number of years. For example, forecasts of growth rates have to be made over not just five or ten years, but extending out forever.
Secret #8: Remove the looser and keep the winner — not the other way around
For many it is worse than having a tooth pulled to sell a stock for a price lower than what they paid for it. If you buy a stock for $20 and it drops to $10, so long as you don’t sell, then it can be referred to as an unrealized loss. In this case you can say to your spouse, “Don’t worry, dear. It’s going to come back.”
Similarly, many can’t wait to sell as soon as they can see daylight between the purchase price and the current price. If the price has gone up be a few dollars, they want to sell and “lock in the profit”.
We referred to this as watering the weeds and pulling up the flowers. They are examples of what I call investor diseases. The disease of holding on to your losers I call get-evenitis. The disease of selling winners I call consolidatus profitus.
We found that people tended to trade out of winners into stocks that performed less well. In the opposite direction, the study showed that the losers in their portfolio tended to continue to underperform. It was really the case that once a loser, always a loser.
We found that people would have been better to sell their losers and keep their winners. Instead, they did the opposite, namely keep their losers and sell their winners.
Suppose two simple changes were made: the investors sold their losers and held on to their winners. On average, the study showed that their average annual performance would have gone up by almost five percent per year.
The difference between the two strategies is even more marked when taxes are taken into account. When you claim a loss you are getting a tax rebate and so you want this as early as possible. In contrast, with a profit you are paying tax so you want to delay this as long as possible. But, as we just learned, the average investor tends to take profits early and losses late ending up on the wrong side of the taxman.
This gives us confirmation of secret number eight: Remove the looser and keep the winner — not the other way around
Of course, this is an oversimplification. There are times when it is better to keep a stock when the price has gone down. In fact, it may well make sense to buy more. At other times, it is better to sell a stock after it has gone up. Each case has to be treated on its own merits.
This leads to the question. Just when should you sell? A large survey carried out by the Australian Stock Exchange showed that investors found it much harder to know when to sell than when to buy.
Similar results were found in a survey of nearly 300 investors that I carried out. Almost 50 percent said that they either regularly worry or constantly worry about when to sell their stocks.
The general rule which is full of common sense is: Sell only when you can be very confident that you can do significantly better with your money in another stock. The problem is to be able to determine when this is the case.

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