Wednesday, November 18, 2009

Take Losses First?

You'll never go broke giving contrarian advice!

One of those "Investment Advisers" posted something on the Internet the other day:
"Take Losses first, Take Profits Last"
I thought this was an interesting mantra, but to some extent, it illustrates the problems with the stock market and investment advisers in general (See my article "Beware of Financial Advisers"). The market tends to be viewed like a slot machine, and silly mantras like the one above are repeated by these know-nothing (or know-little) investment advisers or bankers, who pat themselves on the back for being geniuses, when all they have done is ride the wave of the stock market over the last two decades.

By the way, mantras like this, which are catchy and simple, sell well. People want to condense investing into two or three simple rules, rather than viewing the market as the complex device that it is. It is nearly impossible to craft simple rules that apply in all situations, as no two companies are alike, markets change over time, and companies change over time. What was true for investors in the 1960's doesn't work today. The enthusiastic ravings of the "Motley Fool" may have made a lot of "sense" in an ever-rising market. But do they really comprise real sound advice? Or just something catchy that sounds good on television or in a newspaper article?

The theory behind "Take Losses First" is that you should dump a stock before it tanks, rather than ride it all the way to the bottom. This can be good advice, particularly in retrospect. Hindsight is indeed 20:20, and this article make best use of historic information to make the author look like a genius.

(The article I cited above uses historical information to make the author look smarter than he is. You should have sold XYZ corp at $10 a share, taking a loss, before it went down to 50 cents! Well, duh, any "genius" can say that, using last year's stock charts. I should have bought yesterday's winning lottery numbers, while I am at it. I should have bought Microsoft in 1983. There are a lot of things I should have done - in hindsight. It takes no real effort to go back through historical data and make yourself look like a genius. It is a sham game, though).

The problem with that theory, is that it is difficult to know whether a stock, having lost 10% of its value, is set to "tank" or merely "correct" over time. If you manage your portfolio by dumping every stock that goes down in value, then you will be doing nothing more than the dreaded "buy high, sell low" scenario. In a relatively short period of time, you churn your account in an ever downward direction, as you dump every stock that goes down. And here's a clue: All stocks go down in value over time. Most of them go back up, however.

Perhaps more disturbing is the author's attitude that "stocks aren't lifelong commitments". There is some truth in this, as eventually, you will have to sell out of all your investments to make use of your capital in retirement. But for the average investor, you should be taking the long-term view and using the "buy and hold" strategy of investing - investing in stocks that will slowly increase in value over time and generate income as well. Unfortunately, it seems like such stocks are getting scarcer and scarcer these days.

(A company selling the lastest techno-gadget may be a hot stock today, but in five or ten years may be irrelevant. The Palm Pilot was the "must have" handheld a decade back. Then the Blackberry had its day in the sun. Today it is the iPhone. What is next? Perhaps tech stocks such as this are not such a good investment for the "buy and hold" investor, as they pay no dividends and their values fluctuate widely based on the latest product developments. Both Google and Microsoft stocks have done well. But in 10 years or 20 years, both companies may be largely irrelevant. Apple is only as good as its next product).

So should you "dump" a stock that goes down in value? I think the key here is to have a strategy and to do the research, not just apply fixed rules and mantras. If the underlying company appears to be going insolvent, then perhaps it is time to get out. On the other hand, if the company appears to be sound (paying dividends, making profits, well financed) then a minor blip in price perhaps should be ignored. And sometimes you just have to take the risk and ride the wave. That's what investing is all about - risk-taking.

My experience with General Motors stock is perhaps a case in point. This was a stock I should have "gotten out of" early on, or better yet, never gotten into. Having worked there in the past, I knew all too well about the internal rot within the organization that would eventually be its downfall - and I should have walked away. But as a "buy and hold" investor, I felt that over time, the company would prosper, as it was the largest carmaker in the world, and it certainly couldn't fail, right? Perhaps that was mistake number one, not doing the research and understanding that the profits of the 1990's were based on sales of SUVs and trucks, and if those markets tanked, the company would quickly become insolvent. That the Japanese were taking larger and larger shares of this lucrative market should have been a warning sign. The "car based" economy itself may be a thing of the past, as people drive less and cars become a commodity item. I ignored these signs - investor error.

And as the author of the article cited above describes, I "rode it all the way down" like Slim Pickins in "Dr. Strangelove" and now am proud owner of something called "Motors Liquidation" stock, worth about 65 cents a share (up from 60 last week! a real buy! Perhaps not!). For average investors, knowing when a stock is going to "tank" versus "correct" is hard to fathom, particularly when everything is tanking, as it did in February of 2009.

But the good news is, my "exposure" was limited, as I only had a couple thousand invested in GM at the time. Thanks to discount brokerages such as E-Trade and Ameritrade, you can diversify even a small portfolio into many stocks and other investment vehicles with relatively low transaction costs ($9.99 a trade or less). My E-Trade Account was rolled over from an IRA at Fidelity (Equity Income II). While another account we still have in Fidelity (Equity Income) struggles to reach 75% of its former glory, my self-traded account in E-Trade is nearly dead even with where it was last year. So despite my "mistake" with GM stock, I am doing better than the market gurus at Fidelity.

Why is that? Well, to being with, for every GM in my portfolio (alas, there are more than one) there are at least two stocks that I didn't bail on that came back to increase in value. 3M (Symbol MMM), for example, "tanked" dropping nearly 20% in value last year. But today, it is worth a few percentage points more than what I paid for it. Long term, I don't think the company is going bankrupt (I could be wrong about that, of course!). But again, perhaps I need to do more research.

Dow Chemical is another one of those "tanking" stocks that has dropped nearly half its value. The question is, do you think it will lose the other half, or go up in the future? If you sold your Dow Chemical and took your loss, what would you invest the money in? Dow Chemical? It makes no sense to "dump" a stock only to buy the same stock back (or a similar stock that has declined in value and is poised to go back up).

You see, the question is whether you think the stock will go up, despite your initial mistake in pricing the original investment. A company's fortunes wax and wane, and stock prices can be overinflated. But that doesn't mean the underlying company is going away - necessarily. If you bought Dow at 50 and now it is at 25, maybe you should sell if you think it will drop to 12. But on the other hand, if you think it will stay at 25 and maybe slowly recover to 40 next year, perhaps it is worthwhile to keep it. After all, if you were not invested in it in the first place, you'd be buying it, right?

Ford is another case in point. I bought Ford at, well, let's not talk about it. Today it is not worth nearly as much as I paid for it. Should I "dump" the stock now? Well, actually, Ford appears to be poised for a slow comeback. Investing in new cars and advertising during the recession, they will likely increase market share when economic recovery occurs (GM and Chrysler, forced to cut back on development and advertising due to bankruptcy, will likely recover with smaller market shares). The stock has likely bottomed out (how much lower can it go?) and it will rise gently over time. Dumping it now would be silly. I should have dumped it early on. But not having that hindsight to rely on, the point is moot. From a perspective of today, is the stock going to increase or decrease in the future? Looking back on your losses is not really relevant for predicting the future.

On the other side of the coin, "Take Profits Last" is something I do not subscribe to, either - at least as blind rule or mantra. Many people dumped their Avis stock (Symbol: CAR) early this year (2009) as rumors of the company's bankruptcy were floated around. The stock plummeted to 74 cents a share in February. Many of those who bailed on Avis and took their losses first perhaps wished they hung onto the stock instead.

On a whim, I bought 1000 shares, for a whopping 750 dollars. In retrospect, I should have liquidated my entire portfolio and bought Avis. If I did, I would not be talking to you now. As Ron White says, I'd be living on an island with my new friends! Actually, if you bought nearly anything in February 2009 (other than GM stock or other now-bankrupts) you would have made money by now. But in February 2009, none of us had any money to invest, or were too scared to invest. Many were following the "take loses first" advice and unloading, further driving prices down. So that's the rub, right?

I forgot all about my Avis investment, as I felt that a $750 investment was trivial, and that maybe over the long haul, Avis would recover in price. Recover it did. When I logged onto my E-Trade account later that summer (another good point for the small investor: Don't try to time the market or over-trade or check your investments too often, it will just drive you nuts!) I was astounded to see that the stock had gone up 1200% in value. My tiny investment of $750 was now worth nearly $10,000. If only I had invested $7500 - or $75,000!

Now, to many folks, the initial reaction would be "Wow, what a winner stock! Better hang onto that!" and they would keep the stock, not realizing that such radical gains would not be sustained. I immediately sold 7/8 of the stock, locking in most of my gains. Why did I keep a small portion of it? Well, long term, the company will probably do well, and it will gradually increase in value, but there is always a chance it will tank again. Since I had made so much, I could afford to gamble on Avis with a small amount. Riding a fast rising stock is risky business. As they say, "what goes up, must come down" and this holds true for stocks. So I dumped most of it.

I did a similar thing with a bank stock I bought when a friend of mine decided to start a bank. I invested $10,000 (a lot of money to a small investor like myself), borrowing on my life insurance to do so. The stock went up to $40,000 in value after a couple of years. I immediately sold $10,000 of the stock. Panicked, my friend (now a VP at the new bank) called me and asked me why I sold. "Well, I invested $10,000 and now I have it back. If the rest of the stock goes down in value or even tanks, I got my money out". Take profits first. And over time, the stock has done well. Despite the recession, the remaining $30,000 invested is worth.... $30,000. There was little lost by "cashing out" my initial invesment.

Selling a stock that shoots up in value locks in your gains. Selling a stock that declines in value locks in your losses. And yet these investment Gurus often advise the latter. Why? Because if the great unwashed masses buy high and sell low, then those in-the-know can make some money by doing the opposite.

These same investment Gurus often advise buying stocks that shoot up in value, which is often a big mistake. During the "dot com" era, I had a friend who did this. He watched all the financial networks and online discussions and kept tabs of stock prices on a day-to-day basis. When some startup company made big news when its stock shot up, he'd buy it - leveraging his investment with options, which he paid for using cash advances on his credit card (double ouch!). As you might imagine, things went horribly wrong for him.

By the time a company stock is making big headlines, it is too late for you to invest. The people who are making real money are the ones who invested before the stock was publicized. The stock price will rise, to be sure, as all the Johny-come-latelies like yourself invest. The early investors will be happy to sell you their stocks, at a huge profit. Once over-valued, the price will come crashing down again, leaving you with another "buy high, sell low" in your portfolio.

Again, stocks are not like Las Vegas - or at least they should not be. If you are buying and selling stocks based on "tips" or thinking you can "beat the market" - good luck. Because beating the market is like trying to beat the dealer at Vegas. The house always wins.

Buy and hold stocks are usually a better deal for the small investor. For example, Stanley Tools has always been a good bet for me. They pay a regular dividend, and the stock price is fairly stable. They sell a line of products that does not seem destined to go away any time soon. I got into their stock paying $50 a month through the shareholder services program. I don't have a lot invested in it, but it sits there in my portfolio, chugging along.

For us "little guys" the best thing you can hope to do is diversify into a number of different investment vehicles - stocks, bonds, mutual funds, life insurance, savings accounts, and the like. Some should be risky, sure. But most should be fairly secure, if not in fact government insured - the moreso as you get older.

If you do decide to take a "hands on" approach to investing and buy stocks, don't put all your eggs in one basket. Rather than looking for the 'big kill', look for long-term stocks that will hold their value over time (or not decrease too much in value). Oftentimes the formulaic advice of investment gurus or their stock tips are fraught with peril. Stocks, like any investment, will go up and down in value over time. It is nearly impossible to predict the future value of any stock, other than to do extensive research. Locking in your losses makes no sense if the stock was picked as a "buy and hold" stock. Panic selling is never a good idea. Expect to take losses, and take them in stride.

And beware of advice of the Investment Gurus...