Winning and losing stock market behaviors

During the first half of 2005 the S&P 500 lost 1% of its value. Fortunately for followers of my monthly investment newsletter, The Cohan Letter, the average stock mentioned there – taking into account my 2% stop-loss rule -- has risen 12%.

Since I began following the stock market, I have found that it’s a jungle out there with no simple rules for making money. I have won some and lost some. Based on this experience here are five winning stock market behaviors and five losing ones.

FIVE WINNING BEHAVIORS

1. Buy studiously into momentum. Sometimes there is a good reason that stocks in an industry are going up. If you can convince yourself that the trends driving up the stocks are sustainable – invest in a market leader.
2. Read all financial filings. Financial filings contain a lot of data that can really help you understand the company. While they are often tough sledding, reading them can make a big difference because so few investors actually take the time.
3. Talk to customers, employees, distributors, and analysts. Even fewer investors take the time to talk with a company’s customers, employees, distributors, and analysts. As a management consultant, this research is a natural part of my job. It should be the same if you want to buy a stock.
4. Get out before the news hits the cover of Time. I remember that Amazon.com’s Jeff Bezos was named Time’s Person of the Year in December 1999. That date would have been a pretty good time to have sold the stock which now stands 69% below its December 1999 peak of $108.
5. Use stop losses rigorously. Since none of these rules are fool proof, winning investors must prepare for the possibility that they will be wrong. I like a 2% stop loss – while this might keep you from making money if a stock rebounds, it is better than continuing to hold onto a loser with no real logic for why it should be sold.

FIVE LOSING BEHAVIORS

1. Buy into hot tips. About fifteen years ago I worked with a fellow who seemed to be constantly trading multiple stocks. This seeming market guru convinced me that he knew what he was doing. When he told me to “back up the truck” on a Mexican waste management firm, I decided to invest in the company. I never read the financial statements and lost most of my money.
2. Ignore the cockroach theory. Once you have made an investment, a piece of your ego goes into making money in that stock. If there is a piece of bad news about the company, such as an accounting problem, that could be a cockroach – and if you see one there have to be at least 10 more waiting to emerge. But if your ego is attached to the stock going up, ignoring the cockroach theory will likely lose you money.
3. Fail to take risks seriously. Stocks that have been going up tend to continue going up – until they don’t. One of my recent favorites was Taser International which seemed on a rocket ride from 50 cents at its IPO to the December 2004 peak of $33 – only to tumble to a recent $13. Readers of the financial statements would have known that there were all sorts of lawsuits against the company and that the company was grossly overvalued – it peaked at a P/E over 100.
4. Wait too long to sell. Not having a stop-loss can be disastrous. But it is also important to have a way to take profits. One of the luckiest things I ever did was to set an automatic sell on a stock which I had purchased at $6 a share. It had since risen to $80 and I was convinced it would keep going up. But I was persuaded to set an automatic sell order – which I set at $100 -- before I left for a trip to Korea. Amazingly enough the stock hit that price while I was asleep in Seoul. A year later it was trading in the teens. Most investors during the dot-com boom did not have this kind of luck and they lost bundles as a result. The same thing could happen to today’s real estate investors.
5. Sell short on a hint of bad news. Selling short – borrowing stock from a broker, selling it at current market prices, with the hope of paying back the stock loan with lower priced shares – is extremely risky. In theory, an investor’s liability is unlimited. For example, if an investor sells short at $20, the stock could keep rising and unless the broker forced the investor to cover – which in practice they would – the investor might be forced to cover the position after the stock had risen, say 20-fold. Selling short can be a great way to make money – as several investors did on Enron back in 2001. Those investors had done a lot of homework on Enron but they were going against the tide of public opinion before the truth came out and they made their fortunes. But it is far more common to get wiped out trying to short stocks.