Saturday, October 01, 2005

First, do no harm

Through September, stocks mentioned in The Cohan Letter have gone up an average of 20.6% compared to a 1.4% rise in the S&P 500. Part of this gain is due to The Cohan Letter's 2% stop loss rule – which says that an investor should sell a stock that declines 2% from its purchase price. Several stocks mentioned there have been “dropped” due to this rule.

A stop loss is analogous to part of the Hippocratic Oath “first do no harm.” A stop-loss is similar to the Oath in concept because it is based on the idea that investing money depends critically on removing emotion from decision making. If the best that can be done is to stop the bleeding, then that is what should be done – and as quickly as possible.

Many people invest their emotions in a stock along with their money. That is, when they decide to buy a stock, it might be because an acquaintance they respect has recommended the stock. If the stock goes down, they feel it could strain the relationship with the acquaintance and lower their self-respect if they take a loss in the stock.

Conversely, if the stock rises after the tip, the investor will enjoy with the acquaintance who mentioned the stock their shared gain in net worth. Such social reinforcement can be had through many forums – a country club, an investment club, a day trading office, or stock message boards. Some derive emotional rewards from sharing the ups and downs of owning a particular stock. And when they sell the stock, they are afraid of losing that connection.

About 15 years ago I made this mistake – buying shares in a Mexican waste management company at the urging of a professor who I thought was a market guru. I neglected to read the company’s financial report until after I had invested. After I read the report, I kept trying to reconcile this professor’s recommendation with the phenomenally lousy financial performance of the company. This stock lost most of its value as did my respect for this professor’s investment acumen.

I think of the lost money as a tuition payment for a valuable lesson: check your emotions at the door before you invest.

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