The Iconoclast Investor

Today I’m going to dispel some more investment myths. Please leave any comments, questions or suggestions below.

4. Don’t draw a major conclusion from just one or two events.

Ask yourself:  If you sat down at a Blackjack table and were dealt a 19, what would you do?  Stay, of course; the only cards that could help you would be an Ace (worth 1), or a 2, while everything else would bust you (result in something over 21).

But after you stay, let’s assume the dealer flips his cards … and he has 20!  You lose the bet.  Now … does that mean, next time in the same situation, you should hit on 19, instead of stay?  No!  And the reason is easy to understand-the odds favor you winning more often if you stay, than if you hit.  So you’re not going to change your approach based on just one instance of losing.

Yet that’s exactly what many investors do.  They might sell a stock when they have a 15% loss (correctly cutting the loss short, and preventing potentially serious damage), but then that stock turns around and rallies.  They conclude selling was the wrong thing to do.  Big mistake!

What possibly went wrong was that the investor bought too high in the first place … or, maybe, he just has to tip his hat to the market.  The point is, you want to have a sound process and set of rules to guide you through the investment battlefield.  Don’t overemphasize any one trade, good or bad; think of it as just the first of hundreds of trades you’re going to do in the months and years ahead.

5. Diversification provides downside protection, but concentration allows for outperformance.

Listen to any “prudent” financial advice, and your best bet is to diversify-own 70% stocks, 25% bonds, 5% cash, or something of the sort.  And, for most people, I believe this is good advice; over the longer-term, spreading out your bets in this way will lessen the chance you take any serious hits on the way to retirement.  (I’ve even structured my wife’s 401(k) plan in such a way, with a couple of growth funds, a solid value fund and a little in bonds.)

But if you’re investing to make money in growth stocks, it’s all about concentration.  In the Cabot Market Letter’s Model Portfolio, we own a maximum of 12 stocks when fully invested.  Personally, I tend to gravitate toward seven or eight.  The key is to cut ALL losses very short, and average up on your best one or two winners.  That way, you can make big money when the market is heading up.  Diversification isn’t wrong, per se, but neither is concentration reckless.  Most of history’s most successful investors concentrated in a few top stocks, as opposed to diversifying into 30 or 40 issues.

6. Worry first and foremost about making a profit.  Taxes should be a very distant secondary consideration.

I literally just answered a phone call this week from a long-time, and very good, subscriber.  He owned a stock that’s being bought out, and his question was whether he should sell it.  My answer was simple:  Yes!  Take the money and run.  He had ample profits … but he was hesitant to sell because it meant he would have to pay the taxes.

I understand where this thinking comes from, of course; I hate paying Uncle Sam every April as much as anyone.  But your goal is to develop winners and make money-paying taxes is the (unfortunate) reality of making money.

The key is to consider taxes before you buy a stock.  For instance, if you have to pay 30% of any gains to Uncle Sam, you might consider investing somewhat more initially (in terms of dollars) since, if you win, you have to pay Uncle Sam his share.  And if you lose, you’ll be able to deduct it from your profits (if you have any).  Even if you don’t have profits in a given year, you might figure that, in the long run, you’re going to make money, so any losses this year will eventually offset something in the years ahead.

Now, I’m not a tax attorney, so don’t go taking my words of advice to heart.  It’s just something to consider.  The main point is that your goal is to make money by following a sound system of rules and tools-don’t allow tax considerations to cause you to make the wrong investment action.

These are just some of the many common misconceptions investors have about the market.  I don’t mean that in a  “aren’t they silly for thinking like that!” sort of way.  Just the opposite, in fact, the market, as we like to say (and write), does its best to fool the majority, and take your money away.  It’s difficult to live a normal life, thinking one way, and then think totally differently when it comes to investments.

So hopefully, the information above will help you think differently about the market than you currently do, and help you avoid many of the mistakes that investors–both novice and experienced–continue to make today.