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Harry Koza

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Killing you softly

Harry Koza

TORONTO (GlobeinvestorGOLD) With the romantic month of February upon us, and the RRSP contribution deadline looming, investors are looking to put money to work. Between the chocolate, cupids and cards, and doing something romantic with your significant other, it's easy to become suffused with warm and fuzzy feelings. This applies to your investments, too: it's all too easy to become emotionally attached to a stock, especially (for some insane reason) when your position is under water.

One of the most hoary and time-tested of all trading maxims is "never get married to a position." You are supposed to remain objective about any trade, keeping neutral about your investment, and reacting only to price action and the flow of new information. Well, that's simple enough in theory, but in real life, even for the most disciplined trader, it is all too easy to, if not marry, at least fall in love with a position.

We've all done it. We buy a stock expecting it to rise in price. Maybe an analyst at a large dealer has written a glowing report on the company's prospects, projecting geometric growth in earnings from the company's magnets and Bulgarian bicycle businesses. Or, the company has just invented a better mousetrap, struck oil, found gold, invented a french-fry vending machine that actually works, or in the modern-day equivalent discovered the killer app that will at last enable someone to make serious money from the Internet.

But then, stuff happens. An audit revels that those double-digit sales-growth figures were fabricated. The bicycle plant is a money laundry for the Bulgarian Mafiya. The "visible massive sulphide mineralization" in the drill cores turns out to be iron pyrites. The French fries taste like cardboard and the machines have an annoying tendency towards spontaneous combustion. No one really wants to pay extra to order groceries or pet food over the Internet. And the stock price declines, often precipitously.

NT-N over five yearsYou really should cut your losses and sell, but, gee, the analysts wrote so beguilingly about the company's prospects, and you hate to take a loss, and so, like a deer caught in the headlights, you watch transfixed as your investment heads south. I have a friend who bought Nortel at $80, on the reasoning that it must be cheap there, since it had been $120 only a few months earlier. Then, when it had sunk to $65, he bought more, figuring that if he liked it at $80, he had to really love it at $65. At $45 he bought still more, on the same theory. When the stock fell to $35, he called me and asked me what I thought of Nortel.

Well, I said, a few years back, when it was still at $8 a share and on the way up, it was a hell of a buy. Now, I don't see what is going to stop it from getting back to that level. There was a pregnant silence on the phone. Hello, hello, are you still there? Then he sheepishly told me what he had done.

Why are you still in it, I asked? Are you going to keep averaging down forever? Are you married to this investment? Well, yes, I guess I am, he replied. Ouch! He was badly burned, and later told me he had pushed his planned retirement date back several years as a result of his losses. It's an expensive lesson: falling in love with a stock is usually the most unrequited variety of that emotion.

What level of pain?

It's an important lesson, too, and one that I've likely harped on in this space before. Never, ever, ever invest in anything unless you have determined what level of pain you are willing to take. Remember that you buy a stock in the expectation that it will go up, so you can sell it at a higher price. If it goes down instead, why are you still holding it? Do you think the dip is only temporary, or are you married to the position? The widely accepted axiom that long-term buy-and-hold is the best winning strategy is perhaps true, at least on a geological timescale. On a human timescale, however, even the Wealthy Barber takes the occasional haircut. While most investors have some sort of target price in mind for taking profits when they buy a stock, not many people buy a stock with a stop-loss price in mind.

Maybe that's because a new investment is like a new flame: the excitement, the anticipation, the rush, the buyer's remorse. It can be the same emotional rollercoaster as infatuation. Fools rush in, as the old song said.

A better strategy would be to think of buying stocks as dating, instead of marriage. You date a person a few times, decide there's no chemistry, and go your separate ways. Why should stocks be any different? You buy a stock; it goes down instead of up sell it. Your first loss is the best loss. I like to use a 15-per-cent yardstick. If I buy a $10 stock, I'll sit patiently with it at $9, barring any disastrous news, but when it hits $8.50 (down 15 per cent); I immediately ask myself, why do I still own this dog? And if I can't come up with a compelling reason, I sell it immediately. Sure, it costs me a little money, but better to lose 15 per cent than 30 or 50 or even 100 per cent.

Get out of it immediately

Every professional trader I've ever known Jane the Impaler, Skunk Head, and the legendary Prince of Darkness himself has always told me the same thing: always have a reason for putting on a trade, whether long or short. And if circumstances change, if new information emerges about the company, if you feel a sudden perturbation in the Force, or if you see the CEO doing the Eliot Spitzer perp-walk on the national news, then get out of it immediately. Don't hold on to it.

All too often, investors can get trapped in a loveless marriage with their underwater positions. They come to hate the stock they used to love, but feel powerless to do anything about it, except hope that someday it goes up enough so they can get out even. Of course, if that day ever comes, they usually fall in love with the stock again, and strap on even more of it to make up for the lost time. Like dysfunctional marriages, this often ends in tears.

And, just like in real life, you can stay unhappily married to an investment for a long time. You can grin and bear it, or you can get out. Booking a loss on your position can be expensive, certainly. But as the often-wedded Prince of Darkness always said, "Sure divorce is expensive, but it's worth it!"

Harry Koza is Senior Analyst in Canadian markets for Thomson Financial/IFR. At various times in his career, Mr. Koza has been a prospector, metallurgist, project manager, engineer, as well as an institutional bond salesman for 15 years. His current area of expertise is in high-yield distressed securities and corporate bonds in general.

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