The Good Investor Rule: Focus on How Not to Lose Money

by Steven Sears

The Good Investor Rule: Focus On How Not To Lose Money Splash image

Every year, usually in early spring, much of Wall Street pauses for a moment of silent reflection. Heads are not bowed in remembrance of the fallen, or some historical event. Instead, the silence is in reaction to the somber findings of an annual study that shows many individual investors are trapped in boom and bust cycles of their own making.

DALBAR, a financial services market research firm, recently released the results of their annual Quantitative Analysis of Investor Behavior study. It shows that individual investors have, for much of the past 20 years, significantly trailed market benchmarks, including the S&P 500 index. In 2011, when the S&P 500 had a total return of about 2%, the average equity mutual fund investor lost 5.73%. In 2010, when the S&P 500 rose 9.14%, the average equity investor experienced an annual return of 3.83%. Sometimes, investors have trailed the benchmark by as much as 10%.

The study shows individual investors regularly buy high, sell low, and learn little from their experiences. Severe underperformance is troubling enough since so many people rely on the stock market to finance retirements, cover college tuitions, and and pay for most big-ticket items. But there is another pernicious finding.

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Steven Sears is a senior editor and columnist with Barron’s and He is author of “The Indomitable Investor: Why a Few Succeed in the Stock Market When Everyone Else Fails”( John Wiley & Sons, 2012). .


Janusz Trondowski from Florida posted about 1 year ago:

It is eye opener to some basic questions about investing psychology.

James Carroll from Nebraska posted about 1 year ago:

Kahneman notes that the more well-informed a scientist is, the harder it is to reason with him or her, which produces divergence in areas such as climate change. The ease of system I thinking gets all sorts of people in trouble.

Stephen Shubert from California posted about 1 year ago:

I am exploring and hoping that the AAII model portfolios can be used for initial decision making. I am also looking at the stock screening tools.

I wonder if others have found this approach to be successful, at least useful.

Rick Hartwell from Kansas posted about 1 year ago:

A much appreciated article. It confirms an activity in which I reluctantly read several diverging investment perspectives before making a decision involving any investment change. Although difficult to read something one doesn't "believe", it is often a helpful practice.

Marshall Smith from Alabama posted about 1 year ago:

Face it, most individuals will never have enough knowledge or information to be successful investing in individual stocks. Most should stick to index funds and maybe a few managed funds.

Vern Andrews from California posted about 1 year ago:

Excellant article. I believe, however, that a review of the market, the economy, quarterly and annual reports will provide a good reason to invest or not. A scheme that combines the fundamental, technical, and best use of invetment dollars will define the best quality stocks for investment. When these conditions cease to be favorable the stock is a condidate for sale. See website for more details.

Thomas Clasen from Virginia posted about 1 year ago:

In some cases people sell too soon because they want or need to spend their money. Successful investing requires discipline to a perhaps exceptional degree.

George Westerman from Michigan posted about 1 year ago:

It clarifies the need for Stock Screening vs Shooting from the Hip.

John Portwood from Louisiana posted about 1 year ago:

In investing process is everything. Superior performance in the long run requires a disciplined operating system supported by logical inputs.As a professional money manager I have succesfully employed quantitative screening techniques in the management of institutional and personal portfolios for more than thirty years.The methods used would be recognizable to anyone who has studied the screening programs provided by AAII.The individual investor can win the investment game. All it takes is discipline and the consistent application of a logical decision making process.Unfortunately,discipline can disappear when emotions intervene.We investors are our own worst enemy.

Tom Fields from Virginia posted about 1 year ago:

Good article. Easy to forget is the same rigor used to research a buy decision needs to be applied to a cold, hard, view of what your portfolio holds, and why.
The runts of your portfolio litter - the losers, laggards, and misbegotten are deserving of comptempt, not compassion - that's the hard part sometimes. Our natural inclination to want to help the needy, root for the underdog, etc., only trips us up in a world with a different reality.

Shane Milburn from Tennessee posted about 1 year ago:

Paul Tudor Jones is mentioned in the article, and one of my favorite chapters in the Market Wizards book. I have actually tried to change my investing/trading to incorporate some of his thoughts. But I would point out Jones semms much more of a Trader than Investor, and advocates taking very quick losses and letting winners run.(Many trading pros advocate this approach - although Jones is unique in that he tries to catch bottoms - most traders seem to advocate waiting on a trend).

The problem I have trying to incorporate the idea of selling losers quickly is the opposite side of the coin - how to take profits. If you're going to incorporate trading principle like (sell losers quickly) then to have money to buy in the dips you have to sell during market rises (which goes counter to letting profits run).

The idea of reversion to mean investing very much appeals to me (Buffet's idea of being greedy when others are fearful and fearful when others are greedy), but it is difficult to implement.

I can't say that trying to implement more trading ideas into my investing has been beneficial for me - but I am going to keep trying to figure it out because of the dynamics of the lost decade in the market push me in that direction.

Steven Sears from Iowa posted about 1 year ago:

This is an article to read and re-read again. I have long felt that a short course in crowd psychology would be more valuable in the stock market than a degree in math or accounting. I am guilty on all counts in this article. If I buy a stock at $10.00 and it goes to $10.10 it is a winner and I will hold on even to zero because in my mind 'it is a winner'. Well we Steven Sears's have to help each other. Thanks!

James Mcguire from Georgia posted about 1 year ago:

Great article. Any investor, seasoned or not, has emotional risk as a component. I never buy a stock, but have the security put back to me at a price I want, not a market price. If the position expires worthless, I employ the same strategy the next option period. When a security is assigned, I then pick a rate of return and sell a call opiton to match a resasonable rate of return. This is discipline, and while it does not work every time, it works at least two-thirds of the time or more. But then the seller of options have the same mathematical chance of having a favorable outcome in inverse relationship to the buyer of the same position.

Michael Apcar from California posted about 1 year ago:

Excellent article! If one merely takes from this article "Bad investors think of making money" but "Good investors think of ways to not lose money", the battle of investing is almost half won.
I have desperately tried to minimize losses, but not quite arrived ; for emotions get in the way.

David Harned from Virginia posted about 1 year ago:

While not losing money is a key point in the investment philosophy of Buffet, Graham & other successful investors, they make many other key points which merit further study and application. Controlling greed & minimizing risk are critical..."pigs get fat, hogs get slaughtered". Personally, I have found it helpful to hold a minimum of 25 or so stocks & limit any individual position to no more than 5% of total portfolio value.

Lance Wilcox from Illinois posted about 1 year ago:

One aspect of investing touched on here that could be developed further is how we handle our ignorance. If there's something that can be known but we don't know it, we simply need to do our homework. But in investing, there is always a lot we don't know because it's intrinsically unknowable. Anyone who thinks he can develop a system for winning roulette will be ruined in a casino; there is no gaming the random. We can know long-term market movements (wildly variable but ultimately up), but we cannot know anything about short-term ones. Enthusiasm and fear are both the result of assuming knowledge we do not and cannot have; it's not the emotions themselves but the tacit assumption of knowledge that makes them dangerous. This also suggests that there are in fact diminishing returns from research on any particular stock. Too much of what the research will tell you will become untrue in short order.

Vaidy Bala from posted about 1 year ago:

While this article covers many diverse areas of investment, exactly what one should do, is missing. I think based on my 10 years of individual investing (Self-taught), it is good to rely on fundamentals plus technical analysis. After all, no body can outperform what the Market tells or shows visibly. On another front, intuition is blamed for investment errors, We have to explain what we mean by intuition, self imagination or profound deep insights. Spiritually, insights are clear signals of truth!

Victor Bradford from Colorado posted about 1 year ago:

The suggestions and principles given in this article are not only excellent ones for investors, they are excellent ones for members of other formal and informal groups as well. For example, physicians and dentists are frequently guilty of hindsight bias, which often presents major problems when omparing old and new techniques. By contrast, Richard Feynman famously observed that science demands a belief in the ignorance of the experts -- including yourself. An exalted degree of humility is a distinct virtue: Eisenhower observed a humble but incompetent person can make great contributions, but he said there is no evil a highly arrogant and incompetent person will not do.
Thanks again for this insightful article.

Donald Logie from Connecticut posted about 1 year ago:

I'm not a trader. I am an investor. I sometimes hold things for years, which is not always beneficial. The article reminds me that I need to improve my own processes. I plan to use it with friends, one of whom seems to be trying to evangelize everyone else on the benefits of option trading without discussing risks. Since I've never done this, I don't know exactly what they are beyond losing some money. I have been, though, quite loud about being careful with these things.

Werner Emmerich from Pennsylvania posted about 1 year ago:

You can find good individual equities, but over 80% depend on the particular market as a whole. Study what you have learned from this article and apply it to the market!

George Repetti from California posted about 1 year ago:

On August 5 of last year after reading Stears article in the July issue, I made an entry in my financial journal "bad investors think of ways to make money and good investors think of ways to not lose money". I have tried very hard to follow this advice and as the market has been rewarding during this time, have enjoyed good returns with a relatively conservative, diversified portfolio. As a 74 year old retiree with a portfolio in the multi hundred thousand dollar area it remains to be seen if I will have the fortitude to remain fully invested, assuming investment selection criteria has not changed, when we experience the inevitable 10-15% correction.The concern has always been that time to recoup losses is not on the side of an older investor with modest funds, who counts on a minimum return to provide for a comfortable life style, and tends to reduce holdings during a strong correction (better safe than sorry). This action results in a loss of profit earned during the up period plus gains realized during the recovery period. I don't think I'm the only AAII subscriber in this situation and would like to hear how others deal with it.

Curtis Sears from North Carolina posted about 1 year ago:

I think that I qualify as a long term investor since I still own funds that I bought when I set up my 403b(7) plan in the early 1980s. Every month I contributed the same amount to each. I now am cashing in some of them having now retired. Only one fund am I out of completely, btw I had 8 no load funds. Were they top of the list year after year? NO! However, they were generally average or above most of the time.

I've also, invested in some individual stocks. Sure, some were bad decisions but overall I've done a little better than what I see published as the average returns. Again, I don't trade often. Therein lies one of what I consider my two biggest mistakes. I hold on too long thinking a stock will come back. I need to recognize a dead horse sooner!

The second mistake is that I sell out of the money calls. The effect is the opposite of that above. Yes, I make money but I'd have done better simply holding the stock since I end up selling too soon.

Lesson learned? 1. Buy a good fund and hold it. 2. I'd have done better sticking to lesson number 1 than trying to pick individual stocks. I'm not Warren B. and never will be!

Thomas Pretlow from Ohio posted about 1 year ago:

I have been an investor for four decades. I found this article full of generalizations about why investors make errors; however, I found little that give me any specific clues as to how to avoid many of the errors that are discussed by the author. Everyone knows to "buy low and sell high"; so what! My biggest problems have not changed much over the years and relate to (a) where to set my stop losses and (b) when to sell. I learned nothing specific about either of these problems from this article.

NewJoizey from New Jersey posted about 1 year ago:

Thomas Pretlow - I know your frustration. We, whose focus in life may be on our primary occupation, want to have a flowchart to follow, a hard and fast checklist of things to do and actionable items that will yield us wealth if we follow the path. What we want at some level is a "how to" manual. That would be nice, however I think true wealth accumulation as an investor demands more of us. There are no easy answers. AAII is the closest thing to an unbiased no-frills how-to manual for investing that I've seen. I don't think there are hard answers to your (a) and (b). I think the answer is, to the chagrin of us both I might add, "it depends". What I think is required of us is to observe, try to learn lessons, and try to apply them practically in our own particular environments. That's the challenge, and I don't think it's an easy one. I think it involves a lifetime of constant learning, re-evaluation, critical thinking and revisiting.

my $0.02

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