Even in the spotlight of the demise, or at least bankruptcy of Kodak, many people believe in their ability to divine which stocks to buy and hold forever. Regardless of the fact that once great institutions with eminent positions in our economy will disappear, we hold steadfastly to our belief in our ability to 'know' better. During the past two weeks, I had conversations with four different people defending their rationale for taking significant (in their financial lives) positions in individual holdings. Some of the statement were, to my ear shocking.
"I only buy companies that have been around for a long time."
"I buy companies that I think will be around forever."
"These companies are institutions; will be here long after I'm gone."
"I will never sell these stocks."
My brain, boggled by these statements attempted to add a little reason to the conversation. "Thirty years ago, the Dow was filled with firms like, Bethlehem Steel, US Steel, Union Carbide, Sears Roebuck, American Can, Woolworth and Kodak. Where are these most esteemed companies today?"
Our human brain is blessed with a great ability to reason and think, but it also has a component that is masterful at rationalization. We can come up with all the logic we need to support our decisions, regardless of the lack of facts to back up our conclusions. The results are more bad than good because there is an inherent flaw in our design-our desire to be right and our belief in our own abilities, regardless of the fact that we have zero control over the actual outcome puts us in a distinct disadvantage when making these types of decisions.
I am not saying the individuals should not be buying individual stocks. I am saying that if one decides to take that route, go in with a game plan (holding in perpetuity is not a plan), understand the risks and build in pain and pleasure threshold.
The Game plan: When buying individual stocks, decide what you want out of the stock over a certain period of time. Do you, based on your research, expect a 12% return over the next 12 months? If so, set that as your target and reassess over the course of the year. At the end of the year, think about your results and if it met your expectations. "Let it ride" is not a disciplined strategy.
Understanding the Risks: Obviously, when buying individual stocks, you are making the decision that you can glean better performance than diversifying your position. Can you absorb a loss? If so, how much and over what period of time. Can you outperform the market consistently by employing this strategy?
The Pain and Pleasure Threshold: If your pick dives in the first two weeks by 15%, will you stay put, sell out or buy more? If your stock rises by 20% in a month, what will you do? Build in a sell for your pain and pleasure level. Don't rely on your emotions to make the decision. Just because a stock tanked for a week or soared for a week is not the indication of what it might do over the next 12, 24, or 36 months.
Many who revel in their DRIP accounts and the ever expanding holdings in a limited number of opportunities don't or won't see that they are increasing their overall risk significantly and the impact of their selections getting hammered over their financial well-being. This might be due to an intellectual blind spot or an emotional response to owning a company or companies that they respect or enjoy their shopping experience. The "pretty" companies are rarely the ones that outperform and even the firms that enjoy the spotlight today can become the Kodak's of tomorrow.
Ask yourself, when getting ready to pull the trigger on that stock purchase whether you are being rational, disciplined and realistic. After you've asked that question, ask one more: Are you rationalizing your decision based on your belief in your ability to reason? The chances are-you are. When it comes to picking stocks, not even Warren Buffet picks all winners. Give yourself a better chance to build wealth, diversify your investments, be disciplined and follow a carefully constructed plan that is build around your life goals.
