Psychology -Remembering the Golden Rules and a Salutary Tale

The risk of not having an exit plan is that you become a hostage to some destructive cognitive and emotional pressures. These unseen and sometimes instinctive influences can be a drag on your portfolio and may even make your best investments turn sour. Ben Hobson (Stockopedia)

Some years ago, I spent some time with one of the leading companies in a notoriously cyclical industry. This particular company had managed to consistently deliver market-beating returns, performing particularly well during a major downturn. I asked them what their secret was to beating the competition?

Their answer? We understand risk like none other in this industry*.

The secret to big gains in any business is a mixture of luck (often right place right time) and the ability to take a bigger risk to deliver a bigger return. This company spent an inordinate amount of time analysing all of the risks of a project. Once they had done this, their greater understanding enabled them to enter projects that the competition would disminss as being “too risky” or “too expensive to enter” and they would make big returns. Their bigger returns would then be rolled into new projects where, adopting the same approach, their financial fire power would add an extra weapon to their armoury.

Investing in shares is a risky business. If you did not realise this, then investing is probably not for you. However remaining passive and doing little or nothing is also risky, due to the ravages of inflation. So we all need to take on a measure of risk in order to deliver a reasonable return on our money.

It is reputed that around 70% of investors in shares lose money over time. To the cautious, this would be hoisted as a big red flag as to why you should never invest in individual shares. I am more interested in why the 30% do make money in shares. What are they doing that the 70% aren’t, or failing to do?

In my view, there are three key aspects to making sure that you are in the 30% of investors who make money:

1.            Buy decent quality growing companies never forgetting that Price is what you pay, Value is what you get (Warren Buffett).

2.            Kill your losers decisively if the share price falls below a certain threshold below which you bought the shares.

3.            Have a clear plan for your winners. That will usually involve running your winners as far as you can, but could also involve top-slicing (selling part along the journey), a trailing stop loss (so that you protect a decent portion of your gain if the price reverses) and a wholesale exit of the share if the mood music changes.

I call these my three Golden Rules. The truth is that I have only developed these recently following some both good and some bitter experience.

Each one of these three Golden Rules deserves greater examination and I will look to do this over the course of my blog.

For now, though I want to tell you a salutary tale. A tale where I abandoned my principles and lost money. I don’t get it wrong very often, but in this case I got it spectacularly wrong. I forgot the Rules.

I had some Indivior Shares after Reckitt Benckiser (a long term hold) sold off its Indivior business in late 2014. Indivior make opioid drugs and hold some valuable patents. I was given some shares as part of the RB sale and held them for a while before selling out for a profit when I got bored (a bad motive).

I carried on keeping an eye on them and noticed that not only had their share price risen very nicely since I’d sold, but they had good rating metrics on Stockopedia.

I decided to buy at £4.06 in January 2018 when I was buying groups of shares that met a certain criterion for my SIPP and holding them for a period without putting stop losses in place (I’ve very much now abandoned that “quant” strategy).

The share started well and rose to highs of £4.90 by June 2018. Although I generally look for more than a 20% gain and wouldn’t have sold, putting a stop loss at 10-15% behind this new high would have meant I would always have emerged with a profit (albeit a small one).

However, this was its zenith. From then on INDV had bad luck with a court cases. In late June 2018 they dropped through the price I paid and fell to £3.64. I remained convinced they would rebound back to where I had bought them. After all they were “undervalued” when I bought them?

The truth is that whilst I could not have known all the bad news that was going to befall them, they were clearly not worth over £4. The Market marked them down savagely and I should have sold at this first warning in June 2018. As wise old stock market investors say, “bad news (or profit warnings) come in threes” and there were two further big markdowns in November 2018 and then in April 2019.

I finally sold out in August 2019 for 54p, nursing my heaviest ever loss and an 86% crash in value. Fortunately, my original position had not been that big…They now trade at just below 35p (as of 24 January 2020).

Although I had obeyed Rule #1 by buying what seemed to be a good quality company, I had disobeyed Rule#2 which was to kill your losers quickly and decisively. Rule #3 was also ignored as a trailing stop loss would have made sure that I would have emerged with some profit. I had a plan (buying a basket of shares and not having stop losses) but it was a bad strategy.

I would not allow another INDV to destroy wealth in my portfolio. I learned that news comes in clumps and poor performing shares suffer downwards momentum. How could they be worth less than a tenth of what I paid for them? The truth is that is what the Market is saying today.

It is also poor logic to wait for a share to recover back to the price you paid for it. That price is only significant to one person (you) and is the classic psychological mistake of “anchoring”. This is worthy of a whole post in itself. A share that you bought for £1 falls to 80p (a 20% drop). Did you realise that it has to gain by 25% in order to get back to where you bought it? Much better to get rid and select a better share next time.

Learning from your mistakes makes you a better person in life and certainly a better investor. Never forget that.

*This blog is published subject to this disclaimer which you must read and which you are deemed to accept if you carry on reading.