The Ignorant Investor

Reading a popular market blog today, I saw this quote from somebody identified as "Clay Allen of Market Dynamics":

The investor must make a commitment to eliminating poorly performing stocks just as soon as they can be identified. The best way to identify poorly performing stocks is with a long-term chart that shows relative strength. The investor must have a very clear idea about what constitutes unacceptable performance. There must be a predetermined decision point that cannot be reached without action being taken to sell the stock.”

Now this sounds like a very good idea. Keep an eye on your portfolio, sell the stocks that have turned into disasters. Okay. Always sell the disasters. Problem is, when you switch out of one disaster stock, you face the risks that its replacement is 1) another disaster stock, in waiting, or 2) will be outpaced by the stock you've just sold as time passes.

Hewlett Packard, for example, was a terrible stock to hold from January of 01 to about June or August of 03. Trust me: I held it myself during those dark days. Between January of 2002 and January of 2003, it went from over twenty and down into the low teens, back up to 15, back down to 12 or so, and then is shot up to finish up the year by breaking $20. Now had you bought at $20, as it reached around $12 bucks or so off I assume Mr Allen would have suggested dropping this stock like a hot potato. The thing is, what would you have bought instead that would have done any better?

Had you sold HP when it was at 12 and then mentally wiped the slate clean, then bought it again the very next day, HP would have been transformed from dog into a galloping thoroughbred on your books. The stock almost doubled within a few months, and it's now circling around 28. Outstanding performance, no? The only difference between disaster and hero in HP's case was the day someone bought the stock.

The point is, in reality every day you wipe the slate clean when you're thinking about trading the stocks in your portfolio. At any given moment, if you trade out of a stock you hold, chances are you're only going to trade into another. So you're constantly measuring performance of the stocks you own not against their past performance, but rather against the performance of all the other stocks you might buy. The time to sell is when you believe that the stock will not outperform its peers over the long term, and not a day before. If you think the new stock will go up faster than the one you hold, then sell the old one and buy the new one.

Now the hard part: take a look at GE or Merck or American Standard or Google or anyone of the thousands of other stocks on the market, and you tell me which ones are going to outperform HP tomorrow and the next day. Does anyone know? No, we don't. Some of the analysts and traders on Wall Street think they know, but they're only making educated guesses.

I'm all in favor of educated guesses, simply because we don't have any choice in the matter. Pretty much all life is a matter of guessing about what the future holds. But I would never confuse guesses with facts, as some on Wall Street are apt to do. Then again, I'm not in the business of selling investment advice or selling stocks.