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Book Excerpt: Why Cooler Heads Prevail


Investors who use computer screens to pick stocks don't attract a lot of hype. There's not a lot of drama in combing over gigabytes of data looking for companies with strong sales growth and expanding profit margins.

But this is exactly how Louis Navellier, 49, has carved out a niche as a quantitative, or "quant," investor. Stock picks from Louis Navellier's Emerging Growth, his oldest newsletter, have a 19.2% annualized return since 1985, when Hulbert Financial Digest began tracking it. Today, Navellier & Associates, based in Reno, Nev., runs three other newsletters and manages $5 billion for individuals and institutions.

Navellier lays out his stockpicking strategies in the newly published The Little Book That Makes You Rich: A Proven Market-Beating Formula for Growth Investing. In the chapter excerpted and edited below, he discusses how investors make bad investment decisions by letting their emotions get in the way.

In their hit song, Emotional Rescue, the Rolling Stones promise to come to the emotional rescue of a poor, unloved girl. Much as the Stones can save the broken heart of the lovelorn, numbers can rescue investors from emotionally driven, costly mistakes. I have come to appreciate some things about numbers: They don't panic; they don't get greedy; they don't have an argument with a spouse or associates and, as a result, make bad decisions.

One of the most common emotional mistakes is the "gambler's fallacy." That is a tendency to think that when a tossed coin lands on heads five times in a row it is much more likely to land on tails the next time. This supposition is incorrect. The odds of flipping tails on the sixth try are exactly what they were the first five: 50-50. Each flip occurs independently of the others. Still, we grab onto such ideas to help us rationalize a bad decision.

So what does that tell us about investing? Just because the market has been up or down the past several days doesn't mean it has to do anything one way or the other with tomorrow. Day to day, market moves are random. Still, I hear investors say, "It can't go down anymore." It can, and it will take your money with it.

Another bad behavior is selling winners too soon and losers too late. If you take 5% to 10% profits on your best stocks and huge losses on your worst, holding onto the belief that they will bounce back, your results will be bleak.

SET YOUR WINNERS FREE

Assume for argument's sake that your stock picks go up about 70% of the time (that would make you a superstar). Now suppose you have a $100,000 portfolio. If you take 5% profits on your winners, it's a $3,500 gain over a year. If you lose an average of 20% on the others, it's a $6,000 loss. In the end, you are great stockpicker but still losing money.

Now, let's reverse this. Say you pick 30% winning stocks and made 50% on them each year. That is a $15,000 profit. If you limit your loss to 5% on losing picks, you would lose $3,500. The result is a net profit of $11,500! These examples are extreme but show that by selling bad picks and keeping good ones, you will greatly improve your returns.

Then there's the danger of falling in love with a stock, especially one that has been good to you. When should you sell? When the company's fundamentals begin to break down, such as a failure to meet earnings expectations or a decline in profit margins, or if the stock becomes just too volatile.

Consider the case of online auction site eBay (EBAY). We began buying the stock in February, 2003, as the company was beating Wall Street analysts' estimates. We had a wonderful ride, but eventually the stock became too volatile and risky to hold. In April, 2005, I advised my newsletter readers to sell, and some strongly disagreed. They told me that they did not want to sell, that it was their favorite stock, that they didn't want to pay taxes on their capital gains. These objections mark the usual symptoms of falling in love with an investment. You can show love to stocks, but stocks can't love you back. When they become too risky, you have to sell them and move on, even if they made you rich.

Those who refused to sell came to regret it. By August, 2006, eBay was back around my original purchase price. Investing should not be a round-trip proposition. You don't want to ride a stock to a huge gain only to hold it while it falls back in price.

Investors also tend to fall victim to what superinvestor Warren Buffett calls the rearview mirror effect. That means we tend to be the most influenced by what has happened recently instead of what is happening right now. As the market goes higher, individual and institutional investors become more bullish; when the market has sold off for an extended period, they become more reluctant to buy.

We see this behavior in trading history. Through 1987, the single highest-volume month in the history of the New York Stock Exchange (NYX) was August, 1987, the month the prices peaked. We saw it again in 2000, with volume peaking about six months after prices. At the bottom, volume was less than half what it was at the market high.

Relying on hindsight can have devastating results. In 2002, as investors were licking their wounds from the dot-com bust, the bear market, a recession, and the aftershock of September 11, we focused on the numbers. Our research told us to buy, and we bought. In 2003, as investors moved aggressively into stocks, we had already selected ours.

We can't help our emotional and mental biases. Some are hardwired into us from birth. Some, such as the herd instinct, are just part of our social environment. It is easier to take the pain of market losses when everyone else is feeling it, too. This herd instinct protects us from admitting the mistake was ours alone.

We also like to have our opinions confirmed by others, especially so-called experts. If you want to see this bias in action, talk to someone who is bearish on stocks. They will cite all the doom-and-gloom columnists who share their opinion and drag out charts, graphs, and slides that support their view. Any evidence to the contrary will be ignored!

We also have a tendency to congratulate ourselves for our brilliance when we succeed but blame outside influences for our failures. When a stock we picked goes up, it is because we are clever and made the right choice. When a stock we picked goes down, it's the economy, the Federal Reserve, the broker, or those hedge funds that made things go wrong. A potentially fatal side effect of this all-too-human trait is what happens when we get good results from bad decisions: We do the same thing again, usually to a bad outcome.

I have a friend who trades options who once remarked that the worst thing that can happen to a novice, unknowledgeable options trader is to make money on his first trade. This leads him to believe he actually knows what he is doing, and large losses are sure to follow.

All of these characteristics and biases are part of being human. When put into play in the stock market, they can lead to serious loss and damage to your net worth. I have not figured out how to stop being human, and I do not think you will be able to, either. I know that I can be a sucker for a great story, or get lulled into a false sense of security, or believe my own hype, or even follow the herd, which is why I steer clear of it all when it comes to making money in stocks and instead stick with the numbers.Reproduced with permission of John Wiley & Sons Inc. from The Little Book That Makes You Rich: A Proven Market-Beating Formula for Growth Investing by Louis Navellier. Copyright ? 2007 by Phillips Investment Resources LLC.


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