Work on your Weaknesses Until They’re Strengths
Top 5 Reasons Most Investors Don’t Make Big Money
This Solar Stock is Getting Ready to Run
In a weird way, one of the reasons I like the stock market so much is just how contrary it is-most things that make great sense in life (persevering in tough times, going along with the crowd) actually work against you when you’re investing.
A good example is specializing to improve your results. In real life, the way to make money is to become a specialist-if you’re good at, say, selling products, you want to build up your sales tactics as best you can. The more skilled you are in that single field, the more successful you’ll be.
But in the market, instead of building on your strengths, the best way to improve results is to strengthen your weaknesses. If you’re very good at identifying low-risk buy points, for instance, that’s great … but there’s no reason to continue honing that skill. Instead, focus on identifying your biggest weakness-say, your ability to time the market-and build up that part of your game.
With that in mind, below are what I believe are the five biggest mistakes growth investors make … and some ideas on how to correct them. Note that these aren’t just rookie mistakes, but issues that I’ve seen pop up repeatedly, even among experienced and professional investors.
1. Thinking Too Little about Risk
Don’t get me wrong, you shouldn’t stay up all night worrying about the stocks you own, or worrying yourself out of good trades. But most investors don’t calculate how much money they’re risking on each trade-i.e., how much money they’d lose if their loss limits gets hit (you are using a loss limit, right?). Eventually, not considering risk is costly, when investors take huge positions in a stock that tanks.
I read something a long time ago that sticks with me today: Defining your risk in a stock is very liberating. If you know that your maximum risk (barring overnight gaps) is, say, less than 1% of your overall portfolio, then you can relax. Say your stop gets hit. So what? It’s just one trade. Conversely, if the stock gets going and turns into a big winner, you can make big money.
The solution here is simple: Ahead of every trade, consider how many shares (or how many dollars of the stock) you’ll buy and where you’ll place your loss limit. Then you’ll know your risk of loss.
2. No Plan when Buying a Stock, or They Can’t Stick to It
By “plan,” I’m not talking about some black-box hedge fund trading system; I’m talking about a general set of rules and guidelines that tell you whether a stock is worth holding or not. I get the impression that the vast majority of investors don’t have any plan at all, instead reacting to how they feel that day or week about the stock and the market. And, trust me, if you’re going to invest based on how you feel (or invest based on the news of the day), you’re not likely to do well over time.
Instead, jot down a (very) rough plan for each stock you buy. It could be as simple as a loss limit and a trailing stop, but I tend to use more chart-based information (50-day moving averages, prior support levels) as well. As long as it’s logical, any plan is better than no plan.
That leads me to the part that’s even more challenging than making a plan: Following it. For example, it’s one thing to tell yourself you’re going to hold on from 100 down to 85 … but when the stock plunges from 100 to 90 in three days, it becomes harder to hold on and follow the plan. Of course, your plan shouldn’t be extremely rigid; I like to think of it as a roadmap-if there’s a ton of traffic on the route you’re traveling, it’s smart to take a detour. But you also don’t want to change your entire plan based on a couple of red lights.
And if you decide to change the plan, do it outside of market hours, so you’re not making an emotional decision. In terms of following the plan, the key is to reward yourself not for making money, but for sticking with your plan. The idea is that reinforcing the right behavior (following the plan) will lead to long-term profits, whether or not one particular trade works out.
3. Confusing the Company with the Stock
I just wrote about this in last week’s Cabot Growth Investor. Too many investors confuse the company-which could be very well managed and growing rapidly-with the stock-which will go up and down based on investor perception of the company. Perception is the key word there: A firm can do great for many years, but the stock can go nowhere if investors are constantly ratcheting down their perception of the firm’s future. In last week’s issue, I showed McDonald’s from 1972 to 1980-earnings went up six-fold during that time, but the stock lost 36%. And we’re talking about McDonald’s, not some fly-by-night company!
Now, you shouldn’t ignore the company completely-you still want to home in on the companies with the fastest growth and most revolutionary new products and services. And you don’t want to concentrate exclusively on the chart, either: reacting to every wiggle or shakeout will leave you chasing your tail.
The point is that the company and the stock are two separate things. You’re not buying a major piece of the company and benefiting from its cash flows-you’re buying a piece of paper representing investors’ perception of the company’s future.
The solution here, obviously, is to respect what the stock is telling you. If it breaks major support (especially if the stock completely falls apart after, say, an earnings report), you should sell at least some of your shares to respect the fact that the stock itself has changed character, regardless of what you think of the company.
4. Overtrade, Especially in Less-than-Ideal Conditions
I’m a trend follower who tends to buy growth stocks that are trending higher, so when I think of less-than-ideal conditions, I think of what’s happening in the market today!
OK, it’s not all that bad out there-there are many stocks doing pretty well-but it’s hard to remember a time when the major indexes were boxed in as they’ve been over the past six months: The S&P 500 has been within a 7% range since Thanksgiving and a 4% range since the start of February!
In this kind of choppy environment, the key is to be very selective-trade the best and leave the rest. But most investors don’t wait for their pitch, and instead swing wildly at anything near the plate. I’ve actually seen this as a major issue for many experienced investors-they know how to cut their losses short, but they end up suffering a thousand cuts by constantly taking small losses.
The best strategy for growth investors is to aim for a few big winners every year because that’s where most of your profits are going to come from. (As I’ve written before, investing is a game of outliers.) Thus, you always want to be selective, focusing on the best set-ups and growth stories, which increase your chance of landing a big winner.
The solution is to use a checklist before you buy-liquidity, sales growth, is the stock above its 50-day moving average, etc. And then make sure the stock has all the characteristics you’re looking for before diving in. The idea is to prevent yourself from saying, “what was I doing buying that stock?!?” when you look back at your records at year-end.
5. Not Thinking Big Enough to Make Big Money
I’ve found this to be the issue that trips many advanced investors. They know how to measure their risk. They take only low-risk set-ups. And they have a plan they stick to. But they don’t give themselves the chance for huge profits-somewhere along the way, these investors find reasons that essentially cut their profits short.
These reasons aren’t dumb. The reality is that, if a stock is going to rise 100%, 200%, 300% or more, the run is going to include a few harrowing corrections in both the stock and the market as a whole. In other words, the market is going to give an investor plenty of good reasons to get out before the major uptrend is over.
The solution here is, first, to actually think big-to aim to make big money. You’d be surprised at how many investors are happy to simply book their 20% profit and move on. Simply put, if you’re not aiming to make 100% in a stock, you almost surely won’t.
Second, though, you have to develop a method (usually using charts) that will keep you in a big winner. Long-term moving averages are helpful (many big winning stocks will never break their 40-week moving averages during their multi-year advances), and so is booking some partial profits on the way up-with some gains in your back pocket, you can afford to give the remaining shares more rope.
Of course, I could go on about other investor bugaboos (actually, maybe I will in a future Wealth Advisory), but these are the five most common. If one of them applies to you, fix it! Your portfolio will thank you for it.
As for the market, I’ve recently been fairly neutral simply because the trend of the market has been sideways for months, and growth stocks have been hit or miss-even the best stocks have tended to run for just three or four weeks before stagnating and building a new launching pad. Thus, I’ve been advising investors to hold some cash and be choosy when doing new buying … but also stick with the stocks that are working.
Now, however, I’m getting a bit more encouraged. First, the market is again probing new-high ground; that’s not enough to say the trend is strongly up, but the more times we test virgin turf, the greater the likelihood that stocks eventually get going.
Second, sentiment may have finally cooled off. Less than 30% of individual investors (as measured by AAII) have been bullish during the past six weeks, which is relatively rare.
And third, I’m finally starting to see some new leadership emerge. One stock that I’m watching closely (along with a few others in the Cabot office) is SolarCity (SCTY), one of the leading installers of solar panels on rooftops. The business model has always intrigued me, and now we’re seeing business really pick up.
Here’s what I wrote about the company in the Monday issue of Cabot Top Ten Trader:
“SolarCity is the leading independent player (and one of the leading players, period) in the distributed power movement, which is built around installing tons of solar panels on the roofs of homes and commercial and industrial buildings. The reason the industry is booming is because of the benefits to both customers and SolarCity-customers get these panels for next to no upfront cost, and then pay a monthly fee to SolarCity that is less than their current bill! SolarCity, on the other hand, gets a mushrooming collection of long-term contracts (usually 20 years with a 10-year option after that) that will result in a torrent of recurring revenues in the years ahead. While the numbers are very choppy due to some accounting methodologies, the key is that the company installed 153 megawatts of solar panels in the first quarter (up 108% from the prior year), ending the period with $6.1 billion in nominal payments under contract-that was up from $5.0 billion the prior quarter! For the full-year, the company expects to install nearly 1,000 megawatts worth of power, so the backlog should continue to soar. As SolarCity drives its costs down, and as solar reaches grid parity in more and more states, the possibilities are limitless.”
What has attracted me to the stock isn’t just the great fundamental story, but also the multi-month bottoming period-the stock has tested and held the 45 level six separate times since the spring of 2014, and then enjoyed a persistent uptrend for a few weeks before its recent dip. It’s a volatile name, but I think buying a little on dips, with a stop in the mid-50s, could work out very well as the company continues its breakneck expansion.
And for further updates on SCTY and additional momentum stocks, take a trial subscription to Cabot Top Ten Trader. The advisory features a wide array of stocks and sectors you can benefit from in as little as 30 days.
Chief Analyst of Cabot Growth Investor and Cabot Top Ten Trader