Gain a Bundle From Others' Losses

Readers share strategies that have cost them dearly.
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A couple of weeks ago, I wrote a column about "Blond," a young investor with a plan to make a quick buck in the market. His notion was to invest $1,000, earn 10% in a week, tuck the 10% away, reinvest the thousand bucks, make another 10% the second week and so on. At the end of the year, he'd have more than $6,000. No problem.

The plan seemed so obviously flawed that I was surprised when we got a number of emails from investors who admitted to using similar strategies. I'd like to take a look at a few of them because I think we can learn something about the urge to win and how it can trip us up as investors.

The first letter came from an investor we'll call "Tom," who began the year by investing $110,000 in

CMGI

(CMGI)

, a publicly traded venture-capital firm. Tom doesn't say whether he knew how risky such an investment could be. The start-up failure rate is high. And CMGI doesn't have a product. It's like a shell company that owns stakes in start-ups. It didn't do well, and Tom pulled his money out after it shrunk to $83,000.

In mid-March, Tom bought

Ariba

(ARBA)

at $130 and soon sold it for $92, bringing his cash down to $58,000, which he put into

America Online

(AOL)

at $59. He sold AOL a few weeks later at $53. "Ugh!" was the way Tom put it. I agree. He then tried

JDS Uniphase

(JDSU)

, where he lost more money before pulling it out to "play it safe" by buying

Time Warner

(TWX)

at $88. He sold it at $82.

When Tom wrote to us in November, he had $44,000 left and was looking at

(WOGSX) - Get Report

White Oak Growth,

(DGTNX)

Dresdner Tech,

(FSPTX) - Get Report

Fidelity Select Technology and

(NTCHX)

Northern Technology. "I wish I knew about funds last January," Tom wrote. "It's been really an uphill battle to recapture my losses. But at least I never bought on margin so that helps a little." Had he known about funds, Tom says, he would have bought them in January and sold them in early March, buying them back again in mid-November, which looked to him like a good entry point.

Don't Be Driven by Losses

Apparently, Tom thinks the diversification of funds might have saved him some losses. But his logic is flawed. Like many investors, he believes he could have solved his problems if only he would have bought at the market lows and sold at the highs. It would be nice to have a crystal ball that would allow us to pinpoint those highs and lows as they occur. But none of us has one. What Tom really needs is a more realistic and workable strategy.

The way I see it, Tom didn't really learn anything. Driven by his obsession to avoid a loss, he's become shortsighted in his investment strategy. Studies show that people hate to lose money and that they will take on much more risk to avoid a loss than to achieve a gain. In his urge to make himself whole again, Tom leapt from stock to stock, locking in losses in each one. Now he tells us what he would have done had he known the market would drop in April, and again in the fall.

But I don't think Tom is the exception among beginning investors. I think he's more like the rule. What drove Tom were his losses. When he lost money on his first investment, he felt frantic to recapture it and so he just kept picking new investments, turning his money over faster and faster. It's not even clear that he knew anything about the companies he bought. I wonder, for instance, if he knew that AOL and Time Warner planned to merge.

There's been a good deal of this fear of loss in the

Start Investing community. One investor took me to task for my column last week on selling strategies. This investor put

stop-loss orders on all his stocks so that he'd get out of them if they dropped 10% or 15% below his purchase price -- an approach I said I would never use. My critic claimed he was feeling good because he'd cut his losses while I was still holding stocks that were down 40% or more. But I haven't locked in my loss like this investor and like Tom. As investors, we must learn not to be driven by this fear of loss.

Margin Calling

Notice how Tom patted himself on the back because he didn't buy on margin? That's not the case for two other investors we heard from. In the column on Blond, I said that an investor who loses 50% needs a 100% gain to get back to even.

A letter writer we'll call "Sue" begs to differ. "Nah," Sue wrote. "I've lost more than 50% now because I own semiconductors, fiber-optics companies AND storage-solution companies." But Sue was not worried. "If I put all the money I have left into margin now, a 50% gain puts me right back where I was, minus margin fees."

At bottom, Sue's problem is the same as Tom's, isn't it? She believes that she must cover her losses, and she casts about for a way to do it. Margin, of course, is borrowing money to buy stock. It's similar to the way you use leverage to buy your home. Suppose you have $50,000, borrow $50,000 and put the $100,000 into a stock. If the stock doubles, you turn $50,000 into $200,000. That's what Sue needs to do to get back to even. And that is a mighty risky gambit; if the stock drops by 50%, you've lost all your own money and still have to pay back the lender, with interest.

Just how risky margin can be is clear from our third email, from an investor we'll call "Bill." I was very grateful for the time Bill took to write in the hope that someone would learn from his experience.

At the beginning of 1998, Bill began to invest online. He quickly learned about margin and began to use it. "I was making a lot," he wrote, "sometimes $20,000 in a day. But as I got too greedy and overly confident, I started buying to the limit using margin."

Like lots of investors, Bill did pretty well in 1998 and 1999. But in March of this year when the market fell apart, his investments took a dive and his online broker sold almost all of his stocks to cover his margin debt. In a week, he lost nearly $120,000.

But, like Tom and Sue, he was so determined to get his money back that he kept buying on margin. "I didn't believe that the stock market would keep going down," Bill said. "I was convinced it could only rise -- and soon." So he worked two jobs and borrowed money and pumped as much as he could into the margin account. "The market fell again and fell hard," he wrote. "This time I lost everything, and I still owe money."

So the point is, Bill wrote, "maybe you should tell people to stay away from margin, especially beginners." But Bill added something more valuable. "If someone loses their money, they should never try to get the money back because in the desperation, almost certainly the losses will increase."

Patience Is a Virtue

And that's what all three of these letters are about really, the pain of loss and the desire to erase it. Lots of investors have felt that pain this fall. Times like this will determine how successful you will be as an investor. Will you be driven by fear of a loss to dig yourself into a hole like Tom, Sue and Bill? Or will you learn to develop a strategy, to be patient and to stick with it?

Anyone can learn to become a successful investor. It comes from experience. We have one wonderful investor in our community who calls himself "SeenItAllB4." Whenever another community member gets panicky, SeenItAllB4 points out that this, too, shall pass. But don't let it pass without learning something from it.

At the time of publication, Mary Rowland owned or controlled shares of the following equities mentioned in this column: America Online and JDS Uniphase.

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