Sneak Preview: Streaks Cloud Judgment

Or, as Cramer says in his new book, past performance is not an indicator of future success.
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Editor's note: This is a special excerpt from Jim Cramer's book,

Jim Cramer's Mad Money: Watch TV, Get Rich

. To order your copy and read all the rules, click here.

7. Past performance is not an indicator of future success.

If you make a lot of money in a sector or an industry, it's only natural for you to feel like stocks in that industry will keep making you money. Your instinct is to keep pushing it, to keep trying to find new ways to play the same trend that's already made you big profits. I know because I have this instinct too.

Investing based on your past success in a sector is wrong; worse than that, it's expensive. When you make money in a stock, don't ever let that make you overconfident. Don't let it influence one bit your judgment about similar stocks in the same industry. Every trade, every investment is different.

I don't like to use a gambling analogy, but it will help bring the point home. When you're playing cards and you hit two blackjacks in a row, does that increase or decrease your chances of winning the next hand? You know it does nothing. The cards have no memory, especially when shuffled. The same is true with stocks.

We all want to believe in streaks, we want to be streak hitters, and so we look for stocks that fit into our streaks. But even though it feels right, that kind of investing is a surefire way to lose money. When you invest, and you get a stock right, I know it feels to you as though that should have something to do with other stocks. ... It's just how we're programmed, but the programming is wrong. You have to beat your instincts here and not let your past successes poison your ability to judge stocks.

This rule is the

Bookham

(BKHM)

rule. I had to write it after I recommended Bookham, a telecommunications equipment supplier, on February 1, 2006, on the first stop on the Mad Money Back to School Tour, at Harvard Law School.

Bookham was the No. 2 telco equipment supplier by market share, and when I recommended the stock, it was trading at $6.98. I said the stock had upside anywhere from 30 percent to a 100 percent. In April, two and a half months later, the stock peaked a few cents over ten dollars. It would have made a great trade, but I told people to stay in the stock because I had so much confidence in it.

By July, Bookham was trading at $2 and change. I rode it all the way up, and then way back down.

The thing that really killed Bookham was

Nortel

(NT)

, its biggest customer. When I recommended Bookham, I hated Nortel. It was a terrible company with an even worse stock, and I should have known that it would poison everything it touched. ... Nortel should have been the red flag that told me to give Bookham a sell, but instead I took the Nortel business in stride and kept telling people to buy.

Why did I make this mistake, and how can you avoid making it yourself? I got Bookham wrong because deep down in my reptilian brain, I believe in streaks and I want to have them.

When I got behind Bookham, I'd been having a lot of success speculating on telecommunications equipment suppliers, especially the guys in the fiber-optics end of the business, where Bookham was. Pretty much everybody in the optical components business was raking it in, except of course for

Lucent

(LU)

and Nortel, which were both terrible. I'd recommended both

JDS Uniphase

(JDSU)

and

Conexant

(CNXT) - Get Report

back in September 2005.

***

Because JDSU and CNXT had done so well, I was ready and willing to believe Bookham would do well too. There was a streak -- cheap telco suppliers were making people big bucks, and I had been calling the best ones. I was en fuego, and the next jewel in my crown would be Bookham.

Just as you should

never sell a stock based on panic, a rule from my last book, you should also never buy a stock based on pure triumphalism. ... I know this rule seems obvious, but unless you're careful, the obvious things are the ones that will wreck you. ... Investing is emotional and irrational, and you will make bad decisions because of that fact unless you're very careful to keep your emotions in check. If you feel like you've got a streak, like you're totally en fuego, that's a sign you need to take a step back, forget about your recent wins, and focus on a stock's fundamentals.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider Bookham to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

Editor's note: This is one of Jim Cramer's 10 Rules from New Mistakes, New Rules: Ten Lessons From My Bad Calls, a special excerpt from his newest book,

Jim Cramer's Mad Money: Watch TV, Get Rich

, in stores now. Check back tomorrow for a new excerpt.

From Jim Cramer's Mad Money by Jim Cramer. Copyright

2006 by Jim Cramer. Reprinted by permission of Simon & Schuster, Inc.

At the time of publication of this excerpt, Cramer had no positions in any of the stocks mentioned.

Jim Cramer is a director and co-founder of TheStreet.com. He contributes daily market commentary for TheStreet.com's sites and serves as an adviser to the company's CEO. Outside contributing columnists for TheStreet.com and RealMoney.com, including Cramer, may, from time to time, write about stocks in which they have a position. In such cases, appropriate disclosure is made. To see his personal portfolio and find out what trades Cramer will make before he makes them, sign up for

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