Let's assume you found a stock that meets all of your criteria and fits our
checklist . Before you pull the trigger, we need to discuss your relationship with this stock. That's right, whenever you buy an equity, you enter into a complex relationship -- with the stock, the company, its management, even your fellow shareholders. Before your purchase, you are still in a flirtatious stage -- you have no history with the stock and therefore no baggage. That's the time -- before you get in too deep -- to lay out some ground rules governing this relationship. What you need is a pre-nuptial agreement with the stock. There are several reasons to create a document governing your affiliation with a stock. The first is objectivity: Once you own something, you lose the ability to take a cold-hearted look. You've become invested in the company, literally and figuratively. After you've (hopefully) invested serious time and energy before deciding to make a purchase, you become emotionally invested in the trade. Emotions are the flip side of objectivity, and they rush in to fill the void when objectivity is lacking. A stock isn't Old Yeller , but you would be surprised at how hard it is to make a clean break. (A prior column detailed the danger of emotions.) By having a clearly defined set of parameters regarding how long you are going to hold the stock, and under what circumstances you will "file for divorce," you avoid making emotional decisions to either sell too soon or not at all. The second reason is discipline, one of the keys to successful investing. All traders know that without discipline, even the best investment plan is worthless. In the classic investing book Market Wizards by Jack Schwager, the theme of discipline comes up repeatedly in interviews with traders of all sorts: commodities, stocks, currency, futures and fixed income.
Unfortunately, far too few investors actually have any. Indeed, whenever we hear of some hedge fund that blew up, you often hear a manager lament, "If only we had stuck to our discipline." The pre-nup is a way to ensure that you avoid that fate. Third, and finally, you want a record (paper or computer) of what you were thinking before entering this investment. We're all too capable of rationalizing our actions after the fact. I've heard investors come up with every excuse in the world to hold a dying position rather than admit they were wrong and move on. The pre-nup helps to eliminate that counterproductive behavior.
Performance (bad): There are three objectives in jettisoning a poorly performing stock. First, a recognition that you may have been wrong. For whatever reason, the trade simply didn't work. Perhaps it was the timing, or merely a case of bad luck. By having a strategy to cut your losses, you can redeploy capital more productively. Second, avoiding the debacles -- the Enrons, Nortels ( NT) or Lucents ( LU) of the world that whither away to become single digits, or zeros. Avoiding these disasters with only minor losses goes a long way toward keeping your portfolio healthy. Third, a disaster stock can easily dominate an investor's psyche. If you become totally wrapped up in a bad trade, it interferes with your ability to do anything else productive. Think back to how many people didn't even bother opening their statements during the 2001-2003 period. That's how debilitating major losses can be -- and why avoiding them is so crucial. In the near future, we'll look into a few stop-loss strategies that will help you in preparing the pre-nup. The key is to have a written explanation of what will trigger a sell in advance.
The TermsA good pre-nup should answer the simple question: What are grounds for divorce?
For Better or WorseA marriage pre-nup is designed to protect your assets before the honeymoon begins. Experience suggests that once the dishes are being thrown, having an objective, unemotional discussion about who gets what is all but impossible. The same thought process governs the stock pre-nup. It's designed to maximize your retention of assets in the likely event of an ugly equity break up. And it doesn't even need a lawyer!
|1.||Expect to Be Wrong||2.||Your Fault, Reader|
|3.||The Wrong Crowd||4.||Bull or Bear? Neither|
|5.||Know Thyself||6.||Prepare for Battle|
|7.||Bite Your Tongue||8.||Don't Speak, Part 2|
|9.||The Zen of Trading||10.||The Folly of Forecasting|
|11.||Lose the News||12.||Tracking Elephants, Pt 1|
|13.||Tracking Elephants, Pt 2||14.||Nothing Doing|
|15.||Surviving Silly Season||16.||The Zen of Trading|
|17.||Curb Your Enthusiasm||18.||Six Stocks|
|19.||Bended Knee||20.||Time Waits for No One|
|Check back for more of Barry Ritholtz's |
Apprenticed Investor series