Classic portfolio mistakes

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Does your rationale for buying a stock still hold true?

By Nicholas Grove and Morningstar analysts

If you conducted your initial analysis of stock selection carefully, you should have a clear understanding of why you liked each company in the first place, some of the key opportunities and threats, its potential for producing dividends and capital gains, its management and financials, and so on.

But although much of the early work may be over, you cannot simply "set and forget" even the best stocks. Every so often it is worth reviewing each stock to make sure the reasons you bought it are intact.

The rationale for holding any stock may, of course, change over time as the underlying company itself changes. That is normal, but it's important your understanding of the company keeps pace with reality.

The decision to hold on to a stock is not so different to the decision to buy it at the current price. After all, tax and other complications aside, you would only hold a stock if you thought it would earn an acceptable return over time.

Therefore it is almost as important to have a basic rationale for keeping a stock as it is for buying it.

That does not mean you can never take a break, just that you should have a rough idea of what's happening in your portfolio. Then, perhaps every six to 12 months depending on the company, the pace of change in the industry and so on, take a closer look.

Using this two-pronged monitor/investigate approach will help to build an intimate understanding of the company in your mind and you will already be across the major issues when you conduct a closer review.

Regular analysis will help to decide whether you are happy with your current holding, whether to buy more at current levels, or whether to get out and take your gains (or losses).

How much monitoring is needed?

How closely you need to monitor your portfolio depends on the types of companies in it. For the big companies - the bedrock of any sensible share portfolio - the basic story will not change all that often, although when it does the implications can occasionally be dramatic.

Second-line stocks tend to operate in slightly more turbulent waters and need somewhat closer watching, and the story behind speculative stocks can change from one day to the next. For blue-sky biotechnology companies, for example, one major new contract or product line can change the company's investment complexion overnight.

Mistakes to avoid

In monitoring a portfolio, there are four key mistakes investors often make and there are ways to avoid them.

The only reason to monitor each stock in your portfolio is, of course, to arrive at a simple decision: to buy, accumulate, reduce, sell or hold.

There has been a lot of talk about buying stocks and holding quality stocks over the long term, but what of selling? When should you sell - when your stock has gained 15 per cent, or fallen 15 per cent?

Investors probably make more mistakes in selling stocks than in any area of investing, and selling one to buy another can potentially cost you in two ways.

First, the opportunity cost. If you get it wrong, you may not only make a poor return on the stock you just bought, but you may also miss out on gains from the stock you just sold.

Second, the "cost" cost. It is expensive to buy and sell shares all the time and the higher the portfolio turnover the more it will cost you.

The decision to sell a stock is fraught with difficulty and complicated by emotion, and that is why investors so often make common mistakes. Here are the four key ones:

1. Selling a stock because it has done well

One of the biggest mistakes people make in managing portfolios is to sell stocks that have done well and keep those that have done poorly.

Unfortunately, the profit from a stock in the past may have little or no relationship to the profit you will make in the future. There is something to be said for cashing in some of your gain if a stock has moved to a level at which you believe it is overvalued. But don't make decisions about long-term holdings on past performance alone.

Get back to basics and ask yourself: How healthy are those earnings? What are the growth forecasts? How likely is the company to achieve those forecasts?

2. Selling a stock because it has done badly

If selling a stock because it does well is faulty logic, there is equally little sense in selling just because a stock has performed poorly (although time makes the difference here).

If you have held a poor performer for a long period, you need to be absolutely confident that your analysis is not off-beam or that you have not missed an important change. If, however, you have held a stock for just six or 12 months and the market has turned sharply against it, it is time to revisit your original analysis.

Stock prices, remember, venture far away from reality in both directions and if you paid a fair price for the company and the earnings are coming through, or are likely to, there is every chance its performance will pick up.

The risk is that the company may be overtaken by subsequent events before the share price has time to recover, so obviously you need to watch closely any stock that is going backwards.

Selling stocks that have fallen in value often means you buy high and sell low, and that's no way to make a profit. However, just as it is unwise to sell stocks solely because they have fallen in value, it is even more common for investors to get it wrong in the other direction altogether.

3. Not selling a stock because it has done badly

If a stock in your portfolio has done badly, there can only be one of two reasons:

1. The market is wrong.

2. You were wrong about the company when you bought it.

Anyone who believes they are always right will never win in markets. But plenty of investors believe that holding on to stocks that have fallen in value is a smart move because "everything goes up eventually".

That is simply not so. Plenty of stocks skid along the bottom for years. The sharemarket overall tends to rise over time but plenty of shares do not.

Again, revisit the reasons you bought the company in the first place. Have the earnings come through and continue to do so? Did you miss something in your analysis? Even if you conclude that the market is definitely wrong, how long will it take to get it right? Can you identify any key trigger events for that to happen, and can you afford to wait?

4. Not selling a stock because it has done well

If many investors are tempted to sell stocks because they have made gains, others take it too far in the opposite direction, refusing to sell shares that are well past their used-by date, because "they've always done well in the past".

If you believe that, then answer this question: Why does every advertisement for an investment product carry a disclaimer along the lines of, "Past returns are no guarantee of future returns?"

If you are beginning to think that some of the biggest mistakes have a common thread, you're right. Many investors come unstuck by making decisions to buy or sell based purely on historical share price movements.

Although these are obviously worth monitoring, it is the fundamental outlook for a company that usually determines its share price performance and record of paying dividends over a long time - the duration of concern for the majority of long-term investors.

About the author

Nicholas Grove is a Morningstar journalist.

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