Posts filed under “Psychology”

Apprenticed Investor: The Stock Pre-Nup

Tscm_1The latest "Apprenticed Investor" column is up, and its called "The Stock Pre-Nup."

Let’s assume you found a stock that meets all of your purchase criteria. Its a company that you really like, one that you plan on purchasing. Before you pull the trigger, however, there are some issues we need to discuss: Specifically, your relationship with this stock — and why you need an agreement before you buy it:

Why A Pre-Nup?

Whenever I discuss this concept with investors, they invariably ask “Why A Pre-Nup?” There are several reasons why you should create a document to govern your affiliation with this stock. Let’s briefly review them:

The first is objectivity: Once you own something, you lose that ability to take a cold-hearted look at something. You’ve become invested in the company in more than one way.  Lots of time and energy has gone into selecting the stock. You have developed a reservoir of knowledge about the products, its market, and the firm’s management.

You become emotionally invested in the stock. That means that you may have a hard time putting the old girl down when the time comes. A stock isn’t Old Yeller, but you would be surprised at how hard it is to make a clean break.

Emotions are the second reason for the prenup. They are actually the flip side of objectivity, and are what rush in to fill the void when objectivity is lacking. (We discussed the danger of emotions previously)

The ideal time to work out an exit strategy is while you are unemotional, objective, and not too involved. 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 next reason is discipline. Its 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 which “blew up,” you often hear a manager lament  – “if only we had stuck to our discipline.” The Pre-nup is a way to insure you avoid that fate.

Finally, you want a record (paper or computer) of what you were thinking prior to entering this investment. We are 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 from that trade. The pre-nup helps to eliminate that counter-productive behavior.

Prior Apprenticed Investor columns can be found here.

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