Taking a Psychological Stock Position
In a recent post about value investing and art collections, I discussed the pain of finding a winning stock and selling it too soon, then watching it climb for years afterward. There’s a related pain that doesn’t hurt as much but is economically worse, i.e., identifying a great bargain, never buying any, and seeing it go up seemingly forever. It doesn’t hurt as much as selling too soon because you didn’t hold it in your hand and let it slip away, but is economically worse because you didn’t make even a little money from your original insight.
In summer 1998, my partner and I were sitting around our office discussing the growth of the Internet and it occurred to me that if computing were to move mostly online where there was a universal language, Java, then Microsoft’s operating system would no longer be as dominant. “It could be good for Apple,” I said, and my partner agreed. We were at that time the rare investment professionals who used Macs, so we were particularly interested in Apple’s outlook. I checked Apple shares, then trading at the split-adjusted equivalent of $0.20, and did nothing. Later that year, when I became more certain that we were right about Apple’s improved prospects, I checked again and saw that the price had gone up to $0.30, a 50% gain in a few months. This time I didn’t buy any because “I missed it”. I MISSED IT!!1
It’s easy to say, as James Cramer often does, that you buy your portfolio every day and what happened in the past doesn’t matter – but it’s hard to be that disciplined. I repeated my Apple mistake with other stocks, both in my personal account and in the funds I co-manage. And it’s not just me. A few months ago, I attended a dinner with successful tech people in Silicon Valley and when the question was asked how many of the 20 or so attendees owned Nvidia, only one raised his hand, while many of the rest winced as if slapped. I’m guessing that the absence of Nvidia holders in this group that included semiconductor experts was not a vote against the company, but was because they had MISSED IT. Since that night, Nvidia has appreciated another 70%, adding to the pain.
To avoid more missed opportunities in my PA and my funds, I had to find a way to overcome my mental barrier against buying a stock that I had considered and passed on at a lower price. What we have done in the funds for some years now is: when we have a strong interest in a new name but are not sure that we want to build a big stake, we buy a toehold – even as small as a 0.10% weighting in the portfolio. I call it “taking a psychological position.”
If we do this and later become convinced about the stock, and it has declined since our first purchase, we can buy more at a better price – a win. But more important for the mental side of investing, if the stock has gone up since our first purchase, we can tell ourselves that we’re just “adding to the position”. (If I had bought even $500 worth of Apple at $0.20, I wouldn’t have had any trouble buying more – adding to my winner – at $0.30.) If, on the other hand, confidence is not achieved after the initial assessment, we can sell our toehold without a big impact on the portfolio.
This technique can also work for selling: if you are turning negative on one of your holdings but haven’t decided whether to exit fully, you can sell a little. If you then become sure, you will have already “broken the seal” and can more easily sell the rest. One of the hardest and often the most necessary things to do in investing is to sell a formerly profitable position after it’s already down 20% or more; this mental trick makes it a little easier.
I recently saw a CNBC interview with famed trader Stanley Druckenmiller in which he said that he follows a rule learned from his old boss, George Soros: invest then investigate. When an idea is presented that seems attractive, Druckenmiller quickly buys some – if it’s a sectoral idea, he buys a basket of stocks – and does his research later. He said that when he first purchased Nvidia, he couldn’t even spell it.2 Unlike me, Druckenmiller doesn’t dip his toe in but goes in with big dollars. If he concludes upon deeper review that the idea was a mistake, he sells it all back immediately, even if he takes a significant short-term loss. What I know about myself is that unlike Druckenmiller or Soros, I have trouble admitting my mistakes and cold-bloodedly taking losses. Therefore, my psychological positions have to be small.
If you decide to try this strategy, you should first ask yourself whether you are a trading God like Druckenmiller or Soros or a mere mortal like me, and size your trades accordingly. Just as a poker player must know his own tells, a serious investor must discover his psychological weaknesses and deny them opportunities to take control and do damage.
I finally bought Apple in 2008, when my 11-year-old son suggested it to me based on a stock investing project he was doing at school.
When someone of Soros’ magnitude changes his mind, it can have a serious impact on a market or even a country. I remember but cannot verify that in summer 1994 Soros’ Quantum Fund moved into Russian stocks and bonds, and that when he personally reviewed the situation in the fall, he decided it had been a mistake. (I recall his colleague Gerry Manolovici saying to me at a cocktail party, “They [Russia] aren’t going to make it.”) The story was that Soros quickly sold all his Russian assets, which may have helped spark a ruble devaluation. To be fair, deval would likely have happened sooner or later, but the summer ‘94 bubble and its abrupt popping set Russia’s economy back for quite a while.