Streetwise for Sunday, May 20, 2018

As we close out the first-quarter’s earnings season, many blue-chip companies look exceptionally attractive as investment candidates. Earnings for companies in the S&P 500 index were up about 26 percent during the first quarter, when compared to the same period a year ago.

It was the highest year-over-year quarterly earnings growth rate in seven years. Excluding the energy sector, earnings growth was still about 24 percent. Revenues on average were up about 8.8 percent.

In addition, inflation concerns calmed down after the Consumer Price Index (CPI) for April increased by only 0.2 percent, coming in below the consensus estimate of 0.3 percent. Furthermore, the core CPI, which removes energy and food prices, increased by only 0.1 percent, lower than the consensus estimate of 0.2 percent.

Therefore, it would seem logical that adding some strong corporate performers to your portfolio will likely garner attractive profits in the months and years ahead. So, what could go wrong? Basically, it is a lack of patience. Self-control and patience…while they are great virtues they run contrary to human nature.

Looking back, two finance professors, Brad Barber and Terrance Odean did a study several years ago that confirmed once again the sound principle of buy and hold. The study titled, “The Common Stock Investment Performance of Individual Investors,” vindicates what Benjamin Graham wrote 50 years ago, “The investor’s chief problem – and even his worst enemy – is likely to be himself.”

The research found that investors who trade frequently earned a return well below that of those who held long-term. According to Barber and Odean, the average household would typically hold a stock for 15 months. Active traders held stocks on average for about 120 days.

The main reason for poor performance, the authors emphasized, is the cost of trading and the frequency of trading, not portfolio selection. If taxes had been considered, the depletion of profits would have been even greater.

In two other papers, “Do Investors Trade Too Much?” and “Are Investors Reluctant to Realize Their Losses,” Odean discovered that when investors decide to sell shares, the stocks they buy “actually underperform those they sell.” In other words, people who trade frequently make poor investment decisions. Basically, they end up switching out of good investments and into poor ones.

Why? It’s hard to say for sure, but Odean’s research indicates that investors are especially prone to sell a stock that has declined in the past and then suddenly posts a small move upward.

Specifically, individuals will hold on to losers because it makes them feel better that they have not locked in a loss. In doing so, they minimize regret by reciting the mantra that there is still hope. Then when the stock rises – even if there is still a loss – they feel better about selling it.

Odean speculated that one reason for heavy trading is the ease of buying and selling over the Internet. The authors’ research also postulates strong evidence that, “There is a tendency for human beings to be overconfident.”

Specifically, investors think they can time the market when the weight of the evidence shows they cannot. They confuse genius with a bull market.

“In an up market,” Odean wrote, “you’re going to think, I’m a good investor, a really good investor.” They feel that’s true, he said, even if a portfolio returned 10 percent in a year in which the Standard & Poor’s 500-stock index gained 20 percent.

So, brimming with self-confidence, investors are more likely to believe they can jump out of one stock and into another at precisely the right moment and make a killing. “If you are the smart guy who picked the last winner, then it makes sense that you think you can pick the next winner,” Odean wrote.

The answer to all this is simply not to make high turnover an investment option. Instead you want to invest in companies so successful that you can and will hold them for years, not months. And in the process, you will find yourself much less concerned about short-term market trends or the business cycle.

Lauren Rudd is a financial writer and columnist. You can write to him at LVERudd@aol.com. Phone calls accepted between 9 AM and 3 PM at (941) 706-3449. For back columns please go to www.RuddInternational.com.