Picking the flowers and watering the weeds

As I explained in my 1999 book, Investment Traps and How to Avoid Them, stock market investors are reluctant to take losses. Terrance Odean, the Rudd Family Foundation Professor of Finance at the University of California, Berkley published a seminal study in 1998 describing investors’ tendency to hang on to losing positions and to dump profitable positions.

As Professor Odean described it, investors left to their own devices without any advice are much more likely to sell a profitable position (you never go broke taking a profit) and to keep a losing position (I’ll hang on until it comes back to my purchase price). He found that people are about twice as likely to sell a winner versus a losing position. Of course, this quirk might be costly if the ones that are sold, the ones that go up after purchase, are better companies than those that are kept, the ones that go down. And, as it turns out, this is exactly the case. According to the findings of the study, the amount of performance forfeited by selling the winners too quickly and hanging on to the losers too long is 4.4% annually. Since the long-term return on the stock market has averaged about 7% this is a lot of growth to give up just because an investor doesn’t like to admit that he made a mistake.

The only thing that should matter to an investor is what will happen to the share price and the company value going forward into the future. What price I paid for my stock doesn’t make any difference at all. For example, if you bought 1,000 shares of Blackberry recently at $6 and I bought 1,000 shares of Research in Motion five years ago at $100 we both are going to get exactly the same performance on that stock from this day forward, with Blackberry trading about $10. It might be lot easier for you to sell it at $10 today, to book a 66% profit than it would be for me to sell at a 91% loss. But that shouldn’t matter at all.

Now the current state of the Canadian stock market presents a dilemma for many investors. What to do about shares of Canadian Natural Resources, MEG or Suncor? Some long-term holders will still have profits and most recent buyers will have substantial losses. Some people that own shares today in energy companies are “talking their book” which means that they believe their holdings will go higher because they have to believe that because they own energy shares. That’s a bit circular, isn’t it?

The supply issue in the energy market is a serious change. Saudi Arabia insists that they won’t cut production before the summer, and suggests that others, like Russia and the U.S., should cut their production first. This isn’t likely to happen since Russia needs the money and the U.S. is a “free market” economy that will let the demand and supply factors sort it out. The U.S. government has no control over what private sector energy companies decide to do, but high-yield bond markets might refuse to lend any more money.

As was shown in last week’s blogpost the energy sector cycles are measured in years, not months. It could take a long time to sort this out, especially since supply isn’t likely to shrink until producers start to shut down and stop drilling. On the other hand, it could be just a few months before a rebound starts if enough shale producers cut their budgets. It feels like it’s more than just a temporary pause, though.

But given the investor psychology issues that Odean confirmed in his research, investors are more likely to hang on to losing positions and even to double down by buying more shares now that prices have dropped so much. And that could be an expensive choice, if the crude oil price doesn’t rebound soon.