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How Important is it to be Right?

In the market, being right causes many to be stubborn with each and every stock they buy.

Husband vs. Wife

Being Right or Making Money

A Handful of Fresh Breakouts

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A few weeks back I came across a fascinating article in Time that highlighted a study that involved a couple in New Zealand. The goal was to study the age-old maxim that it’s better to be happy than to prove that you are right all of the time—i.e., it’s not worth debating or fighting over most of life’s details, it’s better to simply go along and get along, especially with your spouse. (You know this is going to be good, right?)
So they set up an experiment; instead of describing everything, I’ll just quote the article (which was published December 17 online, and written by Belinda Luscombe, an editor-at-large for Time):

“So they found a couple who were willing to record their quality of life on a scale of 1 to 10. They told the man, who wanted to be happy more than right, about the purpose of the study and asked him to agree with every opinion and request his wife had without complaint, even when he profoundly didn’t agree. The wife was not informed of the purpose of the study and just asked to record her quality of life.

Things went rapidly downhill for the couple. The man’s quality-of-life scores fell, from 7 to 3, over the course of the experiment. The wife’s scores rose modestly, from 8 to 8.5, before she became hostile to the idea of recording the scores. Rather than causing harmony, the husband’s agreeableness led to the wife becoming increasingly critical of what he did and said (in the husband’s opinion). After 12 days he broke down, made his wife a cup of tea (New Zealand is, after all, a Commonwealth country), and explained the experiment. At this point the Data Safety Monitoring Committee, as the researchers called it, stopped the study because of “severe adverse outcomes.”

“This was a genuine piece of research where we hoped that both parties would be happy as part of one person agreeing with everything the other said,” says the study’s chief author, Dr. Bruce Arroll, who seems to have a pretty well-developed sense of humor. “We thought that we would find a method of creating marital bliss (and probably a Nobel Prize if we had succeeded).”

The researchers concluded, shockingly, that humans need to be right and acknowledged as right, at least some of the time, to be happy. In politics, people often note that there can be no peace without justice, and that’s true of the domestic sphere as well. The researchers also noted that this was further proof that if given too much power, humans tend to “assume the alpha position and, as with chimpanzees, they become very aggressive and dangerous.”

I’ll leave that part about chimpanzees for someone else to comment on. The point is that we, as human beings, deep down inside, actually derive pleasure from being right. Call it ego, call it human nature, call it whatever you want, the point is that all of us have a pre-set button that desires to, at least sometimes, to be right.

We’ve all seen this (or lived it) at some point, even with small children—when a kid is constantly told he’s wrong, he’ll either rebel or suffer some sort of depression. Conversely, when someone (say, a co-worker) proves himself correct on a matter, he tends to feel he’s earned his keep.

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As it turns out, this ingrained desire to be right most of the time can not only spark the meaningless spousal argument (“Who wants salad? I want pizza!!”), but like so many basic instincts, it also causes big problems for investors. Some investor once coined the phrase “Do you want to be right, or make money?” and, while most investors believe these are one in the same, they are not.

In the market, being right causes many to be stubborn with each and every stock they buy. It’s almost as if every stock purchase represents a major financial decision that will affect that investor’s life. I see it all the time—subscribers will agonize over every decision with every stock. Their real fear isn’t losing a few hundred bucks, it’s being wrong—if they sell, they’re giving up hope, acknowledging that their initial, detailed analysis was incorrect.

However, to make money (at least as an intermediate-term growth investor, like me), what really counts isn’t maximizing every single trade. Instead, it’s really the outlier trades that count; the big losers and big winners are what drive your results. In other words, you want to lose small and win big.

Below is a histogram of results that would be typical of a successful few months’ worth of trades. These wins/losses aren’t measured in dollars (though they could be); they’re expressed as a percent of what was risked. In other words, if a trade’s initial risk was $1,000, and the trade ended with a loss of $1,000, it would be a -1.

Conversely, if the trade resulted in a profit of, say, $2,500, it would be marked as a +2.5. (Initial risk = Loss limit minus buy price, multiplied by the number of shares.) All of the trades had similar initial risk, FYI, with each blue bar representing a trade result. These are ordered from worst to best.

Details aside, you can see that the vast majority of trades came in between -1.0 and +1.0 (there were a few in the middle you can’t see that were basically break-even trades, giving a reading of 0). That makes sense, as most of your trades are going to cancel each other out.

Importantly, there were more losing trades than winning trades (44% winners, to be exact)—thus, this investor was wrong more often than he was right! However, as mentioned above, what really counts are the outliers, and you can see toward the right side, there were eight trades that were above +1.0, including five above +2.0 and one north of 6.0!

In fact, when you do the math, it turns out that the average for every losing trade was -0.31, while the average from all the winners was 1.23. That means the average winner was nearly four times as large as the average loser! That’s how the growth investor makes money.

To be clear, I’m not claiming the win rate is meaningless—the goal is to have both a high win rate and some huge winners. But if you’re overly concerned with always being right, chances are you’ll hold onto losers, while booking your winners too early ... exactly the opposite of what successful growth investors do.

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January’s are often tricky for the market, what with myriad crosscurrents from a variety of retail and institutional investors. And we’ve seen plenty of ups and downs already this month, including this week’s huge downdraft Monday, and equally huge rebound on Tuesday.

Now, to be fair, coming after a huge run since October, this up-down-up-down action is a sign of distribution; the action tells you the bulls and bears are fighting it out. At the very least, it’s a slight change in character from the relatively smooth uptrend we’ve enjoyed in recent months.

On the flip side, what encourages me is that I’ve seen some breakouts so far this year among a few growth stocks ... really, the first big-volume lift-offs from well-formed bases I’ve seen since November. Moreover, even during Monday’s weakness, none of these stocks took on too much water, and most snapped back quickly as soon as the market bounced back.

I’m not going to pretend the action of a handful of growth stocks are the be-all and end-all to determining the market’s health, but I do think you can use them as clues to the market’s speculative sentiment. Thus, keep an eye on names like Yelp (YELP), Pandora (P), Canadian Solar (CSIQ), Workday (WDAY) and YY Inc. (YY); if a few of them fall back into their prior bases, it would be at least a short-term yellow flag. So far, they’re all looking good.

In fact, the stock I’m writing about today is Canadian Solar (CSIQ). The solar sector as a whole is hit-or-miss (about half the stocks look good, half don’t), but CSIQ is one that’s acting very well, and part of it has to do with a unique business plan. Here’s what I wrote about it in Cabot Top Ten Trader two weeks ago:

“Like all solar stocks, Ontario-based Canadian Solar, one of the largest solar power companies in the world, has been through some huge ups and downs in recent years. But the company, founded in 2001, had a monster year in 2013, partly in concert with the global recovery in solar and partly due to some big deals that are unique to Canadian Solar. The company specializes in building big power facilities that are sold to companies that will tie them into the local power grid. The most recent sale was a $57.4 million deal, announced on January 2, to sell the Mississippi Mills plant to TransCanada. Mississippi Mills is a 10 megawatt facility, and is the fourth of nine such facilities that will be sold to the same client. Just today, it was announced that the company’s 30 megawatt solar project in Xinjiang (Western China) had been completed and connected to the power grid. Successful construction and installation news is fairly routine for Canadian Solar and investors like the company for its vertical integration (everything from silicon ingots, cells and modules to giant power plants) and its global reach. Germany is still the company’s largest source of business, with the U.S., Japan, China, Canada and Spain filling out the list. The company’s 54 cents in earnings in Q3 came after eight quarters of losses, and investors are betting that the company has turned the corner to consistent profits (estimates are north of $2 per share in 2014) in a supportive environment for solar power.”

Since that time, the firm announced the completion and grid connection of another 10-megawatt solar project in eastern China, which was constructed in just three months. Touting the results, management said “This project is another good demonstration of Canadian Solar’s success in the development and construction of utility-scale solar power plants on a global basis as well our growing momentum in China, a rapid growing emerging market that is poised to become the world’s largest solar market in the years ahead.”

It also inked a deal with supply north of 84,000 solar modules to National Renewable Energy Corporation for four utility scale solar projects totaling 25.3 megawatts in North Carolina.

As for the stock, let me be clear: It’s already had a huge, huge run. It was the biggest winner of 2013! So by no means am I saying the stock is early on in its advance.

However, shares did tighten up beautifully from mid-November through year-end, and then exploded higher on the first day of 2014. It ripped ahead from 30 to 40 in just four days (!), pulled back calmly and, this week’s is powering ahead again. t’s very volatile, but the powerful momentum, big earnings estimates and terrific price-volume action has me intrigued.

I actually missed CSIQ in Top Ten when we wrote it up, looking for a dip that didn’t come. However, given its action since then, I think you could buy a small position (maybe half what you’d normally buy, dollar-wise) in the upper 30s, with a loose stop near 32. Then, if (and only if) CSIQ advances, you could consider adding a few more shares. I wouldn’t be looking to push the envelope too much, but if things go well, there’s big potential here.

For further updates on this stock as well as additional momentum stocks, click here now.

Sincerely,
Michael Cintolo

Chief Analyst of Cabot Market Letter

and Cabot Top Ten Trader

A growth stock and market timing expert, Michael Cintolo is Chief Investment Strategist of Cabot Wealth Network and Chief Analyst of Cabot Growth Investor and Cabot Top Ten Trader. Since joining Cabot in 1999, Mike has uncovered exceptional growth stocks and helped to create new tools and rules for buying and selling stocks. Perhaps most notable was his development of the proprietary trend-following market timing system, Cabot Tides, which has helped Cabot place among the top handful of market-timing newsletters numerous times.