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It’s All Psychology

No matter how much you study up on the concepts of investing, being a good investor really all comes down to psychology.

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It’s All Psychology

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No matter how much you study up on the basic concepts of investing (how to find a winning stock, how to time the market, etc.), and no matter how much you delve into and master more complex topics (how much of a stock to buy, how much risk to take per trade, etc.), being a good investor really all comes down to one thing: Psychology.

Why do I say that? Let me give you a quote from Reminiscences of a Stock Operator, spoken by the character Larry Livingston (actually famed trader Jesse Livermore) on this topic:

“I sometimes think that speculation must be an unnatural sort of business, because I find that the average speculator has arrayed against him his own nature. The weaknesses that all men are prone to are fatal to success in speculation...

“The speculator’s chief enemies are always boring from within. It is inseparable from human nature to hope and to fear. In speculation, when the market goes against you, you hope that every day will be the last day--and you lose more than you should had you not listened to hope--the same ally that is so potent a success-bringer to empire builders and pioneers, big and little.

“And when the market goes your way, you become fearful that the next day will take away your profit, and you get out-too soon.

“Fear keeps you from making as much money as you ought to. The successful trader has to fight these two deep-seated instincts. He has to reverse what you might call his natural impulses. Instead of hoping, he must fear; instead of fearing, he must hope. He must fear that his loss may develop into a much bigger loss, and hope that his profit may become a big profit. It is absolutely wrong to gamble in stocks the way the average man does.”

Following this up have been studies about how the human mind operates. One such study asked people to choose between two options—either a sure-thing win of $10, or a game where half the time you make $30, but half the time you get nothing. Logically, you should take the second option; your expected return is $15, compared to $10 for the first option. But of course the human mind likes to avoid uncertainty—it strives to maximize the chance of winning, not to maximize profits. And thus most people go with the sure $10.

Ironically, though, it’s the opposite when it comes to “negative lotteries”—if you offer people a small-but-sure loss, versus a lottery where the expected mathematical loss is bigger, most people take the second option. Why? They don’t want a sure loss, preferring to take their chances at making it back.

All of that is why most investors sell winners quickly, while refusing to cut losses short. Unfortunately, I’ve talked with many investors over the years who have suffered huge losses because of this very trait. As Livermore said, the weaknesses that all people are prone to are fatal in the market.

So how can you use psychology to your advantage? My best recommendation is to keep records of your own trading. Obviously, the simplest record-keeping is provided by your brokerage firm in the form of your monthly statement. Actually, that is very valuable, and if you haven’t done so, I strongly recommend you find a free hour or two on the weekend and enter in your monthly values going back as far as you can (assuming your brokerage firm provides past statements online). Such a move will instantly tell you the most important thing to know—how you’ve done.

Beyond that, I also think it’s a good idea to keep records of your individual trades. Personally, I do a lot on Google Spreadsheets online, so it’s always saved, updated and accessible from any computer or mobile device.

However, what I would ideally advise you to do is to keep some sort of trading journal. (It doesn’t have to be a literal journal you’re writing notes in; just typing them on Word or maybe using Google Documents is enough. Anything to get your thoughts recorded.) While keeping records of your performance and your trades is vital, most of the time those only tell you the what ... that is, what actually happened. Keeping some sort of brief journal can lead you into the why ... and that is the real key to improving your trading.

I like to think of having a journal as surveying some new territory ... but instead of mapping out new land area or ocean, a trading journal allows you to map out your own psychology! By recording why you bought or sold a stock, or what caused you to take an action, you can very easily go back and learn your weaknesses and strengths. And then you can go about fixing your weaknesses and building up your strengths. Yes, it’s that simple.

For instance, I learned years ago that my personality, for better or worse, abhors drawdowns in my equity (pullbacks from an equity high). Said another way, I don’t like losing much ground, even if it comes on the heels of some solid gains. Of course, some giveback is inevitable—I’m not a daytrader—but I really hate making, say, 5% early in the month only to give back 4% of that by month’s end.

Not only does such action bother me, it usually leads to poor decisions; I might panic out of a healthy stock just because I want to “lighten up” in my portfolio ... only to see the stock I sold move significantly higher without me.

Knowing this, there are a few potential solutions. One might be to have smaller positions so that the ups and downs of any stock or two don’t weigh on your nerves as much. Another might be to “trade around” a core position in your stocks—for example, you might start with a 12% position in a stock, but trim that to 7% or 8% if the stock has a great couple of weeks, then try to add some back on weakness. That’s a bit advanced, obviously, but many investors do it.

The point here isn’t to harp on this one weakness or come up with complicated solutions. My goal is to get you to take some time every day or two, or even every week, and write up your thoughts on the market, your stocks, what you’re seeing, etc.—it doesn’t have to be a long essay, just a paragraph or two that you can store and, when you’re sipping eggnog or have some downtime, go back and examine.

It might sound a bit corny or time-consuming, but I can promise you it can make a real difference in improving your trading.

As for the market environment, I remain generally bullish because the intermediate- and longer-term trends of the market and most leading stocks are up. Short-term, I do wonder whether last week’s much-talked-about “breakout” from many leading indexes might have sucked in a few late-comers; about 600 stocks on the NYSE and Nasdaq hit new 52-week price highs last Thursday. That can often be a short-term exhaustion sign, which usually leads to a period of correction and consolidation.

Still, I can’t conclude that the sellers are suddenly going to come out of the woodwork—if the evidence shows that in the days ahead, then I’ll change my tune, but right here, I’m optimistic any pullback/correction that comes will be relatively well contained.

So the goal is still to find (and hold onto) great growth stocks ... though they don’t have to be all technology or retail names. In recent sessions (really ever since the European central bank said it was flooding its system with money), commodity-related shares have perked up, though many are still repairing the damage from horrific drops during the May-June-July time period.

So, today, I want to bring an oil stock to your attention; it has excellent fundamentals and a very intriguing chart.

The company is Ensco (ESV), a huge British firm that owns the second-largest oil drilling fleet in the world. Its rigs run the gamut from shallow-water to ultra-deepwater drilling, but it’s the latter that is really making a splash—that’s where most of the firm’s whopping $10 billion backlog comes from! Ensco’s acquisition of Pride International has boosted growth, and analysts see the bottom line leaping 61% this year (to $5.35 per share) and another 31% in 2013 ($7 per share) as higher-priced contracts kick in. Shares also pay a solid dividend (37.5 cents per share, per quarter for a 2.5% annual yield).

The stock itself had a decent comeback in the 2009-2011 period but, like many drillers, effectively topped out in April 2011 around 60. It fell hard during last year’s baby bear market, bottoming at 37, then rallied back to 60 earlier this year ... but then it suffered another pullback, this time to 42! But now it’s rebounded again and tightened up just south of 60.

The upshot of all this is that ESV has etched a 16-plus-month base, has great growth numbers, a more-than-reasonable valuation (12 times trailing earnings) and its sector is finally kicking into gear. I think a clear breakout above 60 on huge volume could be bought, as such a move would likely kick-off a longer-term move.

Now, just FYI, if the price of oil collapses in the weeks ahead, all bets are off—commodity stocks can be tricky that way. But the set-up is there, the earnings growth and dividend are pretty much baked into the cake, and the stock’s liquidity (it trades nearly $200 million of volume per day) should make it a favorite of institutional investors.

All the best,

Michael Cintolo
Editor of Cabot Market Letter

Editor’s Note: Mike Cintolo is Vice President of Investments for Cabot, as well as editor of Cabot Market Letter, a Model Portfolio-based newsletter of the best leading growth stocks in the market. Mike took over the Market Letter at the start of 2007, and since then he’s beaten the S&P 500 by 8.5% annually thanks to top-notch stock picking and market timing. If you want to own the leading stocks in every market cycle, be sure to give Cabot Market Letter a try by clicking here.

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.