The simplistic view of the investing process is that we choose great stocks, hold them for a long time and eventually grow wealthy through the power of compounding. It is a logical and compelling idea, and people like Warren Buffett prove that it does work. The problem is that in practice, this is a tremendously difficult thing to do and is not nearly as simple as it sounds.
The majority of mutual funds can't even outperform the indices, yet amateur investors are convinced that they can easily produce great returns just by choosing the right stocks and holding them for the long term. We hear all the time about the stocks that were big winners over the course of years, but there are thousands of stocks that fail for every one that becomes a leader.
The problem is that many people believe that the investing process is finished once they choose the right stock. They just sit and wait for the profits to start building and do nothing when it turns out that they picked a dud rather than the next Microsoft (MSFT) or Apple (AAPL) .
While good stock selection will make life much easier, it is the management of your stocks after you buy them that will determine your level of success more than anything else. A good trader should be able to choose stocks at random and still make money, and when that same trader is given a good stock pick, then the odds of success are exponentially higher.
We are told we should be patient and hold for the long term, but when your money is tied up in the wrong stock, then the power of compounding works in the wrong direction. The suboptimal performance and opportunity costs accelerate over time the longer you are in the wrong stock. The investment process should not end with stock selection. It is only starting. Once you recognize and embrace that idea, then you are in control and have the power to deliver market-beating returns.
A helpful way to think about portfolio management is to imagine a contest between two investors. Both are given a random selection of 10 stocks that they can buy, sell, or hold at any time over the course of a year. The issue of initial stock selection does not come into play in this scenario. It is all about finding strategies to manage these stocks as they develop. Traders will want to consider technical setups, fundamental issues, and overall market conditions. Those things change every day and will determine how a stock is handled. Even if the stock selection is very poor, a good trader should be able to develop effective management strategies. The smart thing may be to just immediately dump a particular stock, or maybe it might be smart to just hold it through all the market gyrations that are sure to occur, but the development of strategies to cut losses and build gains will determine your success more than the stock itself.
One common issue for investors and traders is that picking a stock triggers an emotional reaction. We not only become financially invested in the stocks we buy, but we also become emotionally invested in them to some extent. We want to think that our decision-making process had some value, so we are reluctant to immediately admit that maybe we made a mistake.
This emotional attachment to a stock we have carefully chosen and then held for a while, hurts our ability to manage positions objectively. Rather than focus on poor price action, we focus on the fundamental arguments we used to buy it in the first place, and that undermines effective portfolio management.
The best advice I can give is to think of stock selection and investment management as two separate things. Don't let your emotional attachment to a stock prevent you from implementing a methodology that helps you to cut losses and build gains.
Stocks are just the vehicles we drive to navigate the market. If we choose a good stock, then our task is easier, but even if we choose a bad one, we can still win the race if we drive it effectively.