Controlling Fear

by Robert Sheard
(TMF Sheard)

LEXINGTON, KY. (August 25, 1998) -- We've covered a lot of territory (some areas more thoroughly than others) since the Workshop opened its doors. With Friday being my last day, I'd like to spend the rest of the week revisiting some of the topics I've learned the most from.

Fear is perhaps the greater of the two dominant emotions gripping investors, the other being greed. Everyone fears, to some extent, the big mistake that results in a major loss. A variety of investment strategies try to incorporate some measure of protection against such losses. Some work better than others.

When I first began investing directly in stocks, I was attracted to the possibility of using stop loss orders, much on the order of William O'Neil's plan of selling any new purchase that drops 8% or more. That didn't last long. Some stocks corrected that much as a regular matter and I got whipsawed routinely.

Later, a group of readers performed an extensive study of different sell-stop levels on a field of top-performing growth stocks. One had to drop down to stop levels of somewhere on the order of the mid 20-percent range before one stopped losing more money to whipsaws than one saved from steeper losses. That didn't, and still doesn't, seem all that practical to me.

What I've come to over the last year is to abandon stops altogether and turn to diversification as my risk-protection measure. Rather than worry about whether I'm going to get whipsawed in a normal correction or whether my stop will have any effect at all if the stock collapses while the market's closed, e.g. Cendant <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CD)") else Response.Write("(NYSE: CD)") end if %>, I decided to spread my risk across twenty stocks.

If a Cendant-like disaster befalls one of twenty positions, only 2% or 3% of my portfolio is shaved off. Not fun, but nothing I'll lose sleep over. If I were holding only five stocks, however, a loss of that magnitude would have cut a 10% swath through my crops. That I personally cannot accept.

Other plans exist, of course, including other ways of setting sell stops. But I've found that holding a few more positions (diversifying, not de-worse-ifying) is the easiest and most reasonable approach. It takes my fear out of the equation and lets me concentrate on greed (bwa-ha-ha-ha).

Check out the latest file updates for the Workshop:
New Rankings | 1998 Returns | New Database

[Robert Sheard is the author of the The Unemotional Investor (Simon & Schuster, 1998) available now at Amazon.com and your local bookseller.]