The investor’s chief problem—and even his worst
enemy—is likely to be himself.
—BENJAMIN GRAHAM
You may not realize it, but the more engaged you are with your investments, the more likely you are to return a loss. When I first began investing, I was the worst in the world; I watched every fluctuation of a stock throughout every day. I could barely focus at work because I was so worried about logging onto my online brokerage account to see how much I had either lost or gained. If it was a day when the market fell by 150 points and I lost $300, I was selling my stocks with no questions asked, regardless of the loss.
The interesting thing about this behavior is that I would become even more frustrated as the stock would rise the following day or week because I could see the gains that I had missed. Seeing the potential gains led to desperation on my part, so I would buy as the market was trading higher and repeat the process all over again when the market turned for a day’s loss.
This process is very common for an investor; in fact, most investors live in this process for years before ever even attempting to change. I completed about four to five cycles of this behavior before I stepped back, took a look at myself, thought about my actions, and realized what I was doing wrong. I realized that it wasn’t my fundamental research that was causing me problems. My problems were due to my behavior and my inability to honor my research and trust that I had made a good decision. Of course, there are times when you are simply wrong. But my initial problem was that I never gave it time to see if I was right, and I never slowed down and considered the fact that the stock market is volatile, and when you own a stock, your gains/losses are going to change with every hour of the day.
As investors, we take a lot of pride in the way we choose stocks and our fundamental research. When we buy a stock, we have such high expectations that we get scared when the first thing goes wrong. This is the ultimate behavior that you are trying to change, and since you bought this book, I am fairly certain that you are familiar with the cycle. If not, then perhaps you fall into the second category of active investors who wait to sell and refuse to sell because of such strong biases toward your decisions.
Most of the time, an investor’s fundamental knowledge is sufficient to return gains, but it’s her emotions that get the best of her. Therefore, I wanted to develop a very simple, methodical way to eliminate all emotion associated with the buying and selling of a stock so that I could place 100 percent of my energy into my fundamental research. This simple change involved using limit orders for all of my buying and selling and setting a period of one to two years for each investment. Now I will be the first to admit that there are some times when I will trade a stock or that let my emotions get the best of me, but for 80 to 90 percent of all my investments, I use limit orders to eliminate the emotion, therefore preventing an unhealthy behavior.
One of the most significant shortcomings for investors is not fundamental analysis or even knowing how to identify an undervalued company, but knowing when to take the profits and sell the holdings. There is not a single investor who hasn’t experienced a period of time when he had made substantial money from an investment and then watched it dwindled away as the stock fell. In some cases, it even returned a loss as the investor waited for the stock to rebound.
It is a normal human characteristic to never be satisfied. As humans, we always want more. Whether it is a nicer house, a newer car, or a better job, we are never satisfied and always strive to obtain more. The same is true with investments. Investors find it difficult to sell a stock that is performing well. It doesn’t matter if we’re up 20 percent, we will tell ourselves to hold on and wait for even larger gains. This often continues until the stock reaches its peak, but we continue to wait in hopes that it will recover, and we often lose all our gains.
The primary objective of investing is to return more money than your initial investment. Based on my experience and years of dealing with other investors, the best way to ensure gains is to use limit orders to eliminate the emotions involved in buying and selling a stock. A limit order is an order you can place either before or after you buy a stock that automatically buys or sells shares once the stock reaches a certain price. You can set a limit order that will expire in one day, or you can set a good-till-canceled (GTC) limit order that will remain active until it is either canceled or the order is filled. For example, if shares of Costco (ticker symbol COST) are priced at $87, you may decide after looking at the charts that it has a tendency to fluctuate between $75 and $95. Then you may want to place a limit order for $79 or even $80 because you must account for growth. To better explain this, let’s look at my investment in Google (ticker symbol GOOG) and how I used limit orders to buy and sell stocks to return the largest gains by eliminating the emotions of a purchase.
Google was the first significantly large investment of my career. Before Google, I had invested $5,000 to $10,000 into several different companies and was able to keep a large cash position. During June and August 2008, I began to accumulate shares of Google until I had purchased 43 shares at an average price of $485 per share, which was $200 less than the stock had been priced in the prior year. Although the market was getting crushed and the fundamentals for 90 percent of all companies were being affected, Google maintained its growth and continued to post fairly impressive quarters of growth. Therefore, I felt that $485 was below its fair value considering its growth, and it most likely would not trade too much lower. Even if it did trade lower, I felt assured that the stock would recover because it was not experiencing the same difficulties.
This is a good time to reiterate the importance of price/earnings (P/E) and price/sales ratios in regard to identifying value. When I bought Google, it was trading with a P/E ratio of around 30 and a price/sales ratio of around 8, which some may think was too high considering the state of the economy. However, the company’s Android operating system was catching fire, and it had good growth and a positive outlook and had traded with much higher ratios in the past. As a result, I felt as though it was a good value play because the company maintained a positive outlook and was growing at such an excessive rate despite the horrible economy. This is a good example of how value is determined not only by the trading metrics but also by a company’s growth and historical trading tendencies. At $485, Google was much cheaper than it had been in the past with much better fundamentals. Looking back, I could have bought the stock much cheaper, but with this strategy I was only trying to buy low—it didn’t matter whether it was the lowest point. I was just buying at a point that I know was cheap and that should appreciate in value.
During three months following my initial purchase of Google, the stock fell to a price below $300, and my loss was disturbing. This indicates that I could have bought the stock cheaper, but I did feel as though Google was a stock that would recover because its fundamentals were still strong, and growth was imminent. When I purchased the stock, I believed that it was near its bottom. Even if it would have dropped, I had bought it with the understanding that any price under $500 was value, regardless of short-term direction. I had already decided that I would not sell but would perhaps acquire additional shares if the stock remained at such low prices. However, as rapidly as it fell, the stock began to rise. The stock reversed and was trading at over $400 within six months. Consequently, with the market in recovery or moving in the right direction, I began to think about the price at which I should sell.
At the end of 2009, Google had surpassed $600, which means that I had already attained a gain of $5,000. At this point, I considered taking profits but encountered the problem that I have been discussing. I wanted more. I did not sell the stock for a $5,000 gain, and subsequently, the stock began to fall. I watched as my $5,000 return diminished, and the stock’s $610 price dropped to $580 and then to $550. I finally sold at $525. I still returned a gain of more than $1,700, but considering the volatility of the stock, I should have returned much larger gains. This is when I developed the idea of using limit orders. I still liked Google but was not willing to purchase it for more than $525 per share, the price at which I sold. Therefore, I put a limit order in to buy shares if it reached $485, which was the price I paid to buy the stock in 2008. I did not care if the position filled (was bought), but if it did, I believed that it would once again be a good value play with fundamentals improving.
Almost exactly two years after I first bought Google, in June 2010, my limit order was filled at $485. I used the proceeds I received from the sale of the stock the previous year to acquire 46 shares, three more than what I had owned before. This time, however, I was not falling into the same trap. Within days, I set a GTC limit order to sell my 46 shares of Google once it reached $600. I did not care if it took days, weeks, or months; I set the limit with the idea of holding the position for one year or until it reached $600. If not, I would reevaluate my position.
When I first set the limit order to sell Google once it reached $600, I thought it would take about a year for the order to execute. In just four months from the time I bought the 46 shares, it surpassed $600, and my order was filled. At this point, I saw the true genius of this simple strategy and decided that I would attempt to repurchase shares of Google if it dropped to $500. I believed that $500 would be insanely cheap for the stock, especially considering its constantly improving fundamentals. The reason I set the order for $500 instead of $485 was because the company had improved over the last year. So I had to account for fundamental growth and assume that the stock’s bottom-level price would be higher than it was two years prior when I first bought it.
I had already kept a large cash position, so I didn’t believe I was losing by not investing the money into another stock. Because value investing is all about patience, getting the best price, and identifying strong fundamentals, I was more than willing to wait for my price to be reached. I might add that most investors are unwilling to wait for a stock to reach a price with this strategy because they feel that they are losing money if they are not investing. When this strategy is used, it does more than just eliminate the emotion of buying or selling but also changes the perception and the behavior of those who are patient enough to wait and allow the volatility of the market to create the value. At this point in time, stock prices have stayed the same for the last 12 years, yet the fundamentals are constantly improving. Therefore, valuations are better. As a result, the number of value-presenting opportunities are plentiful, but in order to take full advantage, you have to remove the emotion involved with the investment or you might as well play a game of blackjack.
By the time my $600 order had been filled, I was preparing to purchase Google for the third time if it dropped to $500. I had set aside my earnings from my Google investment for a planned one year, and if the stock dropped to $500 within one year, then I would buy. If not, I would invest elsewhere. In June 2011, the stock once again fell to $500, and my limit order was executed.
After purchasing Google at $500, I decided to keep the same strategy and set a limit order for when the stock reached $600 once again. I did not have to wait nearly as long this particular time because it reached $600 in one month. As a result, I attempted the strategy once more with the belief that if something is not broken, there is no need to fix it. In August 2011, it reached $500, and my limit order was executed for a third time, making it my fourth purchase of Google. I sold for the final time in November when it reached $600.
Following the sale of my Google shares in November 2011, the market was priced extremely cheaply owing to the sell-off. As a result, I felt that there were better opportunities elsewhere and invested my Google proceeds into Apple, a company I thought presented more upside. In a period of just three years, I returned unparalleled gains simply by eliminating emotion and allowing a system to buy and sell a fundamentally strong undervalued company.
When I first began in 2008, I purchased 43 shares, but because of the gains, I had been able to purchase 66 shares on my final investment in Google. As a result, my final return was nearly $40,000, which was nearly double my initial investment in a stock that had increased only 25 percent from the time I first purchased it at $485 per share. Now these results are not typical; usually I am only able to purchase a stock once or twice.
The important thing to remember when using limit orders is that sometimes the price will not be reached. Therefore, you must determine an allowed time for the position and then decide whether you will abandon the order and rethink your position if the order is not executed. For example, if the year had passed and my order had not been executed, then I would have moved on to another stock. Even if it was priced at $525, I still would not have purchased the stock. I would only buy at $500.
The goal of using limit orders is to eliminate emotion so that you don’t deal with the “want more” attitude when it is time to sell. This strategy eliminates the need for both buying and selling a stock, so all you have to do is find a stock that is fundamentally growing, has strong metrics, and is priced for value. In other words, it makes investing simpler and gives you one less thing to worry about while providing a more effective way to invest.
Over the last few years, I have spoken in detail about this particular strategy from the time I began using it. The reason is simple: There was a time when I made the same basic mistakes as everyone else, and although I still make some of the same mistakes, the occurrences are fewer and farther between. One of the primary reasons that I am such a big fan of using limits is because they assist investors in avoiding the common psychological pitfalls that I have discussed and allow investors to focus solely on fundamental analysis and finding a good entry rather than the day-to-day activity that forces them into the trap of emotional trading in the market.
For some, this strategy makes sense and will be simple to execute, but for others, it will be extremely difficult. If you are one of the thousands of investors who trade on a daily basis and try to play trends, then I believe that you will find that it is very difficult to stop. It is just like an addict who knows that his behavior is ineffective but cannot stop. Both habits impact the same part of the brain; therefore, you must treat it like an addiction and take baby steps to change the behavior. You should try using limit orders for a week or month instead of yearly and lower the desired return. As a result of heavy volatility, your order will be executed often. If you find that this is still too difficult, then create a dummy account and practice with fake money. Compare the return of your dummy account with the return on your real account. Sometimes seeing the effectiveness of a strategy is all you need to begin the process of changing a behavior.
Retail investors can be separated into several different categories according to their goals. Those who are closer to retirement or have more wealth have no problems with this strategy. For those who are trying to “get rich” in the stock market, this strategy does not satisfy the immediate gratification that many desire. Either way, this is a very simple strategy and one that I have discussed in great detail on several occasions. It is also a strategy that can be customized to meet your individual goals. Therefore, I want to take some time to answer some of the most common questions regarding using limit orders. Here are the five most frequently asked questions that should help you and make the process simpler. The important point to remember is that the strategy can be customized and that you can adjust my techniques to your personal preference and still be successful. The goal is not for you to mirror my choices but rather to become a more intelligent investor who eliminates the most common of mistakes.
Question 1: Isn’t this strategy expecting gains?
Answer: It is a thin line between the expectation of gains that leads to emotional decisions and the expectation of gains that leads to an investment in an undervalued company. If you buy a stock, you naturally expect to return gains, or you would not have purchased the stock. However, you are not “counting” on a trend or a quick rally to return large gains. The purpose of this strategy is to allow you to focus solely on fundamental analysis and compare it with a company’s valuation to determine whether or not it’s over- or undervalued. For those who day trade or trade actively, they expect quick gains and chase potential gains via geek-bearing formulas. Those who use limit orders are investors who plan to invest in a company but are willing to sell if the stock reaches a level of acceptable return. Since the goal is to return more than your initial investment, this strategy makes sense because it ensures that you take profits, an action that some miss because they always want more.
Question 2: Do you always have a set amount of time for the investment?
Answer: Yes. I always have a set time before I manually close the position or reevaluate the position. In most cases, it is one year, but investors can decide for themselves how long they wish to hold a certain stock.
Question 3: Do you ever have multiple limit orders on one stock?
Answer: Absolutely! My limit orders range from one to three per investment. Presently, I am holding four different companies that I believe are presenting unprecedented value compared with current fundamentals. Therefore, I have three limit orders on each company. For the first limit order, I may sell 20 percent of the shares; for the second, I will sell 30 percent; and for the final order, I will sell 50 percent of the shares. Once again, this can be changed based on goals.
Question 4: How do you determine the goal price?
Answer: It depends on the company. For investments with multiple limit orders, the final order sometimes can be double the purchase price, although this is rare. These are small-cap investments or companies that are growing by large margins and trading with single-digit P/E ratios, among other factors. As a rule of thumb, I use a 20 percent gain. With this strategy, I have waited many months for the order to execute and other times only weeks. If the stock purchased truly is a value investment, my theory is that 20 percent upside is fair and achievable.
Question 5: What about the buy price?
Answer: I usually look at a number of factors such as the trend of the market, the price as it relates to 52-week price performance, earnings growth, and balance sheet. Anytime I decide on an investment, I research thoroughly and buy when the stock has fallen for some reason other than fundamentals. As I explained earlier, when a stock trades on an uptrend, it always reaches a peak before correcting and falling. When it is trading lower, it will bounce off the bottom before either trading higher or leveling to trade even. The goal should be to buy as it is trading lower, after it has bounced off the bottom or when it’s trading flat following a downtrend. The most important point to know is whether it’s a value stock. Are the fundamentals improving, does the company have a good outlook, and why did it fall? You must answer all these questions. If you establish that it fell for some reason other than fundamentals and it’s priced cheap, then it could be time to buy.