Sunday, March 12, 2006

Chasing stocks and understanding risk

I have covered this topic in different forms before - I just have more great examples. I read financial newspapers and journals, like a lot of investors do. But I have not watched a single financial show on TV, and will not in the future. Reading, and especially watching shows with hyperactive presenters, tend to make people chase stocks and lose money. Read for the information - wait until you can digest it before you act. A day's gain or loss following a newspaper/show pick does not mean anything, unless you are a rich investor with millions to spare (and lose).

Part of the reason most investors act this way is because we are not able to fathom risk. Also, various biases make us act irrationally. A 10% gain in a day looks lot more appetizing than a 300% gain over a year, but that shouldn't be the case, unless your end result from the previous investing habit does indeed ensure better absolute returns over a longer stretch of a year or more.

One of the Barron's picks this week is Investment Technology Group (ITG), a provider of electronic trading services. This, practically unheard of, company's stock has been doing great over the last 2 years. Barron's talks about a possible 10% upside from here. As with such picks, the stock will see a bump tomorrow, with short term traders trying to make some big gains, but most will end up making a few cents! I will be watching from the sidelines. I bought into ITG slightly more than a year ago, at $12.88/share. I made a mention of it in this post following Archipelago's acquisition. On Friday, ITG closed at $49.5/share. My average price takes into account the buy transaction cost as well. Any gains I realize at this point will be treated as long term capital gains, with the corresponding lower tax rate. Why am I giving you all these numbers ? To give you an idea of how much capital you will have to risk to make the same absolute returns I have made, if you were to buy tomorrow and realize the 10% upside that Barron's sees. You will have to risk 32 times the principal I had invested originally. Moreover, given the spectacular runup, one minor bad news will send the stock reeling. Insiders have NOT been buying recently and infact, they have been selling. Why did I buy at $12.88 ? Because the stock looked cheap by value measures, but the most important reason was that insiders were buying at open market prices. Why did I decide to keep the stock even after the runup so far ? Because there have been hints by management that if the right offer comes along, the company will be sold. Did I take less risk when I bought in earlier ? I think so. My only planned for action tomorrow - inaction. Not exciting, I know, but I like it that way.

Another pick, this time a short pick going by the negative tone of the piece, from Barron's a couple of weeks ago was Greenhill (GHL), an M&A advisor. I had mentioned in a post about profiting from advisors that I owned Greenhill shares. I had bought the shares at around $22/share. On reading the Barron's piece, I was tempted to reconsider this holding, but decided that the best course of action was inaction, especially since I believe that we have not yet seen all the M&A action possible in this cycle. The stock barely moved in reaction to that piece and still trades at around $65. No complaints there.

So when will I consider selling those shares ? Never, barring any dire need to raise cash.

Update: The stock, in net, hasn't budged since the piece!


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