Editor's note: Emotional investing is a surefire way to suffer big losses in the market... or miss out on huge returns. Whitney Tilson – editor of Stansberry's Investment Advisory – joins us today to share his own experience with the latter. In this essay, most recently published in the Stansberry Digest last month, Whitney details an easy three-step process you can use to avoid holding on too long... or selling a winner too soon.

Take the Emotions Out of Investing

By Whitney Tilson, editor, Stansberry's Investment Advisory

When you buy a stock, one of two things will inevitably happen...

It will go up. Or it will go down.

In the beginning, it's really that simple. You buy a stock with just two possible outcomes.

But the truth is, things can get complicated quickly. And as that happens, it often leads to one of the biggest mistakes an investor can make... letting your emotions get in the way.

When you let your emotions take over, you often rush into decisions that you'll regret later. That's the case no matter which way a stock is moving.

One common and costly mistake is selling a big winner too early...

That happened to me with Netflix (NFLX).

On the day Netflix's stock bottomed in October 2012, I pitched it to a crowd of 500 at my Value Investing Congress and then went on national television on CNBC. I said Netflix was going to be the decade's Amazon (AMZN), a stock that had risen 20 times in the previous 10 years. And as it turns out, my analysis was spot on...

Over the next two years, the stock rose sevenfold as Netflix's streaming business grew. But as the stock kept moving higher, I made a terrible mistake... I started to let my emotions take over.

After the stock doubled, I sold half my shares. And when it doubled again, I sold some more. As the stock was doubling a third time, I exited the position altogether.

My analysis revealed that Netflix was trading at a 90% discount to its intrinsic value – in other words, a "10-cent dollar." My investment thesis played out even better than I could have hoped for... So why was I selling it after it doubled? It was still a "20-cent dollar."

I thought I was conservatively managing risk and didn't want to be greedy. But I had it backward... To build a successful long-term track record, you must be greedy when the opportunity arises. Finding a monster stock like Netflix only happens maybe once in a decade – or even once in a lifetime. So it's critical that you make the maximum amount of money on such moonshots.

I should've made more than $100 million on Netflix for myself and my investors. Instead, I made less than $10 million. Of course, that's not terrible... But it was a costly mistake.

It's equally important to harness your emotions when a stock is running against you...

Take SodaStream, for example. Its machines turn regular tap water into sparkling water with the touch of a button.

I knew SodaStream had a great business model. The company sells a product that people use over and over. And the carbon-dioxide bottles in its machines need to be replaced regularly. So SodaStream made something like an 80% profit margin doing so.

But the company had botched its marketing in the U.S. and was also relocating its main factory to Israel, so its sales and earnings were down. I patiently waited until the stock had been cut in half and bought a small position in 2014.

It turns out that I was way too early. The company continued to struggle, and the stock kept drifting lower and lower... for nearly two years!

Making the right decision in these situations is critical. Had I stumbled into a "value trap" that would never turn around (in which case I would have needed to sell)? Or was the company still strong, with fixable problems (in which case I should have bought more)?

It was extremely painful losing so much money for so long. Emotionally, I wanted to sell and never think about that terrible investment again.

But I was able to set aside my emotions and focus my analysis on the fundamentals, which remained strong. I added to my position all the way to the bottom – and was well rewarded.

In early 2016, SodaStream's stock took off as I expected...

By the time I closed my funds in late 2017, it was up five times. And then PepsiCo (PEP) bought the company in 2018 for 12 times the price from only two years earlier.

It can be challenging to figure out whether a stock is just hitting a few speed bumps (like SodaStream) or if it's doomed for good (like old-school film company Kodak). But by following a simple three-step process, I realized that I should hold on to SodaStream...

First, assume the market is right and you're wrong...

It's important to start with this mindset because it helps overcome the natural bias we all have to not want to admit to making a mistake.

You must respect the market. The hard truth is that most of the time it's right... and you're wrong. My experience with SodaStream was the exception, not the rule.

Second, you must figure out what you've missed and actively seek out disconfirming information...

Redo your work... But don't just rehash what you already did. That won't lead to any new conclusions. Instead, you must ask – and honestly and correctly answer – a series of key questions.

Have you made a research error? Are you possibly missing anything? Have you openly and carefully considered contrary arguments? Have you invented new reasons to own the stock (so-called "thesis drift")?

Many smart investors lost a lot of money owning Kodak's stock in the decade before it filed for bankruptcy in January 2012. It wasn't an unreasonable investment initially... The company had one of the strongest brands in the world, it generated robust cash flows, and its stock traded at a low multiple of earnings. Sure, digital photography was a threat to Kodak's film business, but it seemed far off – and the company was making investments to compete in this space.

For most investors who lost money with Kodak, the mistake wasn't so much the initial purchase. Rather, it was failing to recognize that the film industry was rapidly being obliterated and that Kodak was getting no traction in the digital arena. So its profits were destined to disappear.

The key is to tune out the noise and think clearly and rationally. Focus on the fundamentals... If the company's earnings rebound, its stock will as well.

Finally, to make the right decision, you must pretend like you don't already own the stock...

It's difficult to make the right decision about a stock you've lost money on. The emotions are powerful.

On one hand, you're probably telling yourself that if you liked it at the price you bought it, you should like it more now that it's cheaper. That may be true – but it could also be a value trap. No matter what, you must resist the temptation to double down again and again to try to recoup your losses. Remember the old saying... "You don't have to make it back the same way you lost it."

On the other hand, your emotions could be telling you to sell, so that you don't have to suffer any more pain and never have to think about this terrible stock ever again.

There's also a powerful feeling of wanting to wait until it gets back to the price you bought it at before selling.

You must resist all of these feelings. Emotions are deadly when it comes to investing...

I've found that it helps my thinking to pretend I don't own the stock. I ask myself, "If I were 100% in cash today and building a portfolio from scratch, would I own this stock? And if so, what position size would I have?"

Doing nothing may be the best option, but you also must have the courage to admit to making a mistake and get out – or know that you haven't made a mistake and buy more.

If a stock is going against you, follow this simple three-step process. And if you wouldn't buy the stock if you were constructing a portfolio from scratch, then you should sell it immediately.

Regards,

Whitney Tilson

Editor's note: You can control your emotions – if you have a system. Our company just released a breakthrough that shows you an investment's potential before you even get in... analyzing the most critical factors to see which stocks could soar as high as 100% – and which are likely to crash. Whitney recently explained how this never-before-seen "quant" strategy can help you navigate 2024... and demonstrated exactly how it works. You can watch a replay right here.

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