“One of the saddest lessons of history is this: If we’ve been bamboozled long enough, we tend to reject any evidence of the bamboozle. We’re no longer interested in finding out the truth. The bamboozle has captured us. It’s simply too painful to acknowledge, even to ourselves, that we’ve been taken. Once you give a charlatan power over you, you almost never get it back.”

Psych 106: Never Average Down In A Losing Stock

By Donald H. Gold, INVESTOR'S BUSINESS DAILY

(Part 6 of Investors Business Daily Exclusive Series
Hope, Fear And Greed: Psychological Barriers To Successful Investing)

Averaging down in a falling stock is like lending money to your brother-in-law.

Your wife insists, so you write a check. Months later he needs more money. You may lend him more, but you surely must feel sad about watching that money going out, knowing you'll never see it again.

In the stock market, you have to quickly admit when you're plain wrong. If you can't do that, investing could become an expensive hobby for you. In growth investing, throwing good money after bad is never a good strategy.

Still, you must have heard this idea a hundred times from a hundred different people: If you buy a stock and it goes down, buy more. As you buy it cheaper, your average cost declines.

When the stock finally turns around and rises, you have more shares at a lower price than would have been the case if you had just frozen up and held your original position.

So what's wrong with this approach? Everything.

First of all, you're buying a stock that's falling. Wouldn't you rather be buying a rising star? Isn't that why you've been screening for that handful of potential winners?

Second, by averaging down, you'll end up with more shares of a loser than you had originally planned. Your portfolio could become dominated by bad stocks.

Perhaps worst of all, you'd be inviting disaster. And in the stock market, such invitations may well be answered.

The big assumption in averaging down is that the stock will, at some point, turn around. What if it doesn't? Your portfolio will be decimated, and you'll rue the day you ever started trading stocks.

To win in growth investing, add positions in stocks that are rising soon after their breakout. That's how a true leader acts. Averaging up in a rising stock gives you a chance to compound your gains.

Do some stocks never recover? Of course. Others may stay near their lows for years. Citigroup (C) topped out at 57 about four years ago 1. It had been a market leader and as solid a Wall Street name as it gets.

You know what happened. The stock crashed to 97 cents in March 2009 and is now wallowing just shy of $5. Do you still have shares of Yahoo (YHOO), another household name that peaked at 125.03 11 years ago? Yes, it was a fantastic winner in the past. But new bull markets usually feature new leaders.

In these and countless other examples, you'd do infinitely better to cut your loss to no worse than 8% from your buy price. If the stock turns around, you can get back in. If it doesn't, you'll have a far healthier portfolio and you'll still be able to sleep at night.

The Fallacy of Sunk Costs

By FPA member David Zuckerman, CFP®, CIMA®
Last Updated: November 19, 2012

Have you ever seen someone spend an inordinate amount of money on a carnival game in an effort to win an inexpensive prize? If you have, then you have seen the sunk cost fallacy in action. People will often spend a lot to win an inexpensive prize because the human mind is not inclined to rationally evaluate sunk costs. Participants often think that, if they don’t win the prize, the money they have spent on the game will have been “wasted,” and continue to play. This phenomenon flies in the face of traditional microeconomics, which holds that people act rationally and only allow future costs to affect decisions. Behavioral finance, on the other hand, blends the study of economics and psychology to offer important insight into the sunk cost fallacy.

Bias Against Admitting Failure

Investors fall victim to the sunk cost fallacy when they allow the purchase price of a stock to dictate when the stock is sold. The tendency of investors to sell winning stocks too early and hold onto losing stocks too long has been well documented. Many investors don’t consider a poorly performing investment a failure until they sell the stock and realize the loss, and as a result investors are much more likely to sell winning stocks than they are losing stocks. There are two main problems with this approach. The well documented “momentum effect” whereby stocks that have recently gained are likely to continue gaining for at least a short while, works against investors that sell winners. Additionally, holding losing stocks is very inefficient with regard to taxes because capital losses can be used to offset tax liabilities.

Worse yet, some investors try to turn a losing investment around by “throwing good money after bad,” which can have devastating consequences when they increase their position in a poorly performing stock that continues to fall. This is sometimes referred to as trying to “catch a falling knife.” Admitting failure isn’t easy, but sometimes it’s the least costly way out of a poor investment.

The Sports Fans’ Dilemma

One of the best examples of the sunk cost fallacy is provided by Richard Thaler, a pioneer in the field of behavioral economics.

Two avid sports fans plan to travel 40 miles to see a basketball game. One of them paid for his ticket; the other was on his way to purchase a ticket when he got one free from a friend. A blizzard is announced for the night of the game. Which of the two ticket holders is more likely to brave the blizzard to see the game?

You instinctively know the answer - the fan that paid for his ticket is more likely to brave the blizzard. A rational individual would not care whether or not the ticket had been purchased or received as a gift. It is only worth the expected enjoyment of attending the game minus the expected costs of bracing the storm. The ticket itself is a sunk cost because it can’t be returned, and that sunk cost should not enter into the decision to attend the game. The reality, however, is that not attending the game will be more emotionally difficult for the fan who paid for his ticket since he has to deal with the disappointment of not seeing the game as well as the sunk cost of the ticket. The mind has a tendency to classify such an outcome as a “double fail” that should be avoided, so the fan who paid for his ticket will be more likely to drive into the blizzard. With the proper perspective and discipline, however, the fan could instead ask, “Would I still drive into the blizzard if the ticket was free?”1

Know When to Fold ‘Em

One of the terms often used when people use sunk costs to justify irrational decisions is the poker term “pot committed.” People often say they are “pot committed” to fix something old, like a car, because they have high sunk costs that would go to waste if they “threw in the towel” and bought a newer car. In fact, only future costs should matter. Such a decision should only be based on expected future repair costs, utility derived from reliability, utility derived from pride of ownership, and replacement costs (minus depreciation).

Inexperienced poker players often think of themselves as “pot committed” if they have sunk a lot of chips into a pot and they continue to call future raises even if they have little or no chance of winning. On the other hand, experienced poker players understand that being “pot committed” has nothing to do with sunk costs. Instead they analyze the size of the pot, and will only feel “committed” to make a call when the pot is very large relative to the cost of the raise. The only factors that should matter are the cost of the bet, the odds of winning, and the size of the pot. It doesn’t matter where the money in the pot came from – whether the money is the bettor’s own money or from the bets of other players is irrelevant.

The sunk cost fallacy can adversely affect your investment returns if you are not careful. When you find yourself dwelling on the price you paid for an investment, ask yourself what you would do with the investment if it were gifted to you. The same perspective can be applied to cars or equipment in need of repair. And if you need help preventing sunk costs from affecting your personal finances, consider consulting a CERTIFIED FINANCIAL PLANNERTM from the Financial Planning Association with the experience and expertise necessary to guide you.

FPA member David Zuckerman, CFP®, CIMA®, is Principal and Chief Investment Officer at Zuckerman Capital Management, LLC in Los Angeles, CA. He serves as CFP Board Ambassador and Director at Large for the Los Angeles chapter of the Financial Planning Association.

I have noticed in the last year is that paid promoters are now paying individual/private iHub posters to promote the stocks they (the promoters) have been paid to promote...Unfortunately, I don't believe that most of these private promoters are accurately disclosing their payments

Due Diligence Definitions

1. General: Measure of prudence, responsibility, and diligence that is expected from, and ordinarily exercised by, a reasonable and prudent person under the circumstances.

2. Business: Duty of a firm's directors and officers to act prudently in evaluating associated risks in all transactions.

3. Investing: Duty of the investor to gather necessary information on actual or potential risks involved in an investment.

4. Negotiating: Duty of each party to confirm each other's expectations and understandings, and to independently verify the abilities of the other to fulfill the conditions and requirements of the agreement. Also called reasonable diligence.

Definition of 'Due Diligence - DD'

1. An investigation or audit of a potential investment. Due diligence serves to confirm all material facts in regards to a sale.

2. Generally, due diligence refers to the care a reasonable person should take before entering into an agreement or a transaction with another party.

Investopedia explains 'Due Diligence - DD'

1. Offers to purchase an asset are usually dependent on the results of due diligence analysis. This includes reviewing all financial records plus anything else deemed material to the sale. Sellers could also perform a due diligence analysis on the buyer. Items that may be considered are the buyer's ability to purchase, as well as other items that would affect the purchased entity or the seller after the sale has been completed.

2. Due diligence is a way of preventing unnecessary harm to either party involved in a transaction.

Due diligence is the routine process by which investors diligently investigate the entrepreneur and his/her company to confirm the authenticity of a business endeavor. This may entail researching business founders and their management team, reviewing documents, endless amount of questions, and asking for references. In a recent study conducted by the University of New Hampshire’s Center for Venture Research, angels who practiced increased due diligence received more overall profitable returns. Experience has also shown that without performing detailed research to verify an investment prospect, an investor is taking a significant risk.

What is Due Diligence?

Due diligence is used to investigate and evaluate a business opportunity. The term due diligence describes a general duty to exercise care in any transaction. As such, it spans investigation into all relevant aspects of the past, present, and predictable future of the business of a target company.

Why is Due Diligence Conducted?

There are many reasons for conducting due diligence, including the following:

* Confirmation that the business is what it appears to be;
* Identify potential "deal killer" defects in the target and avoid a bad business transaction;
* Gain information that will be useful for valuing assets, defining representations and warranties, and/or negotiating price concessions; and
* Verification that the transaction complies with investment or acquisition criteria.

In securities trading a trader is said to be under the influence of the fictional narcotic hopium when she/he finds themselves deeply in the negative on the wrong side of a trade. The trader will continue to hold the position in the hopes that the security will return to the value at which they acquired it. (eg. staying long in a stock position when the price continues to plummet)

Motivated reasoning is confirmation bias taken to the next level. Motivated reasoning leads people to confirm what they already believe, while ignoring contrary data. But it also drives people to develop elaborate rationalizations to justify holding beliefs that logic and evidence have shown to be wrong. Motivated reasoning responds defensively to contrary evidence, actively discrediting such evidence or its source without logical or evidentiary justification. Clearly, motivated reasoning is emotion driven. It seems to be assumed by social scientists that motivated reasoning is driven by a desire to avoid cognitive dissonance. Self-delusion, in other words, feels good, and that's what motivates people to vehemently defend obvious falsehoods.