We just can’t sell our losers! Some will actually buy more shares to average down the cost basis. Why is that? If sticking your index finger into an outlet resulted in an uncomfortable shock would you then try it with your other fingers?  After you dipped your hand in water?

Market psychology can turn an astute investor into Moe, Larry or Curley. So the question that is so critical is how do we take emotion out of our investment decisions? When we take a position in the stock market we have made a decision; we own it. When it turns south we take an emotional hit; was I wrong? We have a tendency to believe that the choice was the correct one and the price will recover. Most investors also tend to underestimate the financial hit a loser can cause and once that loss becomes substantial there is little to recover.

Can You Sell a Loser?

According to a research report published in 1998 by behavioral-finance professor Terrance Odean of the University of California, Berkeley, retail investors are 50% more likely to sell a winner than a loser despite the fact that the sold stocks continue to outperform those that were held. This trait is characteristic of many mutual fund managers, real estate investment trusts and some hedge fund managers as well. Perhaps that’s one of the reasons that most actively managed mutual funds underperform the market benchmark. There is actually a new emerging science called neuroeconomics which combines the techniques of neuroscience with theories from psychology and economics to study financial behavior.

So the battle continues: human nature versus maximum investment success. To achieve the latter we must have a structured investment plan in place. The first question we should ask ourselves is “would I buy this stock today given the information available?” If the answer is no why not trade the laggard in for a great-performer? Another way to put it is “Is the cash invested in the laggard better off where it is or in a healthier financial soldier?” These questions, as simple as they appear on the surface, will lead us to better investing and maximizing our returns as we shut the door on emotion. Furthermore, when we unwind a loser we can use the losses to offset up to $3,000 of ordinary income on our tax returns (speak with your financial advisor).

What is a structured plan as it relates to the BCI Methodology?

We have a set of rules and guidelines for both stock and option selection as well as position management. We select only the greatest performing stocks in the greatest performing industries factoring in common sense parameters like earnings reports. We evaluate market conditions and equity technicals to dictate strike selection. After executing our trades, we manage our positions by being PREPARED with a series of exit strategies that will both mitigate losses and maximize gains. Selling a loser is something that I have struggled with (in the past) and most of you as well. Whether you subscribe to the BCI methodology or have another system of investing I hope we can all agree that taking emotion out of our investment approach will benefit us all and help guide us to becoming CEOs of our own money and ultimately financially independent. A structured plan must be in place.

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COUPON DISCOUNT for Alan Ellman’s Encyclopedia for Covered Call Writing ends Monday:

We are offering  a discount of $5 + FREE SHIPPING for Alan’s newest book: Alan Ellman’s Encyclopedia for Covered Call Writing. The total discount will be $8.75  GOOD UNTIL October 31st, 2011. Premium members are ALSO entitled to your everyday premium discount (***enter the Blue Collar store from the premium site). Be sure to enter coupon code “book3″.

Here is the link to the Blue Collar store:

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Market tone:

This past week’s economic reports were mixed but more positive than negative and took a backseat to encouraging progress on Europe’s sovereign debt crisis:

  • GDP rose at an annual rate of 2.46% during the 3rd quarter calming fears of another recession
  • Consumer confidence fell in October to the lowest level since March of 2009
  • Consumer spending was surprisingly strong in September rising 0.6%
  • Residential homes sales fell 0.9% in September but sales of new homes posted a better than anticipated gain of 5.7%
  • Orders for durable manufactured goods fell by 0.8% in September BUT when we take out orders for aircraft durable goods orders actually rose by 1.7%
  • Wages, salaries and benefits to civilian employees grew by 0.3% in the 3rd quarter

For the week, the S&P 500 rose by 3.8% for a year-to-date return of 3.9% including dividends.

Technically, this has been an encouraging few weeks. Viewing 6-month charts of the S&P 500 we see the market benchmark breaking through resistance and the CBOE Volatility Index (VIX) dropping below 30 for the first time in a while. See the two charts below:

The S&P 500 breaks above resistance

The VIX dips under the 30 level

The favorable economic reports and news on the European debt crisis along with the technical confirmation is exciting and encouraging. There are trillions of dollars on the stock market sidelines waiting to boost this market to greater heights but a large percentage of retail and institutional investors are hesitant to jump in. One of the issues that you may be hearing about in the near future relates to the lack of adequate liquidity for the institutional investors impacting their bid-ask spreads and pricing opportunities. We also must keep an eye on global issues taking a turn for the worse. That seems to be of more concern than our own economy. In my humble opinion, it is still premature to plan the party for a new, explosive bull market but I like what I see of late.

Summary:

IBD: Market in a confirmed uptrend.

BCI: Cautiously bullish but starting to integrate a small percentage of out-of-the-money strikes into my covered call portfolio.

My very best to our wonderful BCI community,

Alan ([email protected])