Getting Out When The Going Is Good

“There are two fools in every market: one asks too little, one asks too much.” – Russian Proverb

I was talking to my brother-in-law, RF, about stocks this afternoon. He was telling me about the beating he took in the market and his attempts to bring his portfolio up to the surface again. I was saying that, in my view, the smartest thing investors could learn from this recent history was that you shouldn’t invest in a business because of its prospects. You must invest in what it already has. (This is actually a rather big and important investment idea. We’ll get back to it another day.)

The other big lesson investors should have learned, I told him, was to cut losses. We all make bad investments from time to time. The secret to surviving them is to get out quick and with as much of your original investment intact as possible.

RF agreed with me — but that’s not what he did.

In principle, it’s easy to understand the reason to use a stop-loss order — but in practice, it’s hard to do. Getting out of a bad investment means admitting to yourself that you were wrong. That’s tough. Tougher still is giving up all chances that the business will somehow reassert itself.

You don’t want to give up. But sometimes you should.

I told RF that I had read about studies showing that a disciplined approach to buying and selling stocks — buying them for a consistent reason and selling them when they perform badly — is the most important factor when investing in the stock market. Yet few investors do that.

“It’s the same with businesses,” I observed. And then I told him something I’ve told you many times before. When I think back to all the businesses I’ve launched — and there have been hundreds of them (I’m counting individual publications as separate businesses, as they should be) — I can think of few or no cases in which a business that ended up good started out poorly. “From what I’ve seen,” I said, “you know right away if the business is going to work. The good ones start out strong. The bad ones either bomb or — worse — start out just OK.”

“That is so right!” RF said. He talked about the jewelry stores he has started for his business, which sells middle-level jewelry to consumers in shopping malls. “Our million-dollar stores start out as million-dollar stores. Our $600,000 stores never reach a million.”

He told me stories of so-so starts that he poured his heart and soul into, hoping to make them pick up and go. In most cases, nothing good happened. In rare cases, the business improved — but never significantly.

“That is exactly what I’ve been telling my ETRs,” I told him. “It’s interesting to hear that this principle applies to the retail business as well.”

“In fact,” RF continued, “it’s gotten to the point where I can tell in the first week whether a new store should be promoted or closed. Trouble is, we have five-year leases. So we can’t close them even when we know we should.”

I suggested various ways to overcome that problem but came up with nothing RF thought might work.

Then I asked him about another pet theory I’ve shared with you: the parallel notion that really good employees start off really good and mediocre employees, regardless of how much time and attention you give them, stay more or less mediocre.

“True again!” he said. And then he told me about some trouble he was having with a store manager and how it was apparent to him from the very first week that this person was not going to be able to make things work. Here, again, he had a problem cutting his losses. His partners did not all share his assessment, and his “human-resources” director was giving everyone the impression that firing people was nearly illegal.

“Sounds to me,” I said, “like you’ve got an upward-managing manager (see Message #327, ‘Inward vs. Outward Business Management’) and a personnel director who wants to be noticed.”

RF’s jewelry business is a good one. He and his partners have gone from selling plated chains in flea markets to operating 16 stores in malls all across the country. They started out making barely enough to support the four guys who were doing everything and are now employing more than a hundred families.

They have succeeded by hard work, persistence, and learning from their mistakes. Two of the more common mistakes — investing too long in poor-performing businesses and hanging on to less-than-stellar employees — they really don’t want to make again. But leases and regulations make that difficult.

But “difficult” is not “impossible.” And understanding these two mistakes is a big accomplishment and a great place from which to take the next step.

How does (or will) this apply to your business?