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Yesterday I wrote an article about JetBlue (NASDAQ:JBLU) and AMR Corporation (AMR) and by the number and type of comments I received, it was clear people are interested in what is going on with American Airlines. Since the bankruptcy filing I have ramped up my research on AMR and well as the other airlines (which brought me to short JetBlue yesterday).

AMR is a classic example of why "risk aversion" must be avoided at all costs. Risk aversion is so powerful and so controlling, it is one of the leading causes of why so many fail as traders and investors. Risk aversion is a concept under a broader theory of "behavior finance." Understanding behavior finance as well as risk aversion is paramount to becoming a better investor. There are many really good books on the subject and I have read quite a few of them. The last book that covered the subject in several different ways, and is the last one I have read, is titled "Trading On Target" by Adrienne Toghraie. You can read my book review here.

In another non-airline industry article I wrote about the dangers of allowing emotion to play a part in investment decisions. Surprisingly, many actually wrote comments defending emotion as a useful tool in making choices with money. The evidence I have read makes it very clear, it's a quick and effective method to lose money.

By now if you have not already set aside time into learning what risk aversion is, you are likely to want to know what I am talking about. Here is a very simple (and slightly extreme) example to demonstrate the concept:

Let's say you own XYZ corporation which happens to be a penny stock and you invested $500 in about three years ago and you basically forgot about it. Along comes today and looking through my articles like you do every day (an author can hope, right?), and come across my latest XYZ write up about how they may have cured the common cold and the stock is now worth $100,000 from the buyout offer they have on the table. Stockholders including yourself are given a choice. You can sell your shares now for $100,000 and pocket the gains, OR you can wait for the final FDA approval on the drug. You find that in the next study, the drug has a 50/50 chance of two possibilities. Possibility one is the drug actually makes colds worse and if so the company will have to file for bankruptcy as they are out of money. Possibility two is that the drug actually does cure the common cold and "Dead Cold Pharma" will be willing to buy your shares for $220,000. Ask yourself what you would do in this situation. The math geeks like me quickly come up with an answer that is mathematically correct but still may not be the path taken.

The correct answer is you SHOULD hold out for the results and try to get the $220,000 because the payoff is greater to hold. By holding and waiting, the payoff is $110,000 which is greater than the $100,000 offered by selling now ($220,000 / 50% chance equals $110,000). Some people (especially those who put a higher lifestyle change value on $100K over those who don't) will say "yeah, I understand I am losing $10,000 by taking the "bird in the hand," but I place a value on being able to sleep."

The same can be said about not selling a losing stock position. The avoidance of loss makes people say (raise your hand if you ever said any of these), "I will hold out until it gets back to even," "I will buy some more and average my cost basis" (often followed by the getting back to even statement), It can't go any lower because (insert self justification reason here), "This is a good long term hold" (after you bought it without a written plan to do so), "after this or that it will move back higher."

Looking at AMR we can see on October 3rd, 2011, AMR made it loud and clear things were not flying smoothly. Over 76 million shares traded hands and the company ended the day with a much smaller capitalization. In the following days, AMR stock did move higher to retrace much of what was lost in late September and the beginning of October, but as it did, it often ended the day lower than the opening price. A stock that opens with a gap higher and closes higher compared to the day before BUT closes lower than the open is screaming "retail buyers, professional sellers." Usually, the professionals win these types of contests, especially if they happen to win many times in a short period as can be seen in the AMR charts.

How do you prevent or at least mitigate risk aversion? Sorry there is no quick sure fire fix for all and I will explain why. But some can prevent it, and almost all can mitigate it to various degrees with little effort. The first and most important tool is to use a written investment plan. Like so many things in life, if you fail in your planning, you are planning to fail.

Here is a good starting point, but far from complete:

You must write down first the reasons why an investment does not make sense for you (people tend to focus on how much can be made and give little to zero thought on how much can be lost). This also helps with "confirmation bias" which I write about often and is another portfolio killer.

Write down the reasons why an investment does make sense for you.

Talk to your financial planner about your ideas and ask him/her what you are missing and how you can lose in ways you haven't thought about (getting another person's thoughts to help take emotion out of the equation). After still believing you want to move forward, write down the rules of entry (what price, timing in relation to earnings, regulatory announcements etc.)

Write down the rules of exit (is this short term, long term investment, and regardless, what will trigger an exit. This could be a stop loss, stop gain, event like beating/missing guidance, but the rules MUST be written down). Sometimes people will say to me "Robert, I don't know when I will want to sell," or "it's too complicated to write it all down." To which I always reply "if you can't break it down into simple rules when you're not in the investment with zero emotion attached, how can you possibly figure it out in the heat of battle." If you can't figure out the rules of exit, you haven't given the investment enough thought. Oh, and "it's a long term retirement holding" doesn't cut it. Things change (Enron, Worldcom, Lehman Brothers, etc.) you need a written plan.

This brings us directly back to AMR and one quick look at the charts says it all. I have a second grader and if I ask him to look at the AMR chart and tell me what way the price is going, even he can tell you. I have spent massive amounts of time with AMR just as so many others have. Every time I run the numbers I still come up with the odds favoring the stock going lower from here (currently at $0.64 per share). Without reading hundreds of pages of documents, you can simply look at the AMR bonds and get a reasonably accurate picture of what the stock is worth.

It appears unsecured bond holders are going to take a haircut in excess of 85%. Many of the secured bond holders are going to feel the cold wind blowing across their heads after the haircuts they are taking as well. The only bonds that appear to still be without loss are the first liens and newer aircraft bonds. If your bond is backed by MD-80s it may be a good idea to google "uses for old MD-80 aircraft for around the home" to see what type of value they may have if AMR walks away from the older aircraft completely.

How does looking at bond prices tell us what we already can see by a look at the stock chart? We know that if the bond holders have claims, the shareholders will more than likely get totally wiped out. With AMR stock trading about $0.64 it makes no difference what price you paid for it. The past is done and the only important thing to decide is "what are the odds of making money holding on vs. the odds of letting go?" I believe the odds favor the strategy of selling AMR short which means I would sell my shares if I owned any. Also, I believe the current price is a total gift that should be taken while offered. Any day the NYSE can delist the shares. It is my experience that shares delisted fall 30% or more within the first week on the pink sheets. After that it is usually a quick pace to zero (or near zero).

Even with some type of government (state or federal) bailout, I have not been able to put together a scenario where the shareholders will end up with any value. In fact, a government bailout (which I don't believe is likely) will likely mean LESS not more of a chance for shareholders to receive anything at the end.

Short sellers of stock are what I consider the "smart money" on Wall St. Shorting is generally done by relatively advanced market participants, using relatively advanced strategies, with relatively well reasoned and very thorough analysis of a company. This compares to the average retail trader who may or may not know who the board members are, much less the deep sub-surface movements in the markets and finances of a company. Yesterday, once again, AMR was on the NYSE SHO Threshold Securities list. Stocks don't make it on this list because all is going well. The reason stocks end up on this list is that so many short sellers want to short the stock that borrows run out and fail to deliver pile up. Short sellers don't get it right all the time, but they get it right so often that paying attention to what they are doing pays off.

For some selling now before the end of the year will mean a tax write off (obviously consult a tax advisor) of some or all of your loss. Because capital losses often have limits that can be used against earned income per year (perhaps $3,000, but check), if you have a loss that can't be fully taken in one year, you will likely want to start the process as soon as possible.

I can already read some of the comments that will come so let me add in "what can I do if I refuse to sell?" If you really want to hold shares because "so and so said we may get out of this at a much better price later," than you can look at options? The bankruptcy is likely to last at least a year and even if the shares get delisted, they will likely trade for a while. The February $1 strike call options are trading for about $0.06 cents each with an implied volatility number that is off the map at 173% (still somewhat cheap mathematically indicating few believe it's going to trade in the money). Also, May $1 calls are going for about $0.10 each.

Due to the cheapness of the call options, if someone wanted to buy a "lotto ticket" with AMR one could buy the May $1 call for about $0.10 each with the thought of dumping into any kind of news spike in the share price. This of course is not much different than many chain letter Ponzi schemes we get in our mailbox once in a while or throwing money down on the pass line at a craps table.

Lastly, the only other option choice would be to buy protection against further decline in share price. It will not come cheap though. Everyone is looking to mitigate loss or capitalize on an expected loss in share price. You can buy February $0.50 put options for about $0.16 each. If the shares go to zero by the expiration date in February (February 17th), you can collect a gain of $0.34 each. I put trading options as a distant second to selling the shares. Remember that risk avoidance is emotion trying to override logic in financial decisions. It's also usually wrong.

I use a proprietary blend of technical analysis, financial crowd behavior and fundamentals in my short-term trades, and while not totally the same in longer swing trades to investments, the concepts used are similar. You may want to use this article as a starting point of your own research with your financial planner.

Source: AMR Corporation And Avoiding Risk Aversion Losses