Investors Magical Thinking

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I have a friend named Ben (Magician Ben) who seemingly possessed unearthly wisdom together with emotional fortitude sufficient to resist Facebook’s (FB) IPO hype onslaught back in May, 2012.

Instead of rushing to buy some of the more than half a billion shares trading on that first day at a price anywhere between $38 – $45 (USD), Magician Ben waited on the sidelines, biding time. And during the next three months he continued to wait and to watch as FB’s market price plummeted. As of September 4, 2012, the stock had shed about 60% of its initial value, closing at $17.73 (USD).

The next day, Ben had a feeling that now was the time to get into the game. Acting on intuition, on a hunch that FB had hitched itself to a shining light hovering not far above Bethlehem, he bought $50,000 worth of shares at little more than $18 (USD) a piece. Then he hurried back to the sidelines where he resumed waiting.

More than four years later, seeing that FB was trading above $130 (USD), Ben considered whether to hold or pull the sell trigger. Calculating that his investment had now risen eight-fold, he was pleased to see that selling his shares would net serious money, even after paying capital gains tax.

Yet, Magician Ben wanted more. He wanted FB to make him a multi-millionaire, an after tax multi-millionaire, a thank you-very-much-Mark Zuckerberg-for-allowing-me-to-retire-early-multi-millionaire. His head bobbing about among dream clouds, convinced that FB had been anointed chosen stock of the 21st century, Ben made his decision. His gut told him to hold, that FB’s ascension had a ways to go. There would be no gun smoke that day.

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Magical Thinking

Ahh, magical thinking. Arriving at conclusions based on little more than … thin air, fantasy, delusion. Regardless of the investment merits of FB (and any other investment for that matter) what’s concerning is that Magician Ben’s genius lay in little more than wishing upon a star.

Okay, you say, but so what? The fact is that Magician Ben called it right. Just look at the results! Given FB’s impressive run, isn’t it fair to say that his crystal ball is the real deal, that genius may be extrapolated from his prescient sixth sense, that his forecasts will continue to be accurate and Magician Ben’s dream will come true?

Not exactly. Gain or loss does not prove whether the decision to invest was ‘right’ or ‘wrong’. Rather, the usefulness of the rear view mirror is limited to showing how an investment fared. In the long run, if Magician Ben is to manage a successful portfolio, if his stable of stocks are to produce more winners than losers, he will need more than intuition to form the basis of his decision-making.

 

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All About Process

Investing is far from an exact science. It’s an art form. It always has been and will remain an art form, meaning that it is interpretive, allowing ample room for differing approaches and paths to success.

Even Magician Ben’s wishful thinking approach qualifies within the investing art’s broad parameters. However, although it is easy to implement and commonly employed, reliance on intuition alone, without any substantive support, is foolhardy and ultimately doomed to fail.

Consistently successful investors rely on a process for choosing securities. Within the framework of an investment process, the investor starts with an idea that, on the surface, appears to be an opportunity.

Then research is conducted, far beyond the writings of an analyst tout, crowd jubilance or a popular media outlet in the business of attracting reader eyeballs through loud promotion. The process is relied upon for as long as the investor holds a particular security, guiding the investor through to the time of sale.

Knowing that a closed mind is a dangerous mind, the investor gathers and analyzes objective facts and remains open to evaluating all relevant information. Regardless of what kind of securities market analysis is utilized (i.e., technical, fundamental, macro, behavioural) or what type of investor you profess to be (i.e., growth, value, income, contrarian, momentum), information should include that which does not support preconceived theories or biased feelings.

Tellingly, investing legend George Soros (he of the many, many billions) is known to review and reflect upon at least one contrary opinion before deciding whether to proceed with an investment.

So, would anything change for Magician Ben if he was diligent and relied on a rigorous process when investing? Well, the frustrating answer is … maybe. Since there is no perfect investment process, one that generates profit from every investment, the best an investor can do is stack the odds in their favor.


Investor’s Oath

Every stock market investor experiences loss. Without exception. Not once or twice but many times. Loss is part and parcel of the game. That said, successful investors win more than lose. They do so by staying disciplined.

They consistently execute their process, knowing that sticking to their road map reduces, or even eliminates, poor decision-making and ill-informed trading. Through strict adherence to the process, through honoring the Investor’s Oath, i.e., thou shalt do minimal harm to thy portfolio, the investor increases the odds of success.

Because the portfolio will suffer losers, a well thought out process plans for the inevitable. It prepares for loss by deciding beforehand when to fold. While this knowledge is essential, it is only a first step. The second and crucial step involves staying disciplined, selling at a pre-determined price.

Such a plan might look something like this: when a stock is down fifteen percent from purchase price, it is automatically sold thereby rendering magical thinking impotent. By letting go of hopes and dreams that a losing stock will rebound, by accepting loss and moving forward before the possibility of market carnage sets retirement plans back a few years, the winning investor limits downside and juices the odds that total portfolio gain will outweigh loss.


Running Interference

Investment process, comprehensive research, objective decision-making, discipline, all of these are essential to the winning investors playbook. And what would help even more would be an entirely rational mind, one divorced from errant thinking and destructive emotion.

However, investors are human too. Knowing this, and knowing that even superstar investors get sidetracked, winning investors study their own behavior so as to minimize the effect, or prevent the occurrence, of one or more of the following obstacles to success:

  1. Optimism. Under most circumstances, optimism is considered to be a positive trait. However, it may become troublesome for investors when it leads to an unrealistically rosy view of themselves and the future.
  1. Overconfidence. Often stemming from the illusion of knowledge, and overlapping with optimism, over-confident investors may fail to realize that their knowledge is limited, tend to chase returns, and underestimate risk.
  1. Anchoring. After forming an opinion based on limited information, the investor is not willing to change that opinion regardless of new information.

Anchoring inhibits the investor from searching for evidence contrary to their opinion and even if found, this evidence is often dismissed.

It causes an investor to stick with a losing investment or not buy a fundamentally strong company because, for example, they have determined that its price/earnings ratio is too high or are irrationally attached to some other numeric metric that does not meet arbitrary criteria.

Ambiguity. Investors prefer certainty. Unfortunately, the stock market is not in the business of offering certainty.

To compensate for lack of conviction in decision-making, an investor will seek expedient authority (i.e., media, experts) supportive of their position instead of taking the initiative to dig deeper on the research end.

  1. Herding. We are programmed to feel that the consensus view is the correct view. As a result, most of us are hard wired to follow the herd. Big mistake. You have heard it umpteen times: the crowd buys high and sells low, thinks like a lemming and is prone to falling off a cliff. As an investor, having the strength to break from, or not blindly follow, the crowd will serve you well.

Did I Mention Having A Process?

Today, FB is trading above $150 (USD). The higher the stock price goes, the more Magician Ben believes it’s ascent is never ending. Maybe Ben will be right. Probably not. And he’s a fool for at least not taking some of his enormous profit off the table by selling some of his shares.

But such is human nature when greed comes in to play. Risk is underestimated, or even ignored. And 9 times out of 10, Magician Ben will get burned by his delusional overconfidence. Maybe not with FB, given that many tech stocks are rocketing to the moon just now.

Then again, stocks are notorious for running out of fuel and, in turn, conforming  to the laws of gravity. And this is why an investment process would serve Magician Ben well in the long run. Because all magic carpet rides eventually come to an end.


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Enter Buddha

Greed is an effort to stuff yourself with something: be it money, sex, power or food. Greed is the fear of inner emptiness. One is afraid of being empty so one strives to possess more and more things. One wants to go on stuffing things inside so one may forget one’s emptiness.

With less greed, there will be fewer possessions, and more joy, more music, more dance, more love. People may not have many gadgets but they will be more alive. As long as we relentlessly accumulate gadgets, the soul goes on disappearing.