Why Do Investors Lose Money?

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12 Jul Why Do Investors Lose Money?

Let me start off today with this passage from novelist W. Somerset Maugham.

There was a merchant in Bagdad who sent his servant to market to buy provisions and in a little while the servant came back, white and trembling, and said, Master, just now when I was in the marketplace I was jostled by a woman in the crowd and when I turned I saw it was Death that jostled me.

She looked at me and made a threatening gesture, now, lend me your horse, and I will ride away from this city and avoid my fate.  I will go to Samarra and there Death will not find me.

The merchant lent him his horse, and the servant mounted it, and he dug his spurs in its flanks and as fast as the horse could gallop he went.

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Then the merchant went down to the marketplace and he saw me standing in the crowd and he came to me and said, Why did you make a threating getsture to my servant when you saw him this morning?

That was not a threatening gesture, I said, it was only a start of surprise. I was astonished to see him in Bagdad, for I had an appointment with him tonight in Samarra.

 
Tell me where I am going to die

First published in 1933, I am always fascinated to read and reread Appointment in Samarra. The image Maugham paints is simple yet haunting. Yet, behind the literacy genius lies a very important and often overlooked lesson.

If we know where Death is waiting for us, all we have to do is to stay far away. In that way, our longevity is assured.

Charlie Munger often remarks – Tell me where I am going to die and I will not go there. He was not talking about physical death but rather the mistakes investors make. In other words, if we know exactly what our mistakes are and we do everything we can do avoid them, then success becomes inevitable.

All too often we read and think about what we must do to become better investors. Rather than thinking about what we must become in order to be successful in the markets, I challenge you today to do the exact opposite and think about what we must NOT become in order to be successful.

So what exactly are the mistakes investors make?

The Lottery Mindset: Investors, Gambling and the Stock Market

lottery mindset 2Dr Fong Wai Mun of NUS Business School summed up his 2014 book of the above title succinctly with the following line –

This book is about how investors reduce their wealth through suboptimal investing strategies.

 
This is a book about behavioural finance, about decision making. This is a book about mistakes, about the fallibility of the human mind.

Within the tome, he shares scholarly research about how human beings choose what information to consume, how the information is processed and the eventual outcome that arises. Unfortunately as many studies have shown, we fail to behave like rational creatures most of the time.

In general, our investing decisions are shaped by the following four factors – Preferences,  Mental Heuristics, Beliefs,and Emotions

Preferences

We all exhibit our own preferences. Our choices are what makes us human. They are what makes us unique as individuals. Yet within investors, the choices that we make are very similar as a whole.

For example, we tend to exhibit the familiarity preference. When a choice is to be made, we tend to gravitate towards the familiar. Many investors own stocks of the company they work for, or stocks within the industry they are in.

Investors also invest in their home country without realising that diversification across borders actually has a positive effect on long term performance. Familiarity is comforting but definitely not profitable.

We also prefer lottery type stocks – companies that holds the promise of many fold returns attract investors more than companies with staid businesses and regular prospects even when the latter is almost guaranteed to generate stable returns over the long run.

Research over the decades have also indicated that investors prefer to hold concentrated portfolios. The consensus is that investors tend to have four to six counters in their portfolio and this preference is not limited to retail investors, but professional money managers as well.

While holding a concentrated portfolio might be seen by many as a road to riches, more often than not it is a surefire way to ruins. There are few free lunches in the investing world and diversification is definitely one of them. Sadly, few are to realise it.

Heuristics

A heuristic is mental shortcut we use to approach a problem. It is a quick and easy way to process information and to arrive at a conclusion. Remember the time when you drove past the scene of a horrific car crash and immediately started driving slowly and more consciously after? Or why you feel particularly angsty taking an aeroplane after reading and watching clips about the airplane that had fire pouring out of its wings.

That is the availability heuristic at work. Events that are more impactful and recent are more ‘available’. We judge them to be more likely to happen versus events that are not so recently etched in our memory.

The availability heuristic is the reason why investors tend to sell out and stay out after the market crashes, exactly when they should be buying for maximum profits. It is also the reason why investors choose to pile on more stocks when the market makes new highs. The memory of new highs is very ‘available’. Buying high and selling low is definitely not a sound investing strategy.

Beliefs

As investors, we are also prone to biased beliefs, the most common of which is overconfidence. Research has shown that we tend to exaggerate the precision of our knowledge, think that we are better than the average person in knowledge and skills and also think that we have better control over external events.

This overconfidence leads to flawed decision making when it comes to investing. We build more concentrated portfolios, buy and sell more than we should. We underestimate the risk we are taking and we become even more overconfident after making some gains from the market.

Bearing this in mind, the more competent and mature an investor is, the less confident he is about the markets. Conversely, the more confidence an investor exhibits, the more pain he is setting himself up for.

Emotions

Traditional economic theories assume that people make decision solely to maximise their utility. If everyone is rational, the only thing that matters is final wealth. Nothing else will come in between.

The truth is furthest away from that. In reality, investors care about their gain and loss episodes as much, if not more than their final wealth. The incident of gaining ten dollars and then losing five (for a net gain of $5) is not the same for investors who make a gain of $5 outright.

Investors dislike losses almost up to twice that of gains. In other words, a loss will cause double the pain than a gain of a similar amount. This is the reason why we hang on to our losses when we are better off cutting losses.

And with gains and losses comes greed and fear. The incompetent investor would use these two emotional pillars as a drunkard would use a lamppost – for support rather than illumination. Buying decisions and selling decisions will be based on these emotional triggers.

greed and fear

The competent investor reacts entirely differently. He is above his own emotions. The levels of greed and fear illuminates and sheds light on what the market is doing. Rather he gauges and uses it to help in his investing decisions. No one else can put it across better than good old Warren Buffett –  Be greedy when others are fearful, be fearful when others are greedy.

A Long and Prosperous Investing Life

In short, to find success in the markets, an investor should not hold concentrated portfolios, buy high sell low, be overly confident and let emotions dictate his investments. If he can avoid these errors, he would be in a much better state than many.

By not going to where he will die, he will lead a long and prosperous investing life.

image: modewest, behavioural gap



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2 Comments
  • Tacomob
    Posted at 20:00h, 12 July Reply

    Hi Jon, great post.
    I love how you managed to condense the most significant reasons why we investors lose money in such a succinct manner. Others would have filled an entire book with it.
    Required reading, ingrained understanding, followed by conscientious attempts of avoidance for any serious investor.

    • Jon
      Posted at 10:42h, 14 July Reply

      Thanks TACOMOB,

      The thing about behavioural finance is that it cannot be ‘taught’, it must be ‘caught’. You have obviously caught it well!

      The challenge for us bloggers is in not writing to teach, but in writing for others to ‘catch’.

      I like to think of myself as throwing a ball with each article. Too fast and most people won’t bother catching. Too slow, they find it not challenging and move on to other things. It is a tricky balance.

      Let’s do lunch again soon!

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