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December, 2017:

Emotional Swings of Investing

As mentioned before, one of the hardest parts about investing is that sometimes, you’re going to do the work… determine the upside, analyse your risk, figure out the optimum investment size, and still lose. Repeatedly.

And it will suck. Statistically speaking, if you flop a coin 10,000 times in a row, you’re going to come up tails 8 times in a row at some point. And if you make enough plays, investments, whatever, eventually you’re going to go on a losing streak. And we are traditionally risk adverse creatures.

How to combat this? As much as we’re not going to like the answer, it’s the same as everything else. Practice. Our default monkey instincts were just not set up for math, or for finance in general. In fact, most of our “gut instincts” are, when it comes to finance, pretty much wrong. You can see it all the time in the stock market. In 2008, the Dow went to almost half of it’s early 2008 value.

Why wouldn’t it stop at, say, 25% down? That’s a good deal, right? The market is throwing a sale. “Buy low, sell high” right?

Wrong. Our monkey instincts are not built upon wisdom, they’re built on survival and procreation. Which essentially equates to fear and greed. When you open your portfolio statement and realize you lost 25% of your life savings in the last quarter, you’re not too likely to start asking the bank for a loan to invest even more. That’s the fear setting in… “Get out now before I lose the rest!”  So it ends up being “buy high, sell low”.

As you may (or probably don’t) know, I am an aspiring poker pro. Not only do I make money from it, it has also helped me grow as a person in innumerable ways. One of those ways is that it taught me how to lose. Repeatedly. Even when it’s at a much lower level, (I play games with $50 buy-ins), you get used to the feeling of losing streaks. Over time, it takes a lot more losses to start getting under your skin. (Notice how I’m not saying it doesn’t get under my skin at all anymore…) With time and practice, you can desensitize yourself to the negative emotions we experience when me take a hit.

I’m not saying that you need to start playing poker to train your mind, but odds are you do need something to instill that kind of mental toughness into you, because it’s not a standard feature of the human brain. Maybe it’s martial arts and a statistics class. Maybe it’s buddism. (REAL Study… not just telling your friends like most “buddhists”.) But you need to develop that mental toughness somehow…. you’ll be eaten alive without it.

And not only will it help you in your financial life, those skills will spill over into your personal life, too.  You’ll find you’ll become much better at keeping your cool in trivial situations that would have made you crazy earlier.  If you have the mental fortitude to forge on despite a 15% downswing in your portfolio (which IS going to happen at some point), you’re not very likely to go into a rage when someone cuts you off in traffic.  And when you smooth the edges off any  temper you may have and increase your ability to keep calm under fire, your relationships will automatically start to improve.

How long will it take for the American housing market to rebound?

Personally, I think you’ll be waiting a long time. There are many factors that contributed to the housing bubble in the United States in the first place, and most of those were temporary factors.

For example, interest rates are currently as low as they will go. The Federal Reserve has been on record as stating that they intend to keep these superlow interest rates around for at least a couple of years. But, even with the availability of all of this super cheap money, the housing market has failed to work its way back to where it was. At some point, interest rates are going to have to start to climb again. At which point, money will become more expensive to borrow.

Another factor in this equation is simple supply and demand. Back in the day when even a simple job like a customer service rep paid enough money to buy a house, there were many more people in the market. Demand was high. But now, most low-level information service, manufacturing, and most unskilled labor jobs that don’t require the work be done in the same country have been shipped overseas, where the price of labor is drastically lower.

Put yourself in the position of a business owner, but would you rather do? Would you rather pay 10 people in America $10 an hour plus benefits plus payroll tax to do a job that can be done in India by 13 people for one dollar an hour? So until America’s unskilled labor rates become competitive with the rest of the world, or transport costs skyrocket so much that it becomes more cost effective to hire locally, those jobs are never coming back. Realistically, can you envision a reality where Americans back a politician that wants to do away with the minimum wage that makes our unskilled labor market so uncompetitive?

On the other side, there may be a growing demand for housing away from oceans, as cities like New York and New Orleans find themselves in increasing danger of becoming Venice or even Atlantis down the road, and people start to move away from cities on faultlines like San Francisco, but we realistically have no idea when those issues will come to a head. On the time scale of 100 years down the road, real estate further inland will have a major driving force pushing up its prices as people move away from the coasts as water levels rise across the world.

But call me shortsighted, I don’t have a 100 year outlook on my investing.

Am I Lucky or Good?

One of the hidden pitfalls one can encounter in investing is that of overexuberance.

This happens in poker as well, albeit in a much smaller scale.  (Which is why I would recommend taking up the game to anyone serious about taking up active investing… you’ll learn many of the same lessons, but with far fewer zeros on the price tag.)

And I am not ashamed to say that I fell into myself during my early investing career.  Well, I am, but I’m going to tell you anyway, so that we can all learn something.

In both poker and investing, there are elements of luck.  Very big elements.   If you or I were to play only one hand of poker with the best player in the world, we have less than a 50/50 chance of winning, but it’s a lot better than 10%, too.  In fact, our chance of winning that hand are probably no worse than 35%.  And thus, it’s not just possible to win one hand, but it’s actually possible to win several hands in a row, even if we don’t have the slightest clue what we’re doing.

And when that happens, it can be very easy for us to tell ourselves that we know what we’re doing.  That we’re just natuarally talented.   Which would be complete malarky.    And make no mistake, that confusion between a lucky run and real skill can cost you a bundle.

About halfway through 2006, I had a great idea.  In November, the Playstation 3 would be released.  It had been several years since the last generation of video game consoles had come out, and thus it seemed quite reasonable that most users were putting off buying new games, so that they could save their money for the new console and the games that would come with that.   But that’s not the smart bit.  Do I know if games would be flying off the shelves?  No.   It might be a flop compared to analyst’s expectations.  Especially given the very high price of the system. ($600, if memory serves)

Here’s the smart bit.  While I know I don’t know whether or not there’s going to be enough sales to justify an upward move in the share price after the release date, I DO know that there will be a bunch of investors willing to take that bet.

So instead of buying video game maker stock a few days before the release date, I bought options (which multiply your risks and rewards) a few months before, and watched everyone else pile in, hoping to capitalize on all that pent-up demand.  And sold a few days before the system was due to be released.

Smart move, right?  Well, the reasoning was definitely sound.  I tripled my money in the space of 4-5 months.   But it did something else, too.  It made me think I was good.  And the fact that I won huge on that trade blinded my senses to some very, very, basic mistakes that I made that would end up murdering me later on.

First, I had put almost my entire savings into that single bet.  If I had just bought normal stocks and a plane had crashed into a building in NYC again, or ANYTHING came out that would have significantly hurt the company or the overall market, I would have lost a very significant portion of my whole nest egg.

Second, I compounded my first mistake by using options.    If something like 9/11 had happened in that 5 month time span instead of 2001, I would have lost EVERYTHING.  Every single dime.

Sure, my reasoning for making the bet was 100% sound.  But that’s only a tailwind pushing the sails.  The strongest wind at your back in the world won’t matter if a cannonball comes crashing through your boat.   And since I’m not an insider in the company, I would have no idea that there was any internal problem in the company until it was too late.  Bad press release comes out and bang, you’re broke.  Just like that.

But as it happened, planes didn’t crash into buildings.  That time.   For a 6 month time frame, something overwhelming is only going to happen 3-10% of the time, but if I had taken say 30 chances like that in the future, going double or nothing, I was essentially gauranteed to lose everything at some point.

And because I thought I was good, I didn’t spend much time examining my strategy for flaws.  So it let it ride, on another tailwind, that wasn’t as strong.    Then another.  Within 6 months, I had run a little over $50,000 into $500,000.   Life was good, I was God.

Then, a cannonball crashed through my boat.  Goldman Sachs took a 10% hit in one day.  Now if I was in normal stock, that would have left me 10% down.  Not fun, but not a big “Game Over” sign, either.  But these were options.   $500,000 became $250,000 overnight.

Needless to say, it was time to take everything off the table and re-consider what I was doing at that point.   It was then that I started to examine my technique, and not just find it lacking.  I picked up a couple of books on options trading and quickly realized that the concepts these guys were using were waaaaay over my head.  I had no business being in this game with the level of knowledge I currently possessed, which was essentially none.  Not just nothing in options, nothing in investing.    I had just been lucky up until that point, and that was messing with my ego.   And strictly speaking, I was still lucky, because if that drop had been 20%, I would have been dead broke.

That experience was a very valuable lesson for me.  It forced me to learn one of the most important concepts in investing, risk assessment.  It paved the way for me to invest in my education first and foremost.

I tell this story not to caution you against taking a risk and striking out into new territories.   I tell this story so that the experiences (mistakes) that guide your education will not be as expensive as mine.

Be humble.  Even when you win, look back at your performance and see what you could have done better.

 

Defeating Your Biases

In an earlier post, I had talked about how damaging our natural human cognitive biases and belief systems can be to our ability to make reasoned, rational extrapolations about the future.

Now, the question is, what can be done about it?

Carry as few desired outcomes as possible. 

It is well known fact that human beings tend not to question information that tells them what they want to hear, and tend to ignore/attack information that tells them what they don’t want to hear.

If you are a “Right to Life” sort of person, you’re not going to want to hear about the theory of how legalized abortion has led to a drop in crime rates.    Yes, there are rebuttals calling their findings into question.  And if you have a vested desire for “Right to Life”, odds are incredibly good that you’re going to side with them and dismiss the original hypothosis.  If you’re a strict “Right to Choose” person, odds are really good that you’re going to dismiss the rebuttals and go with the original research.

Both sets of belief systems would have  all the while neglecting a third, and very likely possibility:  Both sides are right…. the original research is somewhat flawed, making the correlation not nearly as big as advertised, but still statistically significant.

But if you had no vested interest in the first place, you would be free to read and understand every side of the argument without the need to dismiss relevant information presented by either side because of a need to defend your value system.

How does that effect your real world financial decision making?  Missed opportunities.

Say you were one of (most) people that were very, very angry that banks got bailouts.    People that are angry, by the very nature of anger, are not able to think calmly and rationally about whatever subject is pissing them off.

And that means those people were almost certainly not clear-headed enough to follow that set of circumstances to their logical conclusion:  If a bank that was in trouble got a financial backstop from the government, that means that the chances of it going bankrupt in the near term has become zero.

And since that was a very real risk of any bank that was in that kind of trouble, you can expect that it had a very depressed share price.  And when that risk is removed, you can expect a big jump in the price of that stock pretty much immediately after the announcement.  I used that piece of logic to pick up 30%-in-two-day jumps in both Citibank and Bank of Ireland with almost zero risk.   All because I quickly scan over business news once a day, and don’t have a desired outcome making me unable to accept certain realities.

What else can we do to limit our cognitive biases?  Stay tuned.

How Accurate is My Judgement When it Come to Finance?

Short story: Shit.

Long story:
As we’ve said before, one of the most important factors in investing is being able to assess how likely something is to happen. This can be applied to almost everything. From how likely the Celtics are to cover the spread to how likely America is to bomb (insert Muslim country here) to how likely you are to have to sleep on the couch when you forget your anniversary, everything can be reduced to odds given the information you have available.

But it’s also more complicated than that. Because your ability to assess risk or likelihoods is far from perfect. In fact, if you are just starting out, you probably stink at it.

Think of it for a statistical point of view: think of 10 things that you believe strongly… So strongly that you think they have a 90% chance of being true. Statistically speaking, one of them has to be wrong.

But it’s likely more. A lot more.  The above scenario neglects the fact that we as humans tend to not question information that tells us what we want to hear, and tend to ignore or attack information that tells us things that we don’t want to hear.  We add more weight to the information we here more often, and discounts information that we rarely or never hear.  Anecdotal evidence carries more weight than statistical because anecdotal evidence comes with a story that we can get emotionally invested in.

For example, do you happen to think that the world is getting more violent and angry?  You would be wrong. In fact, the world has never had it so good.  But one could not blame you for believing that. With the advent of 24-hour news networks that make money through advertising and get you to watch by showing you the most shocking thing they can come up with, it would be easy to believe that the world is descending into chaos.

And these biases and cognitive shortcomings mess with our ability to predict the future.

So how can we combat them?

I’ll leave that for another day, but just to be aware of them (and thus not take your conclusions as if they were carved by a god in stone) is a great start.  Just by knowing that we are less likely to take our own perceptions too seriously, or to find ourselves losing our compsure when faced with the differing perceptions of others.