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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.

 

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