Thinking Smarter

INTRODUCTION

This last essay in the “Financial Freedom” Series looks into the mind of the novice investor and dissects the mental traits that keep most from making good returns. It is about the daily mental interaction with the hustle and bustle of the information flow coming from the share market. We are our own worst enemy and the hardest aspect of investing is mastering our psychological and character weaknesses.

ARE YOU A BULL OR A BEAR?

People are natural born optimists or pessimists, bulls or bears. A bull is always enthusiastic and about the future direction of the market or their particular investment. Bears are naturally sceptical and negative about the future direction of the market or a particular investment. Markets are made through the interaction of these two sentiments. For every investor who buys into an investment believing it will rise, there is another who believes the share price will fall and wants to get out. Markets are in balance when bullishness and bearishness are equally weighted, prices rise when there are a few extra buyers, and fall when there are a few extra sellers. It’s as simple as that.

Extreme bullish sentiment starts to fall into the category of greed. Greed is that wonderful warm fuzzy feeling that gets you excited at the prospect of making a bucket full of money sometime soon. You do lots of ridiculous calculations in your head about your future wealth. You lose touch with reality and refuse to see any negatives. You have fallen blindly in love! Extreme bearishness is that gut-churning fear of losing huge amounts of capital really soon! It is the same feeling as when your house is on fire or you are about to have a car accident. Men tend to be more bullish while women tend to be more bearish, so listen to your wife and you will have a more balanced idea of what to do. Try to invest in the share market without being a bull or a bear. Try to remain emotionally neutral if you can. This is always hard because we are emotional beings. In late 1987 I had just sold the house I had built myself and was talked into buying shares in August. My “friend” sold managed investments that had doubled the previous year. I saw $$$$$ signs. I lost half my house in the next three months in the great crash that year. If I had only waited three months! When everyone is a bull then the top of the market is very close at hand. When everyone is an extreme bear then the market is usually about to take off.

To be a natural bull or a natural bear are both weaknesses. The best investors tend to have a little of each and will move into a bullish mood when the evidence justifies it, and vice-versa. They are also willing to change their mind quickly if new evidence comes up that is contrary to what they have been working with. This ability to quickly change your mind is the hardest thing on the planet to do so make sure you master it well. 

THE NEED FOR EXCITMENT

Don’t enter or exit an investment for the excitement. This is not so much of a problem with real estate, but is with stocks. Too many people do this without realising it, particularly younger people. If life seems boring and your internal need for excitement is unfulfilled then investing in the share market can seem to be the perfect solution. It can be the excitement you crave. Mistakes are inevitable with this type of subconscious need. It is identical to the need to play the poker machines or engage in extreme sports. There is a little thrill with every pull of the handle. It is gambling. Those who enter the share market out of a need for excitement are gamblers. Deal with the psychological need first, get your thrills from skydiving or some other sport. Do not start investing in the share market until you have dealt with this problem. You must learn the art of enjoying your investment as it boringly earns you a sedate capital gain year after year, with the occasional setback.

THE VALUE OF PATIENCE

The greatest emotional asset of any investor is patience. Don’t try to become successful too quickly. Learn with small steps and small amounts of money. The market will bring you ample profits if you are happy to take a 10 to 20 year view. If you want to be rich in a year, you are almost guaranteed to fail as an investor. Once you have bought into a company you can very quickly become impatient, waiting for the price to appreciate or for anticipated company developments to occur. It is my experience that company developments nearly always take longer than expected. After six months of watching a share price track sideways an investor can often sell up in frustration, especially if they watch the charts daily. As long as management is moving forward toward their goals, stick with the company. The bulls will find it eventually.

SEEING THE INVISIBLE

Have you ever noticed that you see hundreds of cars identical to yours in the week after you proudly purchased it! Have you wondered why you didn’t see any of them a month before you bought your car. This is a fascinating psychological trait that we all have. I call it “new car syndrome”. The mind sees what it is trained to see. It is almost as if we all live in slightly different parallel worlds as we are all trained to see slightly different aspects of reality! The same process happens with investing in real estate or the share market. You spend your whole life driving past homes that you cannot see value in. Once you do some homework and train your brain, you start to see undervalued properties frequently. It is the same with share investments. Once trained, your brain will see the bargain of a lifetime about once a month. You won’t have to grab the first thing that comes up. You will calmly know that there will be many more investment fish swimming past in the next little while.

TAKING PROFITS TOO EARLY

Human nature loves to lock in small profits. For some reason it feels good to lock in that 10% profit and eliminate the fear that it could reverse into a loss. Much pleasure is generated from the feeling of having made an initial profit. The profit takes all the risk out of the exercise and reduces stress. This is the sign that you are a novice investor and don’t really trust your own research. You should know what the true worth of the business is going to be at the end of your mental time-frame for the investment, which should be a year or two or three, or sometimes five. You should be confident enough to hold till those targets are reached, and to keep holding if the story gets even better. So make sure you let your profits run until you see clear signs of distribution. Distribution can occur in several ways. First, the volume and price picks up for several months and are both rising unsustainably. The shape of the chart starts to flatten after a parabolic rise. This occurs when the larger holders of the company begin to unload to smaller and more ignorant armatures in the heat of a general market top. This is the time to sell, not before. Second, Strong hands sell to the weak but the sheer volume of their selling turns the share chart into a huge dome shape which can take months to form. When you see these chart patterns after several large annual gains, along with a maturing of their product in the market then it is time to say goodbye.

TAKING LOSSES TOO LATE

Human nature also hates accepting failure and loss. We make all sorts of excuses to justify why we made decisions that were wrong. If you don’t believe me, just ask those closest to you about some of your dumb decisions and watch your justifications spill out! When it comes to the share market most people who are new to the game let a small loss slide further and further from their buy price hoping that it will turn around and bail them out. The pain of closing the deal is too great. If they keep the shares then there is still a powerful but irrational hope that things will turn around. The losses then get bigger and bigger and their discomfort becomes an all-pervasive irrational fear. This bigger loss becomes a huge embarrassment to their pride, but as long as they haven’t sold there is still hope. Many novice investors will keep the losing investment with the following justification: “It is only a loss if I sell it. Maybe one day it will come good, and when it does, I’ll sell when I get my money back”. To be honest, not taking a loss on the chin is a sign of pride. You are shrinking your capital and missing out on other potentially profitable investments. Time becomes your enemy, instead of your friend. The key to avoiding this human weakness is to have a mental stop-loss locked in at around 10 or 20% when you first buy the shares. This way you can lick your wounds and live with a small loss instead of seeing your entire capital base destroyed. Capital preservation comes before capital gain. If I had kept to this rule in my early days it would have saved me and my marriage enormous heartache.

DON’T COUNT YOUR PROFITS UNTIL YOU SELL

Many investors have the habit of counting their investment chickens before they hatch. Modern internet brokering accounts allow you to visually see the value of your investments at the click of a button or app. I remember chatting with a friend in the lunch room about a mining company both of us had shares in. It had gone ballistic in the previous few days. A sceptical fellow worker burst our greed balloon with the comment that there is no such thing as easy money. How right she was! Because the profits had come quickly and easily, we both became greedy for more and, when it turned, we were not mentally ready to sell the investment. We lost all our profits and some.

Selling is one of the hardest parts to investing. If you sell and it goes up further, you feel like you are losing money when in fact you have made money. You actually feel lousy after having made a good profit because you think you could have made more. That’s greed right there! If you don’t sell and the price starts to drop after a large run-up you feel like you are losing real money when in fact they were just paper profits. The best time to sell is when you absolutely don’t want to sell. This is usually when the share price has been on a scream and you have just made a bucket full of money, the chart has gone into a steep ascent and every day brings in a new all-time high. Every bone in your body will crave the adrenaline of another day or two like what you have been experiencing. This is the exact time to sell and it is the hardest thing to do. It is like weaning a drug addict off cocaine. I will talk more about the selling process in the essay series titled “Financial Markets”.

BEWARE OF THE BUY PRICE

The price you paid for your shares creates a very powerful and dangerous mental “line in the sand” that can adversely effect future holding decisions. No one else cares what you paid for the shares, but to you it is a crucial indicator of success or failure. Future selling decisions often come down to an analysis of how far the price has moved up or down from your buy price. Sell decisions should firstly be made on the basis of where the company is heading in the future, not what you paid for it in the past. It matters little what you paid for the shares. It only matters where the company is now and where it is heading as a business and as a share price. It is always messy getting in and out. I never seem to be able to get the best price when buying and the next day or week it could be drifting down still further. I have learnt to accept these messy first few days or weeks. As long as my mental stop-loss is not triggered and the company is strong, then let time do its work. Then as the price begins to pull away from where you bought, that price should become irrelevant to all future decision making. When it is time to make the sell decision it should be based entirely on the situation at the time.

MENTAL LIMITATIONS

Often newer investors have self-imposed limitations on what they believe a reasonable return is. This is usually based on the investment fund manager’s mantra that average share market returns range up to about 0-20% pa. This figure is based on what the market index does in the average year. But you are not buying the index. You should be buying a smart company that is operating in a fast growing sector or in a booming industry. I began running my superannuation fund with these low-ball expectations because no one had ever told me you could actually do better than this. I quickly discovered life in the share market was very different to what the typical financial press tells you. It is a fact that you will only ever achieve what you expect in life. Share investments are no different. If you expect fund manager type returns then you will get them. If you expect and aim toward 50% returns per year then you will probably get there after a few years of research and learning. If you fear losing money then you will have miserable losses. After a year of running my superannuation fund I lifted my expectations considerably and I have never looked back. My annual rate of return has been 47%% compounded over 13 years, That period includes the global financial crisis which lopped off nearly $1 million in value from our investments and a three year bear market in gold.

For the first three years of my rejuvenated investment career from 2003 to 2006 I actually expected a return of around 100%. For the first three years I achieved my goal. However, because of this self-imposed limitation of 100% per annum I sold 320,000 shares in a rising mining stock for a 100% profit at 78c in 2005. I had made my 100% profit, it felt great taking it. The shares then went on to top out at $3.40 in 2006. If I had not sold the shares would have created $1 million dollars of wealth by doing nothing! Your brain determines your investing speed limits. So find out if there are any mental speed bumps in your brain stopping you achieving a higher return for you efforts.

CRYING OVER SPILT MILK

This brings me to the next psychological problem with investing. We all have a tendency to bemoan the investment “fish” that got away. No one will ever catch every great investment at the perfect price and sell at the perfect moment. With the benefit of hindsight we would all be Billionaires. The movie “Back To The Future Two” made that point very well. Investments take place in real time with real cash through the application of limited knowledge and wisdom looking into an uncertain future. The short version of that sentence is: It’s a risk. Investment profits that could have been yours with the benefit of hindsight simply form part of the bank of knowledge and wisdom you take into your future decisions. Like all professions it takes time to become an expert at investing. If you constantly look backwards at the profits that could have been made then you will never be able to see the profits that are still coming. I live in Queensland. Locals here often bemoan the fact that they didn’t make real estate investments in the year 2000, because the state has boomed since then and so have prices. But they will be saying the same thing in ten years time about today’s opportunities and these same people are not out there buying right now. Why? Because hindsight makes it all look so easy. Investments take place in the real world and are often filled with emotion. Be future focused, not sad for lost opportunities.

MICRO-MANAGING

Proud parents of a new child are utterly fascinated by every movement and utterance shown by the new bundle of human life. Before becoming a parent these same people yawned with boredom at the rapt attention other new parents displayed toward their new bubs. Becoming a new owner of shares in a company is a similar emotional process to childbirth. Previous to becoming an owner you were rather bored by the whole affair when others talked up their investing adventures. Now you are an owner you are reading everything you can get your hands on for that company and industry. You check the share price every few hours while at work and you can talk of little else around the water cooler. This is a natural but dangerous process. Most people would make better investors if they only spent a few hours a week in research and checking their charts instead of becoming obsessed with every nuance of the market.

In this era of the internet the temptation to micro-manage is huge, and so is the market for products to cater for this urge. I personally only check the markets for about 10-20 minutes a day. Most of my time is actually spent looking at the geo-political issues that drive the large macro-movements in world markets. This is a never-ending source of fascination to me, and it helps me pick up trends very early, often a year or more in advance. It also helps me decide on where the best sectors for investment are. In the end though, the decisions you make to invest in a certain company should be made after careful research and plenty of thought. The better the investment decision the less it needs daily monitoring. Micro-managing could be a sign that you don’t have confidence in the decision you have just made. You will become very emotional and prone to panic selling on the slightest hic-up.

DON’T CHASE THE HERD

Humans are heard animals. We hate being wrong in a crowd and we hate making decisions that will not seem right to our peers. Peer pressure also exists in the share market. People invest in fads because “everyone is making money in this company, you can’t lose.” When the market is rising steeply then we all jump in, get caught at the top, then hang on all the way down and bail out near the bottom.

To be a good investor you have to develop a contrarian mindset. You have to buy your “straw hats” in winter and “gumboot”s in a drought when no-one wants them. The best investments are made when a company is emerging from its price winter into its price spring. The first buds have appeared but the full blossoming is yet to occur. If you can buy when a company is in this season of its development you will be buying truly on good research because there will be no other reason why you would have found out about it. Your friends won’t be talking about it and the press won’t have that company in the weekend paper. In fact, when a company makes it to the front page of the financial press it is a near perfect signal to sell! Lord Rothschild, the famous European banker, is said to have once made the comment to “buy when there’s blood on the streets”. I wouldn’t go quite that far but you get the idea. It feels strange to buy when no-one else is and it feels very strange selling when everyone else is buying in. However hard it feels, this skill must be mastered.

DON’T DAY-TRADE

Let me put this idea in story form: A person enters a city park with a dog. The person releases the dog. The dog enthusiastically darts to and fro, sniffing out new scents and marking territory all over the park. As you move through the park, the dog is aware of your position and keeps roughly within a certain distance from you. But as you leave the park through the far gate the dog is right beside you, ready to go back onto the lead.

You are the person. The dog is the investment. Releasing the dog is the act of buying the shares. The share price moves in a seemingly random pattern over the short term. However, the further through the investment park you go the more you start to see patterns to the movement of the share price. When you finally sell the investment, on the far side of the “park” the price is very close to where you want it to be.

Long term investing is the process of entering on one side of the park and exiting that park on the far side. Day trading, derivatives trading, options trading, futures trading and the host of other fancy methods of short term trading are like trying to predict the movement of the dog over the next 10 seconds. The shorter the timeframe to an investment, the higher the chances of random processes taking over. It is no accident or surprise to find that roughly 80% of the people that trade in these markets lose money, like I did! Some 10% of people struggle along making small profits and losses. Only the professional 10%, who have made these markets their life’s passion, make most of the profits. Steer clear of the temptation to day trade and trade exotic market indexes or strange sounding derivative instruments with no actual business behind them. You are simply taking bets on the movement of indexes.

Short term trading is mostly conducted by young men. Women are usually too sensible for this type of thing! It is financially related to the psychology of powerful cars. There is often an air of ego in the prevailing attitude of day-traders and a lot of people engage in short term trading for the sub-conscious need for excitement and competition. As young men often borrow to finance their vehicles, so with many types of short term trading there is a large amount of financial leverage. This magnifies the gains and losses. Money can emerge quickly in large quantities doing this type of “investing”, and just as quickly evaporate. This is the gambling fringe of the investment scene.

In my experience with futures trading in the 1990’s I turned $20,000 into $10,000 before I figured out the system. I then turned that last figure into $30,000 thanks to the 1997 Asian financial crisis. We then moved to Queensland and, in my naivety, I thought I had this futures trading thing by the neck. I thought I could trade for a living. Big mistake! The financial pressure of having to perform created a state of emotional weakness from which lots of trading losses emerged. After six months, I went back to teaching but kept trading. After twelve months, we were financially devastated.

One of the most powerful lessons you can learn from my futures trading debacle is the value of time. Short term trading tries to circumvent that crucial dimension of investing. When you have done your research and made a sound investment decision, whether it be in shares, property or a business, then time becomes your friend. The further through time you travel the more valuable your assets become. Short term trading is an attempt to override or sidestep the need for time to work its magic. Patience is one of the investor’s greatest assets. Let the dog run the park, just head for the gate and it will find you.

FINAL THOUGHTS

Let me finish up this essay with a few summary thoughts on investing psychology taken from “Money Masters of Our Time” by John Train who interviewed and analysed the investment methods of a number of famous American investors.

  1. You must have a strong but controlled desire to succeed at investing
  2. You must have patience
  3. You must think independently from the crowd
  4. You must have the security and confidence that comes from knowledge
  5. You must be flexible and able to admit you’re wrong
  6. You must stay in your circle of competence
  7. You must never invest on inside information
  8. You must learn to read company accounts
  9. You must preserve your capital, if you don’t thoroughly know the facts, don’t invest
  10. You must correctly size up the supply and demand equation in the market, it’s been working for thousands of years

WHERE TO FROM HERE?

This essay brings us to the end of this series on “Financial Freedom”. I trust you have enjoyed learning about yourself and found out why you behave the way you do in this all-important area of the psychology of investing. The “Financial Markets” series of essays logically follows. Never forget though that the series you are exiting is the more important of the two. If you cannot master your own animal spirits then all the practical information in the world will be of little use.

The “Financial Market” essays that follow will take you through the more practical aspects of investing such as inflation, market cycles, how to buy and sell, market moods and how to value companies. I trust they will be helpful to you.