Modern Investing

by David Schneider

  This attitude towards time horizons is a cardinal sign of true investors. Whereas gamblers and speculators are most interested in making money in a hurry, investors don't mind holding quality assets for an indefinite period. They actually wish for it.

  There is also the factor of immediate and predictable income. Speculators and gamblers might feel under substantial pressure to generate quick returns or immediate financial rewards, but true investors can wait for different payout scenarios that require longer waiting periods. Their livelihood is not dependent on any one single asset. They have money coming in from their day jobs, real estate portfolios, and other existing investments. Even gold and cash reserves give them a very comfortable financial and psychological advantage.

  Full-time gamblers and speculators, on the other hand, don't have that luxury. If they lose or can’t play, they don’t make money. The same goes for full-time day traders. If markets are closed, they can’t earn money. If they have a losing streak for several months, they will certainly feel the pressure. There is the additional factor of debt that needs to be repaid. Speculators tend to be leveraged, adding pressure to perform within a giving time. If they don’t, it’s game over.

  All this gives investors a structural edge and an enormous psychological advantage. They can afford to take better bets with higher chances of winning. These advantages which come at a cost, as we shall later see, give billionaire investors, such as Li Ka-Shing, or Carlos Slim Helú, the mental detachment necessary to cope with uncertain events or even occasional losses. They all follow the same patterns: buying real assets with great income potential with their own financial resources at a time that is very opportune to them. Li Ka-Shing bought real estate and industrial assets in Hong Kong after the British left and everybody believed that Hong Kong was doomed. Carlos Slim purchased prime industrial assets when Mexico experienced its worst recession in a century in 1982. These were all obvious bets, but with higher chances to pay out handsomely and a zero chance of bringing them down completely.

  To sum up, what we have learned in this chapter, there are three distinct understandings:

  Gambling is when you commit money to predicting the outcome of a certain event, the outcome of which is largely determined by chance. Speculating is when you try to predict the future, particularly price movement. In financial markets, that often means trying to anticipate other player’s reactions to particular events. Investing is foremost understanding and purchasing assets at advantageous prices that generate adequate returns and provide sufficient protection for the principal invested. The reactions of others are relevant, but not all-important.

  If the differences are clear, and the structural advantages of investing are obvious, why are so many market participants still gambling, rather than investing? Why is it that most participants make terrible bets, still accept terrible odds, and lose money more often than they actually win? Why don’t they just follow the examples of successful investors? The only logical explanation for explaining illogical decision-making and behavior must be found in individual psychology. We will find answers in the next chapter.

  CHAPTER 5

  WHY WE TURN INTO GAMBLERS

  “It's hard to walk away from a winning streak, even harder to leave the table when you're on a losing one.”

  —Cara Bertoia

  At the beginning of 2007, a wealthy banker asked his maid to come in on a weekend to help out with a social event that he was planning. To his surprise, the maid refused, because she was about to buy her fifth property that weekend. Yes, you read that right. Fifth.

  He asked her for more details about her wondrous adventure into real estate investing. What he learned astonished him; in her neighborhood, everybody was involved in the real estate game. Everything was easy, with no-money-down mortgage loans and simple paperwork. She gave him a quick crash course in subprime finance and house flipping. At the end of her lecture, she sheepishly admitted that she would be a millionaire on paper after this deal and that she was considering retirement.

  He thanked her and excused her. The moment the maid left, he made some calls. He immediately understood that something was amiss in the financial markets. He called his broker and ordered him to liquidate his stock portfolio over the following days.

  In July 2007, only a few months later, the hints of a pending financial disaster appeared when two Bear Stearns Asset Management’s flagship real estate subprime mortgage portfolios evaporated into thin air. Soon after, the bank itself collapsed. And, as we now know, that was just the beginning.

  How could this have happened? How could something so vast and catastrophic come to pass? What causes people to pour their money into “opportunities” that later turn out to be utterly disastrous, and obviously so, in hindsight? The answer, as always, lies in how humans think and interact.

  Market Prices

  One of the most interesting examples of psychology and investing converging is the peculiar significance of price quotations, and the dramatic psychological feedback loops these can cause. The very first stock exchange introduced ever-changing price quotations for the shares of the early joint stock companies. Today, electronic quotation boards have lost none of their ancestors’ power to mesmerize. They have been a never-ending source of psychological torment for generations of speculators, investors, CEOs, and economic policymakers.

  For many CEOs of publicly-listed companies, the power of their own company’s stock price quotation is so strong that they have it displayed at key locations within their offices for everyone to see. When Enron (the energy trading company that went bankrupt in 2001) opened its new HQ in Houston, Texas, their stock price quotations were strategically well-placed at the entire new facility—even in their elevators. “We were consumed by it,” remembers Amanda Martin Brock, ex-Enron executive. For Kenneth Lay (founder, chairman and CEO) and Jeffrey Skilling (former president, COO, and CEO), their share price quotations were the ultimate symbol of success and testament to their superior strategy.

  Prices impose themselves directly on our psyche. When market prices rise, we feel confirmed. When prices drop, we see it as a personal failure. If you’ve ever found yourself checking your phone for price quotes several times a day, even after trading hours and on the weekend, you’ll know what I’m talking about.

  Yet, it’s perfectly possible to be a successful entrepreneur and not worry about price quotations. Ask any private business owner whose company is not listed on public financial markets how they feel about the price fluctuations of their private businesses. They could not even give you a clear answer of what that price quotation actually may be, let alone the tiny daily fluctuations within it. They might have a general idea of how much they would be willing to sell their businesses for, but they could never pinpoint it with precision. They have a mental detachment that allows them to focus on matters that are relevant to their operations, rather than being continuously influenced by price quotations. The same counts for real estate holders. Once you have purchased a property and collected your first rental income, the price quotation for that property becomes irrelevant for many years.

  So, then, why the big fuss? What functions do prices have in economies and financial markets, and how do they relate to investing and gambling?

  Ideally, investing is a very rational process, free of emotional influences. Although stock prices may have nothing to do with the actual success of business, they are easily accessible and highly visible quantifications of market opinions. Even though on some level, everyone knows market prices are the result of a million variations that may have nothing to do with reality and the tangible world, they still fixate on price quotations as a meaningful reflection of their success. In other words, what we see here is a rational thought process being trumped by a subconscious desire for validation. And this is the root of a lot of investing behaviors that, in hindsight, make little sense.

  The Rational and the Not

  Nobel Prize winner Professor Daniel Kahneman of Princet
on University researched the human mind: how we make decisions and how we make mistakes. According to Kahneman, "If we think that we have reasons for what we believe, that is often a mistake. Our beliefs, wishes, and hopes are not always anchored in reasons." In his studies, Professor Kahneman and his late colleague Amos Tversky realized that we actually have two systems of thinking. With their research, they opened a new branch of economics called behavioral economics, and with it the sub-category of behavioral finance.

  What they described was a world where every one of our decisions and every judgment we make is a result of a battle in our mind—a battle between deep-rooted instincts that manifest themselves through our intuitions. We can compare this with psychoanalyst Sigmund Freud’s system of id (the deep, beastly, “reptilian” mind), ego (the subconscious), and superego (provider of moral standards by which the ego operates). In the case of investing, the id is in constant battle with the ego and superego. But whether we call it the “superego” or the “rational brain,” there is a part of the mind that you are aware of that is rational, intentional, and complex.

  Seth Godin, the famous marketing guru, refers to this as the “lizard brain.”19 It controls our intuitive reactions and many parts of our daily decision making. It has evolved over millions of years into a very powerful control mechanism. It is still present and deeply hidden within all of us, coordinating our most elementary body functions, reflexes, and instincts. Just ask a teenager how often their thoughts stray to sex and you’ll see a manifestation of the lizard-brain urge to reproduce. But a feeling tells me not to discriminate young teenage boys.

  When Ego Meets Money

  Excitement and instant financial rewards are all fine if it works out. The problem comes when we are put under pressure, and our intuitive system has to make critical decisions. Decisions that under normal circumstances should be given more time and processed by our rational system.

  According to Kahneman, "our thinking is riddled with systematic mistakes," known among psychologists as cognitive biases. The list has constantly grown in number since Daniel Kahneman and Amos Tversky first investigated them: “They make us spend impulsively and be overly influenced by what other people think. They affect our beliefs, our opinions, and our decisions, and we are not even aware it is happening.”20

  When it comes to money, we can immediately recognize some powerful human instincts, such as loss aversion, greed, and preference for immediate rewards. Add the investor’s itch (the constant need to be active because you might lose out), and you can see that we have a very interesting cocktail of powerful psychological forces that causes various forms of cognitive bias or “human misjudgment.” When it comes to making decisions regarding money, it seems that our lizard brain too often takes hold of us, and with some very dire consequences. It seems that we are genetically wired to gamble and speculate over rational, long-term investments.

  Gambling and speculating give us instant feedback and reward systems. It induces action that is much more stimulating to our lizard brains than anything else. We know from gambling that all players experience an endorphin rush. When our opioid system is sufficiently stimulated, the release of endorphins is a natural consequence and can lead to the feeling of “being high.” In the worst cases, it will even lead to strong forms of addiction. The reverse is also true. We do everything in our power to avoid pain, especially when it involves short-term pain.

  When it comes to gambling, we can all agree that any game of money is much more exciting when we have our results as soon as we have placed our bet. For example, betting on rising or falling oil futures today is much more exciting and financially rewarding than keeping a stock for more than five years.The rewards and pains of it are almost instant. It is not unusual for oil prices to fluctuate 3% up or down on any single day. If daily price fluctuations are too small—like in the case of currencies and some larger stocks—you can always lean on financial leverage, that can magnify any potential gains or losses. Add financial derivatives to the trading mix, and market players can easily make up to 10% in minutes rather than years.

  In contrast, real investing can be extremely boring. If you invest in either bonds, stocks, or real estate, from the perspective of an investor, it can take months before you get your first income in the form of rent, dividends, or interest. For some long-term investments, it can take years before the financial rewards pan out; i.e., when governments increase their tax and fee revenues from new train lines or airports that they have financed. There is no immediate financial reward. In some cases, the pain caused by the psychological torment of waiting can have a much stronger impact on our opioid system than facing immediate losses. Blaise Pascal, the aforementioned philosopher who gave us probability theory, sums it up in his famous quote, “All man’s miseries derive from not being able to sit quietly in a room alone.”

  Is greed good?

  We have developed a natural instinct towards greed. It is without boundaries, gender, or race. In the early days, survival meant having as much food as possible as quickly as possible.

  These days, we have plenty of food, but greed has not dissipated. Food has simply been replaced with money and power. Greed is often the main driver in a player’s decision making. Some might even argue that envy is the main driver behind greed. Nevertheless, Money is scarce for most of us, and it is still hard controlling an instinct developed over millions of years. Greed is also the force that pushes financial institutions and their henchmen to sell less than appropriate financial products to “gullible investors.” It is the force that makes gullible investors buy these products and make them jump on the bandwagon with total disregard for common sense, scrutiny, or the simplest form of due diligence. But, it’s not only greed that leads us into decisions that we might later regret.

  Fear of loss

  Loss aversion is a person’s tendency “to strongly prefer avoiding losses to acquiring gains.” According to Kahneman, we feel the pain of a loss much more than we feel the pleasure of a gain. Most studies suggest that losses are psychologically twice as powerful as gains. If you lose $10 today, you feel terrible. But, if you find $10 tomorrow, you will not be as pleased with your luck as someone who found the same amount without previously losing it. From your perspective, you’re not as lucky as the person who found $10, because you’ve already lost $10. This aversion to loss leads to risk aversion.

  A country that uniformly celebrates risk aversion is Japan. Their experiences with bubbles and economic stagnation have marked several generations of Japanese so much that they prefer to keep their cash stashed under mattresses, swearing never to return to financial markets. It might take several more generations to get it out of their collective system, but bankers and financiers are continually working on this, so that the “great forgetting” can finally set in. The great forgetting is a term popularized by Daniel Quinn referring to civilizations that are doomed to repeat the mistakes of the past.

  The Herd Instinct

  When it comes to the Japanese and the financial markets, there is another crucial example of a powerful cognitive bias called “social proof.” Social conformity is very strong in Japan and at times takes on very interesting and peculiar forms. But it’s not only the Japanese who display a strong form of social proof. We all have a herd instinct in us. We feel affirmed in our choice to buy when everyone else is buying and feel very uneasy holding our assets when everybody is selling. The herd instinct works as an amplifier for many other cognitive biases, particularly fear and greed. In a crowd, it's much more difficult to suppress the urges of greed or the shivers of fear that capture us all.

  The Rearview Mirror

  A classic human misjudgment when it comes to money and gambling is what is known in casino terms as gambler's fallacy: “the belief that the chances of something happening with a fixed probability become higher or lower as the process is repeated.” People who fall for it believe that past events affect the probability of something happening in the future. An example is w
hen a gambler at the roulette table bets his or her money on red simply because red hasn’t been drawn for multiple rounds. Casino operators happily publish their past plays of red and black occurrences or even and odd numbers for gamblers to see. Unfortunately, neither dice nor roulette balls have a memory and past patterns really mean nothing.

  For investors, speculators, and the entire industry, there is something similar to the gambler’s fallacy. It is what Warren Buffett calls the “looking into the rearview mirror” phenomenon. According to Buffett: “(...) investor's projected out into the future what they were seeing. That's their unshakable habit: looking into the rear-view mirror instead of through the windshield.” In other words, what market players have observed in the immediate past is automatically projected into the future. This applies not only to earnings and price forecasts but also to risk calculations and economic forecasts that rely on a similar set of data. This type of fallacy is so common within the professional community that it ensnares leading central banks and academia. It was this fallacy that led to the subprime crisis between 2007 and 2008; people assumed that because house prices had risen for a number of years, they would continue to rise.