They had already proved the validity of this course because when the Federal Reserve Board raised the discount rate early in their joint venture, their equity had declined substantially and then risen to a new high. Bill also had taken comfort in knowing from experience that traders who were undercapitalized were the ones who normally ran into trouble. If you took smaller positions and were well capitalized, you could ride out these countercyclical reactions. At the time, that's exactly what they did. As time elapsed, however, their opinion that commodity prices were headed significantly higher was reinforced by the markets' action and their own self-deception.
Bill still believed in the principle of small well-capitalized positions, but in practice he was not implementing such a policy. As so often happens in such cases, he decided to change tactics "temporarily" and take on some larger positions using the considerable equity that had built up in the account for margin deposit on which to leverage the account more heavily. In his mind, he had "resolved" to return to a more conservative approach, but right now he reasoned that this was the proverbial once-in-alifetime opportunity on which he should capitalize fully. Thus, not only was their success based on a false premise but also their euphoria caused them to toss out the rule book.
All trends come to an end, and this one was no exception. Because both Bill and Jack were so overconfident, they had become careless and lazy in their analysis. They had failed to look out for signs of a top. Interest rates, for one, were rising sharply. Margin requirements also were being raised for a substantial number of commodities on a regular basis because the authorities knew that a speculative bubble was in the making. Setbacks that would have sent both of them scurrying at the beginning of the venture now hardly fazed them. They had become used to dealing with big numbers and were immunized from the considerable volatility that had developed. They could "afford" to lose huge sums of money because they represented profits. Eventually, the surefire trend would bail them out, and they could sell during the next and final leg up.
That leg never came, and for the first time since the venture began, things started to go very badly. From our perspective, it would have been wise for them to have banked their profits and come back to the markets at a later time, but in their overconfident state they did not see the disaster awaiting them.
Even so, Bill began to show concern when they had lost about one third of their paper profits. Consequently, he suggested to Jack that they begin to bail out. Jack had always given Bill complete control over their joint account but had constantly made disparaging remarks about how "they" (i.e., other, smarter investors) always drove the market down before it took off to wean out the weaker sisters. This scenario had certainly seemed to be the case on the way up, and it had largely been Jack's correctly proven cynicism that had convinced Bill to maintain positions he would otherwise have mistakenly jettisoned.
It was therefore with some degree of apprehension that Bill approached Jack with the liquidation suggestion. You have to remember, though, that Bill was not a wealthy person; he had a small amount of equity in his mortgaged house. But this equity now represented only about 5% of his total net worth. The balance of his wealth rested in the joint account. On the other hand, the bulk of Jack's net worth was still in his other business ventures, even though his stake in the joint venture and his personal commodity account represented a considerable sum. As a result, Bill now began to consider the implications of what might happen if things went wrong. If you're going to panic, panic early, he reasoned.
When Bill first had approached Jack about liquidating the account, Jack had agreed although Bill felt that his partner wasn't totally convinced. Events soon proved the wisdom of abandoning ship, however, because the markets continued their downward course. Bill recounts how one morning the two of them were up at 4 A.M. on a conference call to their London broker unloading their aluminum, copper, and gold positions. By the time Bill arrived at his office about four hours later the bottom had fallen out of the market as everyone else had the same idea and the speculative bubble had burst. By the time, the whole episode ended the joint account had declined 65% from its peak level. But this figure was still up considerably from the original investment. Bill had made many mistakes, but luck and a good dose of fear had enabled him to survive to invest another day.
Jack had not been so lucky. His own account was now in worse shape than when they first met. If Jack was trading off the joint account and had basically hired Bill to piggyback on their joint experience, how could this be so? The answer: pride of opinion.
Jack's experience is a graphic example of why so many talented and successful self-made businessmen have problems when they become involved in the markets. First, they would never dream of entering a new business without first gaining some experience or hiring some expert in the field. To some extent Jack did this by setting up the joint account, but by not following Bill completely, Jack, in his own account, was in effect saying to himself that he knew better than his partner. A little pride of opinion crept into his thinking.
Second, Jack had a tremendous knack for anticipating when a market was going to take off, and this astute thinking had undoubtedly been a major reason for the success of the joint account. On the other hand, Jack also had a stubborn streak. This character trait had been of great help in his other business ventures because, in buying and selling companies, it enabled him to negotiate a far better deal. He could easily walk away from a deal until the other party agreed to come to terms. In the marketplace, this trait worked to his disadvantage because it meant that he held on stubbornly to several positions long after the joint account was liquidated. Jack was very good at getting into a situation but totally lacked the flexibility to get out of it when the numbers went against him. Pride of opinion was the principal reason his personal account ended up with a loss and the joint account with a profit.
Jack and Bill eventually went their own ways. Jack gave up speculation, concentrated on his other business interests, and achieved even higher levels of success. Bill continued to manage money but never again repeated the kind of risk taking that he had undergone with Jack.
This true story demonstrates that it is not easy to transfer the skills and abilities that have been learned during a lifetime of business activity to the field of investing without modification. Jack's uncanny knack for searching out good business deals helped him to sense when a market was going to take off, but the same stubborn streak that had been so helpful in getting a good deal tripped him up when prices were falling. He was able to assess when a person might cave in and meet his price, but the psychology of the market is quite different. Markets are not interested in making deals. They are totally independent of the needs or desires of one individual. Consequently, when that person permits the stubborn part of his character to take over, the market sees an opening and pounces on the unsuspecting investor to deliver a financially debilitating blow.
Jack's attitude also demonstrates that someone coming to the market after a long and successful business career is initially at a greater disadvantage than someone like Bill, who had experienced few successes in his relatively short career. This is because someone who has been successful will generally be a lot more confident. Confidence, optimism, and enthusiasm are good qualities for investors and traders to possess but only if they are accompanied by an equal dose of flexibility and thoughtfulness. Given time, if the businessperson can learn from his errors in the marketplace, the chances are that the talents that enabled him to succeed in the business arena will also serve him well in the markets.
The principal lesson to learn is that good traders or investors are always running scared. By this, I mean that they are always looking over their shoulder to see what new development might be affecting the markets. This does not mean that they are constantly being whipped in and out of the market, nor does it mean that they must take a pessimistic view. What it does mean is that they have learned that the moment they relax and feel that they have got everythin
g figured out they know very well that a new factor will come along to threaten their position. Their approach is not the hold-on-at-any-cost attitude engendered by pride of opinion. It is one of complete openness. The rationale is as follows, "Right now I think the market is going up, but if conditions unexpectedly change and I am lucky enough to spot it, I will change my view and liquidate."
Notice the contrasts between Jack's and Bill's attitudes. Jack's successful career had not conditioned him to run scared. He was in the business of buying failing enterprises and turning them around. Even if the economy deteriorated in a manner contrary to his beliefs, the cheap prices at which he was able to acquire the businesses combined with the productivity gains achieved through his management expertise more than offset a general reversal in business conditions. Dogmatism and pride of opinion therefore represented a small part of the equation.
Ways of Fighting Pride of Opinion
Pride of opinion implies a dogmatic outlook. The result is a failure to take corrective action when you perceive that original conditions have changed. The first step in countering this obstacle is to recognize that you actually have a problem. You should review unprofitable transactions and analyze the thinking that got you to that point. That you are willing to undergo this procedure is in itself a step forward. It not only implies that you recognize that you are capable of making mistakes but it also demonstrates that you wish to correct the causes.
The next step is to set up some safeguards to minimize the chances of falling into the same trap again. When you set up a trade or investment, don't ask yourself how much money you expect to make. Presumably, you believe the reward outweighs the risk, otherwise you wouldn't enter the market at all. Instead, ask yourself, What is the worst that is likely to happen under normal conditions? In other words, consider the risk before the potential reward. This process achieves two objectives. First, it sets out the risk-reward relationship. Second, it helps put you in the state of mind that recognizes ahead of time that you can make mistakes.
Assuming that you still go ahead, next determine what conditions are likely to cause you to exit the position. This step will depend on your own philosophical approach to the markets. If your sympathy lies in the technical area, it will involve establishing a support level, the violation of which would trigger a sale. On the other hand, an investor who concentrates more on fundamentals may regard a reversal in the prevailing trend of interest as his trigger point. The device and methodology are unimportant as long as the practitioner has confidence in the chosen vehicle and the approach has been historically accurate. If the practitioner does not have confidence in his investment or trading philosophy and is just paying lip service to it, the chances are good that he will take no action when the condition is triggered. As a result, the whole exercise will turn out to be a waste of time. The final requirement is a commitment to follow through once a preestablished condition has been satisfied.
We have already seen that lucky investors and traders often develop a sense of overconfidence after a successful trading campaign so that clear signs of a pending market top are arrogantly ignored. This is pride of opinion in a more subtle form. We need to remember that it is highly unlikely that anyone will ever consistently turn in super performances year after year. The faster the gains, the more likely they have resulted from the element of chance. A safeguard to prevent that kind of arrogance is to decide ahead of time that once a certain percentage gain has been achieved, some positions should be liquidated and the proceeds taken out of the account and placed in a money market fund or other relatively safe vehicle. This is a typical technique employed by commodity money-management firms. They know full well that when their portfolio managers make huge gains they become careless and arrogant, and so the management of these firms removes the money from the account as a kind of institutionalized defense mechanism. Some firms require their managers to stop trading altogether once a certain amount of gain has been achieved. The manager is then given a "holiday" and asked to come back after several weeks to begin trading again. Because he has to begin all over again psychologically, he thus becomes much more careful.
These same firms have rules that also force managers to close the account down temporarily once they lose a certain amount of money. This also has a purpose because it gives their traders time to ponder their mistakes. Often a written report is required in which the money manager on the losing account reviews his poor performance and tries to identify where he went wrong. After a cooling-off period in which the manager is able to recharge his batteries and find his mental equilibrium, he is allowed to return and continue trading his firm's money. These are sound money-management practices. There is no reason individual investors and traders themselves should not follow them.
5
Patience Is a
Profitable Virtue
Most investors and almost all traders and speculators enter the markets believing that they can accumulate profits very quickly. This expectation is fostered by prominent stories in the media featuring successful money managers and mutual funds or highlighting the riches awaiting us if we had only invested in a particular asset. Instant global communication and the rapid dissemination of news create the feeling that unless we act instantly we risk missing out on a major price move.
These attitudes mean that careful consideration and planning are shoved aside and replaced by impatience and impulsiveness. These temptations inevitably lead to situations where market participants attempt to run before they can walk. Under such circumstances, decisions are made in a manner that is the exact opposite of what was originally intended.
It is probably true that in no other business venture are the majority of participants so impatient for results as in the financial markets. Thoughts of individuals who struck it rich very quickly become the guiding force of many would-be investors who think that it will be quite simple for them to repeat the process. Thomas Gibson, who wrote The Facts about Speculation in 1923, had already considered this aspect of investing when he said, "The element of time can no more be eliminated from successful speculation than from any other business."
A major mistake made by most investors and traders is to try to call every market turn. This tactic has very little chance of success. Not only is there a tendency to lose perspective, but most of us operate in cycles, alternating between winning and losing streaks. In attempting to call every trend reversal, we invariably lose our objectivity and lose touch with the markets. It then becomes only a matter of time before we are pushed off balance psychologically. Trying to call every market turn also increases the temptation to act on impulse rather than fact. Decisions that are made infrequently are much more likely to be more thoughtful and reflective. Deliberation gives us a far greater chance of being successful than trying to call every twist and turn in the market.
Always remember: Even if a current opportunity is missed, there always will be another. The best investment decisions are made when the odds are in your favor. You increase those odds when you assess investment possibilities with a cold, indifferent eye and avoid the day-to-day clutter of the marketplace.
Staking Out Your Claim
The daily financial press and electronic media brim with specialists who are willing to offer an opinion at any time on any of the markets or stocks that they cover. Sally from Financial Daily calls up Harry, a commodities analyst, and asks for his opinion on cocoa, for example. Harry may have no firm opinion one way or the other on the cocoa market, but he volunteers his view anyway purely because he will obtain some profitable exposure in the paper for both him and his firm. Since. he has no strong facts to justify his opinion, the chances are good that his forecast will be inaccurate. Still, it will be held up as authoritative "expert opinion."
He would have served himself and everyone else much better had he politely declined the interview, adding that he would call Sally the next time he saw something of importance developing. Under these ground rules, Harry would choose the appropria
te time to put forward an informed opinion rather than an off-the-cuff one. This is how guerrilla warfare is successfully carried out. Guerrillas by definition are always outnumbered by the army they are fighting, so they have to even the odds by getting the enemy to come to them. They are the ones who chose the time and the place for battle. If they decided to fight every time they came into contact with the enemy, they would run the risk of an open battle where the army would have an overwhelming advantage.
The same principle applies to people who comment on market activity or who are actively involved as traders or investors. Guerrillas have patience, and so should market participants. The degree of patience involved will depend on the time horizon over which the investment or trade is being made. For a futures trader, patience may demand a wait of one or two weeks; for the one-day trader, it could mean four or five hours, and for a long-term, conservative investor, the time horizon could extend beyond a year. The amount of time is immaterial. The guiding principle is that you should have the patience to wait until all your ducks are in a row. It is difficult making money in the markets at the best of times so make sure that you-not the markets-decide when the time has come for trading or investing.
Long-term investors who base their investment decisions on fundamental analyses need to wait for the market to become undervalued. One useful valuation measure is the dividend yield on the Standard & Poor Composite Index. In this respect, Figure 5-1 shows that a dividend yield of 6% or greater has traditionally been a good low-risk entry point. For individuals sympathetic to the technical approach, a reading in the 12-month rate of change indicator below -25% would represent a similar benchmark. These entry points are shown in Figure 5-2.
Investment Psychology Explained Page 8
