Investment Psychology Explained

by Martin J Pring

Fourth, to achieve success in the markets, investors must be disciplined and patient. This advice sounds so simple, yet paradoxically it is difficult to practice. Discipline means constantly gathering new facts and sticking to your rules. This is easy to achieve over the short run but much more difficult to maintain. The only way is to work at it time and again until it becomes a habit.

  You know instinctively that jumping out of a speeding car will be hazardous to your health. Entering poorly reasoned trades when rules are cast aside can be just as devastating to your financial health. The difference is that you can easily perceive the danger from the speeding car, but the consequences of trading recklessly are less obvious. You can read this section through and through and agree with its every word, but it is unlikely that you will fear a trade executed contrary to your rules until you have experienced the pain of losing.

  All great traders and investors also possess patience. A predator waits patiently for its prey, and when the time is right and the odds are in its favor, the predator pounces, ready for the kill. Skilled market operators move in a similar fashion. They do not trade or invest purely for the sake of trading or because they need the money. No, they wait for the right time and circumstance and then take action.

  There is nothing mysterious in this. Let's consider an everyday example of planting vegetables. Gardeners know from experience that the optimum time to do this is in the spring. To plant in the summer would be too late and in the fall or winter no good at all. This is evident to us all. We know that to get the best results we have to be patient and wait until spring, when growing conditions are at their best. However badly we might want those vegetables, we know that it is pure madness to sow the seeds in the winter, because all chances of their survival will be lost.

  Ironically, the dangers in the marketplace are equally great but in this instance we rarely have the patience to wait, largely because we are unaware of the dangers of getting in at the wrong time. If we were, then as rational beings, we would wait until the right moment just as we would wait for spring. That we are unaware of the dangers of impatience distinguishes us from the market wizards. They know and understand the dangers, the rest of us do not.

  Fifth, all great market operators are realists. Once you have entered a position whether as a trade or investment there is always the temptation when things go wrong to delude yourself that everything is still okay. This self-delusion is far less pronounced and even nonexistent in successful market participants. They are quick to recognize when conditions change and the original reason for holding the position no longer exists. They are married to nothing and are not afraid to admit a mistake, however painful it may be at the time. In doing so, they recognize that to hold on will result in even greater pain down the road. This means that they religiously follow the rule to "cut your losses short." Most of us are afraid to admit to ourselves when an investment turns sour. We cling to the false hope that things will get better, rarely asking ourselves, "If I had the money right now, would I still want to be invested in XYZ Company?" Even when we ask that question, we can always find a mountain of excuses for holding on to the position-the coming ex-dividend date, the brokerage costs involved in getting out. The list goes on.

  In Money Masters, John Train quotes Paul Cabot, "the dean of Boston's institutional investors," as saying, "First you have to get all the facts and then you've got to face the facts . . . not pipe dreams." He continues, "There is no way to be a realist unless you've experienced the many facets of reality, which means having attained a certain age. . . . The older you get the more you've had a chance to see how often there's a slip between the cup and the lip."

  Sixth, all successful market operators seem to have the ability to think ahead and figure out what may lie ahead. This does not imply that they have a sixth sense that is unavailable to the rest of us; it is more a talent for mentally rehearsing some of the alternative scenarios. Most of us assume that the current conditions and therefore the prevailing trend in market prices will continue ad infinitum. The truly great market virtuosi on the other hand are constantly looking ahead to anticipate what could cause the prevailing trend to reverse. It is not so much that they are smarter than the rest of us or that they are clairvoyant. Rather, they have trained themselves to question the status quo constantly and to anticipate a possible change of course.

  This training is a form of mental rehearsal for the next event. All possible scenarios are examined and the unlikely ones discarded. Then, when a change in conditions begins to take place, they are able to roll with the punches and take advantage of them. In effect, by trying to maintain a flexible outlook, the successful market operator is far less susceptible to the element of surprise.

  A Sampling of Market Wizards, Their Philosophies, and Their Rules for Success

  Successful traders and investors share basically similar characteristics. I have treated these case studies individually because their time frames and methodologies are so different. I have chosen but five studies from many possible examples. I selected these people because they have all publicly given us the benefit of their approaches and philosophies in a lucid manner. For that we should be grateful.

  Investors

  Warren Buffet

  In The Money Masters, John Train refers to Warren Buffet as "the investor's investor." It is a title well earned. A $10,000 investment in Buffet's original partnership in 1956 would have grown to $300,000 by the time it was dissolved in 1969. In that year, he dissolved the partnership to concentrate on other investments, most notably his controlling interest in Berkshire Hathaway, which was originally a textile company but later became a holding company. The price of shares in that corporation have appreciated from $38 in 1971 to $9,000 in the early 1990s.

  Apart from his talent for accumulating wealth, one of Buffet's outstanding attributes is his interest in educating his shareholders. His annual remarks to shareholders of Berkshire Hathaway are legendary. He also used to write to the shareholders of the original partnership. Every year he communicated the following:

  I cannot promise results to partners, but I can and do promise this:

  a) Our investments will be chosen on the basis of value, not popularity.

  b) Our patterns of operation will attempt to reduce permanent capital loss (not short-term quotational loss) to a minimum.

  In this missive, Buffet was telling his shareholders that he was a value player and contrarian as well as a long-term investor. Preservation of capital was uppermost in his mind as the principal investment objective.

  One important attribute of a successful investor is to stay away from the markets when conditions are not conducive to his chosen approach. In 1969, when cheap stocks were difficult to find and speculation was running rampant, Buffet wrote to his partners:

  I am out of step with present conditions. . . . On one point, however, I am clear. I will not abandon a previous approach whose logic I understand even though it may mean forgoing large, and apparently easy profits, to embrace an approach which I don't fully understand, have not practiced successfully, and which possibly could lead to substantial permanent loss of capital.

  These remarks are most revealing since they indicate Buffet's intention to stick to the rules that had made him successful and that he understood. He could have made money by playing the speculative game but decided against that, because he knew that he might not have been able to get out when things went wrong. Again, he was unwilling to risk his partners' capital. The remarks also demonstrate a willingness to weather the storm and patiently wait for the bargains that appear once the speculative flurry is over, dragging both sound and unsound companies down with it.

  Buffet lists six qualities that he believes are necessary for investment success:

  1. You must be animated by controlled greed and fascinated by the investment process. He believes that too much greed will control you but that too little will fail to motivate you.

  2. You must have patience. His time frame is much longer tha
n the average investor. He believes that you should buy into a company because you want to own it permanently, not because you think its stock will go up in price. His belief is that if you are right about the company and buy it at a sensible price, you will eventually see your stock appreciate.

  3. Think independently. He believes that if you don't know enough to make your own decisions, you should not make any decisions at all. He also quotes Benjamin Graham (the father of fundamental analysis) "The fact that other people disagree with you makes you neither right nor wrong. You will be right if your facts and reasoning are correct."

  4. You must have the security and self-confidence that comes from knowledge, without being rash or headstrong. In effect, he is telling us that if we do not have confidence in our decisions because they have been poorly thought out, we are likely to be spooked as soon as the price goes against us.

  5. Accept it when you don't know something.

  6. Be flexible as to the types of businesses you buy, but never pay more than they are worth.

  Buffet also told Train that there are 11 characteristics of a healthy business. This list is somewhat out of the scope of this book, but it is worth mentioning because of its significance. Buffet says a good business:

  1. Offers a good return on capital.

  2. Sees its profits in cash.

  3. Is understandable.

  4. Has a strong franchise and thus freedom to price.

  5. Doesn't require a genius to run it.

  6. Delivers predictable earnings.

  7. Should not be a natural target for regulation.

  8. Should have low inventories and a high turnover of assets.

  9. Should have owner-oriented management.

  10. Offers a high rate of return on the total of inventories plus physical plant.

  11. Is a royalty on the growth of others and requires little capital itself.

  John Templeton

  John Templeton's claim to investment fame comes largely from the success of his Templeton Growth Fund, which grew twentyfold between 1958 and 1978. Counting reinvestment of all distributions, it ranked as the top performing fund during this period. This marks the pinnacle of his achievements, but there are other highlights before and since then.

  One of his unique and admirable characteristics among money masters is his establishment of an endowment that annually awards a prize for progress in religion. He likens spiritual growth to gardening-if you find a weed you get rid of it, and you do the same for a bad thought or emotion.

  His philosophy is based on the premise that you buy only what is being thrown away and hold on for an average of four years. He recommends that investors search among many markets for the companies selling for the smallest fraction of their true worth. These stocks, he argues, can be found only in companies that are completely neglected, that analysts and other investors do not even consider following.

  As I have pointed out, one of the keys to successful investing is retaining your objectivity. One way to accomplish this is to cut yourself off from street gossip and unwanted solicitations from your broker. John Templeton lives in the Bahamas and instructs brokers not to telephone him but to send him in writing what they think he would like to see. In The Money Masters, John Train tells us, "The distance from [Templeton's] large, cool, porticoed white house . . . to the roar and shouting of the floor of the stock exchange is measured in psychological light-years. The house itself and everything in it are a silent reproach to excitement and hyperactivity."

  Flexibility is another talent that Templeton shares with other great investors. He was a pioneer in the global marketplace, choosing to invest in an undervalued Japanese equity market long before global investing became a household game.

  An additional quality possessed by most successful investors is consistency. For example, Fundscope placed the Templeton Growth Fund in the top 20 out of a total of 400 organizations in making money in bull markets but in the top 5 for not losing it in bear markets. This performance is even more impressive because many of the competing funds also held bonds, which are less susceptible than equities to down markets.

  Examining the lifestyles, beliefs, and investment philosophies of successful investors other than Buffet and Templeton reveals that patience, flexibility, and hard work are irreplaceable allies in the quest for success. Detachment is a much easier goal to achieve for these long-term investors than for the traders whom we shall soon turn to. Summarizing the careers of eight prominent investors in The Money Masters, Train concluded that they practiced 11 winning strategies, as follows:

  1. Buy a stock only as a share in a good business that you know a lot about. In other words, buy the business, and if you have done your homework properly, the price will take care of itself.

  2. Buy when stocks have few friends-particularly the stock in question.

  3. Be patient. Don't be rattled by fluctuations.

  4. Invest, don't guess. A badly chosen investment will surely go against you. If you lack confidence in a stock because you have not done the proper research, you are likely to take a hit when it declines in price.

  5. High yields are often a trap. Growing companies need all the cash flow they can get to plough back into the business. Paying out a high proportion of dividends robs them of those growth opportunities.

  6. Buy only what is cheap right now or is almost sure to grow so fast that it very soon will be cheap at today's price.

  7. If stocks in general are expensive, stand aside.

  8. Keep an eye on what the smart money masters are doing.

  9. Buy investment management if you find company analysis too difficult.

  10. Pick an appropriate investment strategy and stick with it.

  11. Be flexible.

  Traders

  The time horizon for traders is much shorter and the pressure commensurately greater due to the leverage factor. Trading consumes much more energy than investing because of the constant need to refer to price quotes. Consequently, we find that trading is much more a young man's game than investing. We will now consider two traders who were interviewed by Jack D. Schwager in his classic book Market Wizards.

  Ed Seykota

  Ed Seykota lives near Lake Tahoe in Nevada. He is reputed to have achieved a total return of 250,000% on one $5,000 account between 1972 and 1988-a truly remarkable feat. After interviewing Seykota, Schwager came away with the conclusion that he was someone who had found meaning in his life and was living exactly the life he wanted to live. This emphasizes the point made earlier that successful traders and investors have a strong sense of self-esteem and feel good about themselves, in contrast to the fallen stars. Seykota does not have an investment philosophy such as Buffet or Templeton but relies on computer-generated, trendfollowing systems. He uses the systems to filter out buy and sell signals, then uses his own judgment to decide how he should act on those signals. This in a nutshell is his philosophy.

  When asked for his rules of trading, he replied, "One, cutting losses; two, cutting losses; three, cutting losses." This is another way of saying "protect your capital," for if you can do this, at least you live to fight another battle. Another moneymanagement technique that Seykota employs is always to place a protective stop once he has opened a position. In this way, he lets the market judge whether he is right or wrong. Also, in the interest of maintaining principal, he never risks more than 5% of his equity on any particular trade.

  Asked how he handles a losing streak, Seykota answered that he cuts down his activity and waits it out. He opined that to try to play "catch up" is lethal. Later, he volunteered that a costly tendency of many traders is to get emotional over a loss and then try to get even with an overly large position. This kind of activity is doomed to failure, since it reduces objectivity to a minimum. Such traders are not highly geared, because they think it's a good low-risk idea. Instead they are highly leveraged because they want to recoup their lost money as quickly as possible.

  Seykota's trading rules are
:

  1. Cut losses.

  2. Ride winners.

  3. Keep bets small.

  4. Follow the rules without question.

  5. Know when to break the rules.

  The last two points appear to contradict each other, but Seykota, like other great traders, has a passion for self-improvement. He believes that a trader should be totally at home with his approach and with the rules that govern that approach. However, part of the self-appraisal process involves evolution, and this in turn means breaking the rules and substituting new ones. This subject is covered at the end of Chapter 12.

  Seykota summed up his success this way: "I feel my success comes from my love of the markets. I am not a casual trader. It is my life. I have a passion for trading. It is not merely a hobby or even a career choice for me. There is no question that this is what I am supposed to do with my life."

  Paul Tudor Jones

  Paul Tudor Jones represents another incredible success story. After a successful career in the New York cotton pits, he retired to form a money-management firm in 1984. At the end of 1988, each original $1,000 investment had risen to $17,000. Funds under his management grew so large that he has made a habit of returning profits to clients. This reduces his management fees but enables him to do a better job of managing money. It is to his credit when so many in the business try to grab money for management at virtually any cost. This impartiality and detachment from money is part of the characteristics of several market wizards that we have considered.

  In his interview with Jack Schwager, Jones sums up his trading rules as follows:

  Don't ever average losses. Decrease your trading volume when you are doing poorly; increase your volume when you are trading well. Never trade in situations where you don't have control, e.g., in front of a major economic report.