Scott Swallow's Focus On Investment$

Four Costly Investment Mistakes
Today's Trivia Question:
What is the biggest conflict of interest between you and your Financial Advisor?

When I was an independent floor trader at a futures exchange in Singapore for 6 years, I learned that I had to master 3 skills in order to survive: knowledge, adherence to a plan, and emotional control. I bought dozens of books to learn from successful traders, and created a computerized trading system. But emotional control was difficult. My best trades were those that I was most afraid of. My brain told me to buy, but my emotions resisted. And it was difficult to not sell a profitable position - the need to 'take a profit' was always very tempting. But eventually, with experience, I became disciplined. In fact, an older trader once said that he'd never seen anyone hold on to winning positions like I did. At the exchange, over 90% of new traders failed within 1 year. Why? Because they were controlled by emotions. This issue of Focus On Investments looks at four costly investment mistakes that result from failing to remain rational in an emotional world.

Mistake #1: Ignoring the implications of 'The Statman Experiment'

What about you? Are you fully rational? Do you logically act on the facts? Or are you swayed by emotions, and unproven theories? As humans, the odds are stacked against us. Meir Statman, Professor of Finance at Santa Clara University, is famous for his pioneering work in the field of behavioral finance. He conducted the following experiment, with results that have negative implications for investment performance:

Two groups of individuals were given the chance to repeatedly press one of two buttons. Unbeknown to the participants, the first button was programmed to randomly reward them with a prize 20% of the time, while the second button randomly rewarded them 80% of the time. It seems obvious that any intelligent participant would eventually realize that he was far more likely to win if he chose the second button all the time.

The first group learned quickly, and soon were choosing the second button most of the time. The second group was slower, but eventually they too chose the second button over 80% of the time. But then a strange thing happened: the first group regressed! They 'un-learned', and began to choose the second button less often, occasionally 'taking a flier' on the first button in spite of their prior experience. By the end of the test, it was the second group that had won hands down.

So who was the first group?

HUMANS.

And the second group?.......

RATS!

Whereas rats took the established facts at face value, humans tried to outsmart the system, by looking for nonexistent 'patterns', and devising complicated strategies that appeared clever, but were actually just figments of their hyperactive imaginations. Humans find patterns where there are really none. In fact, we find it hard NOT to see them - it's our specialty as a species! Try looking at clouds WITHOUT seeing any patterns - it's remarkably hard. But in investing, it's far better to focus on what's real, simple, and proven to work. There's no great mystery about which investment method works - it's called Value Investing. The real mystery is why everyone doesn't do it, since its practitioners are widely accepted as the most successful investors. Value Investors only consider what's known, not what might be. They try to buy stocks for less than their real worth. If you want to create your own better way, be my guest. Keep pushing button number 1. Maybe you'll be extraordinarily lucky. As for me, I'd rather run with the rats! After all, they are an extraordinarily successful species. Copy the rational rodents, not their irrational cousins: the lemmings.

Mistake #2: Ignoring the implications of 'Regret Theory'

When in London, U.K. two decades ago, my clients were financial institutions: pension funds, insurance companies, etc. I soon discovered that, for most clients, every single position would be a loser! And this was in a bull market! I was flabbergasted. These were supposedly the experts, after all. Were my recommendations all that bad? Well, no, it couldn't be, because in some other accounts, which had received exactly the same advice, virtually every single position was a winner. So what was going on?

Simple: most accounts quickly sold winning positions. A 10% profit made them nervous, whereas 20% was positively scary, and at the slightest excuse - an international incident, or a bad economic number - they bailed out. This process led them to cull all the winners, leaving only duds. Studies have shown that the stocks investors sell outperform the stocks they purchased as replacements, leading eventually to a portfolio filled with losers and poor performers. Psychologists have come up with Regret Theory to explain all of this. The regret of watching a profit turn to a loss can be so great, that investors are willing to forgo years of earnings simply to protect a small profit right now. It's a classic case of an emotion - fear - causing short-term thinking to take over, hurting performance.

Consider business owners: they don't sell out just because the value of their business has gone up. To the contrary, they'll likely increase their investment if things go well. After all, the business has proven itself, so why not invest more? By doing so, they set themselves up to reap huge rewards. Think about it: if you've been in the market for over 10 years, and have purchased average investments, then some of your investments should have tripled. Most investors sell out long beforehand, and so sell themselves short.

Why do most people make far more money investing in their houses than in stocks? Are houses a better investment? Not at all. It's because they don't sell the house just because prices went up. In fact, they usually can't - they have to live in a house. They may move occasionally, but they are still invested in the housing market, year after year. If investors did likewise, their returns would likely outpace returns from houses.

A stock that has gone up 20% is not necessarily more expensive - in fact, it might be the cheapest it's ever been, even though it's at an all-time high. Why? Because earnings may have gone up even more. I regularly advise clients to buy more shares of companies whose stock prices have gone up, but are still cheap relative to their earnings. Business owners continually invest more in their businesses, and so should you. It's only logical.

Mistake #3: Thinking that random investment choices will succeed

Nothing could be further from the truth! Successful business people don't randomly choose a business - they base such a decision on a careful analysis of the pros and cons, the risks, and the potential rewards. Simply throwing a bit of money into every investment class will not yield good results. To succeed, you have to think differently from the crowd, which continually gets over-excited about certain asset classes and drives them to ridiculously high or low levels. We like to laugh at how absurd it was for the value of all the Real Estate in Tokyo to be worth more than the value of all the Real Estate in the United States, as it was in the late 80's, yet just a few years ago, the overvaluations in the hi-tech bubble were probably even greater. Sometimes it's hard to apply discipline and avoid thinking that you 'have to be in' every hot sector of the market regardless of how silly the price is. That's where a good Financial Advisor can help.

Mistake #4: Ignoring your Financial Advisor's 'hidden' conflict of interest

What IS the biggest conflict of interest between you and your Financial Advisor? Is it fees, or commissions? Time spent servicing your account? Providing reports and information? No, not at all. It's the conflict between your absolutely essential need to invest differently from the crowd, and your Financial Advisor's desire to have you invested exactly the same as the crowd! Why? Why do most Financial Advisors subconsciously want you to invest in mediocre, average portfolios, that have no chance of outperforming the market, and may very well pull you down into financial oblivion? Because it's hard to find fault with an advisor for doing the 'typical' thing. If an advisor does take a different approach from the crowd, there will most certainly be periods of time when the crowd's approach temporarily works better. Dan Ferris says it best:

I can promise you that: 1) you need rational expectations and a long-term view to get rich investing, and 2) that a disciplined, highly selective, value-oriented approach, adhered to religiously over a period of many years, is your only hope of getting rich by investing in stocks.

Dan Ferris, "The Fortune of Loss"

I remain devoted to finding the best investments for my clients, conventional or not, and staying committed to them in a disciplined fashion. I have over 16 years experience in financial services, both in Canada, and in Singapore and London. Call me today for a free, no-obligation consultation. It will be well worth your time.

Sincerely,

Scott Swallow, HBA, MBA, CIM