Chapter 30

Seven investing sins

Typical private investors ride an emotional roller-coaster as markets lurch from bull to bear. They will become interested in stocks in the last wild stages of the bull market. Quite likely their first purchase will show a profit, and they are hooked on a new addiction that they think will make them rich. Many will try their hand at speculation, which these days goes by the more respectable name of trading, rather than investing. They move into more exciting, but risky stocks. Some will even go so far as to become full-time day-traders. They attend seminars and buy software that will tell them what to buy and when to sell.

Then the bubble bursts. Having no experience with the cycle of the markets, they freeze. Former speculative favourites fall spectacularly and horrendous paper losses lock in those who were never prepared for, and don’t know how to handle, falling markets. They swear off stocks for life, blaming the promoters and managers of the companies, the regulators, governments and anyone they can think of, except themselves.

The better professional investors and experienced private investors play a totally different game. It is lonely and they are constantly challenged by having to act differently to the crowd and somehow resist the siren calls to join the crowd in their lemming-like rush toward the financial cliff edge. These investors buy stocks when they are cheap. This will be in the last stages of a bear market and the beginning of a bull market. Their task is both solitary and difficult. The financial media will be full of bad news. General opinion is that the stock market will never recover. Others see the stock market as so dangerous that they have totally lost interest in it and see anyone who is dabbling in stocks as a misguided fool.

However, this is the best time to be buying stocks. Markets have a long-term tendency to swing between periods of extreme overvaluation and periods of extreme undervaluation. Professionals and smart private investors start buying at the bottom of the cycle and continue buying on the way up the bull market trend. As prices return to normal, and then stocks become fully priced, they sit and allow the returns to grow their wealth.

Sooner or later the market becomes overheated. The better professionals and the smart private investors begin selling. The broader public discover the bull market and rush in to take these overpriced stocks off their hands. There is such a demand that new stocks have to be created. These are initially the flotation of businesses for which the market is paying silly prices. Later in this process they will be nothing more than proposals to start new businesses. It always ends in tears.

Most of the inexperienced investors who lost most of their money at the end of the process learn nothing from this experience. However, a few do see the lessons and resolve to do things differently next time. They join the ranks of the winners.

It all seems simple enough when the process is understood. Begin buying near the end of a bear market and continue buying on the way up. As stocks become overpriced, begin selling while everyone else is buying and have only a low exposure to the stock market when the bull market music stops.

However, it is far from easy to do. The difficulty is not in the logic; it is in our minds. Almost everything that has been discussed in this book comes into play at some point. However, there are seven specific mindsets that are of particular relevance:

1 Thinking someone can predict the market. There is a widespread belief that we can predict the future, or at least that some guru has this skill and can either tell us or teach us how to do it. The reality is that the future is almost impossible to predict consistently and accurately. In all walks of life, professionals greatly overestimate their ability to make predictions. Nowhere is the task more difficult, and nowhere do the experts fail so often, than in the stock market.

In order to succeed, we need a different strategy. Forget prediction and devise a strategy that will work without our knowing when things are going to happen. It is actually blindingly obvious: buy when stocks are cheap and sell when they are expensive. Warren Buffett has been saying this to anyone who will listen for years. Few listen, but those who do tend to be the ones who succeed.

2 Trying to be perfect. Perfectionists have the hardest time in the investing game. This is because investing is about managing uncertainty, not finding certainties that can be calculated. They hold off investing until the time is perfect. They want to buy right at the bottom. It can’t be done, except by two classes of people — the lucky ones and the liars!

In order to succeed, we have to accept and manage uncertainty. We have to start buying, knowing that the market may move lower before it goes up, because we cannot know where the bottom is, except in hindsight. The best investment decisions will often be the most difficult ones to make.

3 Fear of making mistakes. This is closely related to trying to be perfect. It is not only the perfectionists who suffer here. Nobody likes to make losses. However, because it is impossible to consistently predict the performance of companies and of the economy, the best we can do is to identify opportunities and manage the uncertainty that is an inherent part of investing. We then build our exposure to a portfolio of the stocks that begin to confirm our hopes. At the same time, we sell out of the stocks that disappoint. Critical to this are investing with a margin of safety by buying good companies cheaply, combined with having sound money and risk management.

4 Inability to act independently. Because we need to act in a way that is almost opposite to the general public, investing can be a lonely occupation. Those who need constant reassurance from their peers will find investing very difficult, unless they can somehow surround themselves with others who understand the need to act contrary to the news media and general opinion. This task is at its most difficult at the most important times: around the important turning points in the markets. For this reason, many of the great investors have been strong, disciplined personalities, who often had particularly close associates of a similar mind.

5 Overconfidence. For some reason the general public seem to think that investing is easy. There is now a lot of research on overconfidence that shows the less we know about something, the more we overestimate our ability. The hard truth is that investing is very difficult. It requires formal education, experience, hard work and persistence.

6 Lack of patience. Investing is not about instant gratification. The best investors have always become rich slowly and eschew the temptations of get-rich-quick schemes. They know that what looks too good to be true usually is. Every year life seems to speed up a bit more. We want to pay our money and see the result immediately. Investing is not like that. Basically, it is about taking on uncertainty by devoting part of our savings to fund a business activity. The results take several years to emerge. There is simply no sustainable alternative to investing in good businesses and letting our capital grow with them.

7 Having unreal expectations. The area where the tyro investor has expectations that are furthest from reality is the rate of return that can reasonably be expected. Why else would they fall for the promotion of systems offering fabulous profits? Warren Buffett is arguably the greatest investor of our time. His return was reportedly about 20 per cent compound over the period from 1965 to 2011. Anything above half that rate is good. Buffett stood aside from the wild expectations of the technology and internet boom. They said he had lost his touch. But it was they who had lost their heads.

Summary

The key to investing is to buy when stocks are cheap. This is not easy. The seven mindsets to overcome are:

1 thinking someone can predict the market

2 trying to be perfect

3 fear of being wrong

4 inability to act independently

5 overconfidence

6 lack of patience

7 having unreal expectations.