The key to making money in stocks is not to get scared
out of them.”
—PETER LYNCH
In an article entitled, “Gambling Has Drug-Like Effect on Brain,” in USA Today, Dr. Hans C. Breiter explores the effects of gambling on the brain. Breiter found that the parts of the brain that respond to the prospects of winning money while gambling are the same as those that appear to respond to cocaine and morphine. Furthermore, those who act abruptly in the market, chasing gains and treating the market like a poker table or, worse yet, a roulette wheel, would respond with the same parts of the brain. For many investors, this topic hits home or at least should—if you are trying to identify your own problems.
The study on gambling found that the brain uses the same circuitry for the process of diverse rewards. This topic of our brain’s effect on choice is very complex and has been studied for years with various conclusions. The important thing for us to know as investors is that the brain uses the same system to produce rewards for all actions, and when we experience something pleasurable, dopamine is released, whether it’s eating a steak or using cocaine. The effect of the chemical dopamine is to influence our cognitive behavior such that we continue to take part in the behavior that produces the reward, which for investors also provides a false sense of “skill.”
Allow me to tell you a story that will put all of this into perspective. Back in early 2012, my wife and I spent an afternoon at the Hollywood Casino in Indiana. We had often visited the casino but usually just to eat dinner or play the slot machines. I have personally never been too fond of casinos. I think they are sad places because you often see people sitting at the slot machines dipping into their mortgage payment and just praying that they hit something big. In casinos, the possibility of winning is much more seductive than the potential for a loss, so many people who go into casinos have hopes that their prayers will be answered and that they could make a substantial amount of money. Such people rarely consider the risks.
In my opinion, there is an effective way to gamble in a casino because in a casino you are either lucky or unlucky, and if you stay long enough, you will lose. My wife and I have always operated with a particular strategy: We view a casino like a theme park, in which we are spending money for the atmosphere and the fun of the atmosphere. We take $100 each and start with all the money in our left pocket. Then anything we win we put in our right pocket. Once the money in the left pocket runs out, we cash out and go home. Thus we never leave empty-handed.
Back to the story. In early 2012, my wife and I visited the casino, but neither of us was winning at all, and our $100 each was nearly gone within an hour. I believe that I was playing blackjack, and Natalie was playing the slots. After about an hour, we decided to leave, but on our way out, Natalie saw the roulette table and wanted to play one $15 round. She had never played before, and she said that if she were to win, she would put her winnings in her right pocket, and if she lost twice, she would walk away.
Natalie got off to a good start, winning her first round. Keep in mind that she was only betting “black” or “red,” which gave her a slightly less than 50 percent chance of winning owing to the “0” and “00” plays on the board. After she won the first time, she put the $15 winnings in her right pocket and then played once more—and surprisingly, she won! She then played again, and again, and again and won each time, now five times in a row.
By this time Natalie was five and zero and had won $75, and she began to believe that there was some level of strategy to her success or that she could “feel” where the ball would land next if she walked away from the table, didn’t watch, and went with her first instinct. She then went on to win, win, win, and win again. Now she had won nine times in a row, and she was $135 ahead, and she was convinced that there was some level of skill involved. On her tenth attempt, she lost, yet she still had one more round and was convinced that she had lost only because she did not go with her initial choice.
Natalie continued with her good fortunes and won another seven times in a row before losing. Thus she had won $240. As we left, Natalie felt particularly confident that her winnings were the result of talent and that when she lost, it was because of some outside reason or because she did not trust her initial instincts. She believed that she shared certain connections with the dealer, the speed at which he spun the ball, and that the atmosphere all played a role in her doing the statistically impossible. Yet the truth is that if she won 16 times and only lost twice, then most likely someone else experienced the opposite fate, winning only twice and losing 16 times.
Natalie’s thought process is nothing unusual. In fact, everyone who goes to a casino shares these beliefs (when they’re winning). This is due to the perfect mixture of excitement and the possibility of money-earning activities. In reality, though, there is no skill involved. Natalie was simply lucky. Yet this is hard for some people to accept. Such people go to a casino, sit at a specific slot machine, play only with a particular dealer, and develop a strategy that gives them the illusion that all money-earning activities are the result of strategy rather than luck.
We do this when we trade stocks. Any time those behavioral and pleasurable regions of the brain are stimulated from money-earning activities, it is in our nature to try to find a reason for the win, develop a strategy, and relate the success to skill so that we believe the same level of excitement or reward can be created at a future date. I often compare this example of my wife to that of a day trader. Now there are many people who make a living as successful day traders, and I like to call them “poker players” because obviously there is some level of skill involved in poker, and for a trader who studies trends and spends all day looking at charts, it is possible to develop a system that works better than 50 percent of the time. However, the two—a poker player and a day or situational trader—have striking similarities.
When a great poker player wins a tournament or plays well, then it’s because he or she is talented or the best at playing poker. Yet, if the same person loses, it is because of “bad hands,” one mistake that could’ve been averted, or some other outside reason that doesn’t suggest that the game is in many ways based on luck. The same is true for day or situational traders; they spend days looking at a chart and identifying certain technical indicators that tell them that a stock will “break out.” If the stock does break out, then it’s because of pure skill. Yet, if the stock trades lower, then it is because of an economic situation, a company development, or some other outside reason that acted beyond the scope of the trader’s belief and forced the stock lower. Therefore, the loss was not due to luck or the fact that the stock had a 50 percent chance of trading higher or lower on any given day. Basically, the trader will avoid any and all explanations that could challenge his or her “skill” to call the day-today trends of a stock. In fact, traders rarely realize that they call just as many wrong trends as correct ones. This is so because in order to keep the brain satisfied, the dopamine rolling, and the excitement building, we must take credit and convince ourselves that there is some measureable strategy to follow that will allow us to experience these pleasures once more, even if the large return on the stock or the roulette game was nothing more than pure dumb luck.
Aside from our need to find a skill level for any money-producing actions, there is also a biological factor or a mind/body relationship that also aids in this process. There is strong scientific evidence that suggests that the prospect or anticipation of financial gain triggers a flurry of dopamine activity similar to that of an addict. These high levels of dopamine create a desire to make emotional decisions in the same way an addict must continue to take more drugs to achieve the same “high.” A person who makes such emotional decisions must place riskier bets to receive the same level of satisfaction. In “Genetic Determinants of Financial Risk Taking,” Camelia Kuhnen concludes that the more money that was available to participants, the more money they invested in risky investments over safer investments. When the potential for a large return was present, the investors were willing to take larger risks, further showing the stimulation that we seek for large returns or a quick buck and how the potential for large returns often can cloud our judgment. One problem is that such an investor does not realize the desire for this reward, and it also prevents him or her from having the ability to assess risk. A good example of this action occurred during the initial public offering (IPO) craze involving social media stocks, which led to risky behavior or buying significantly overvalued stocks for the possibility of returning quick and large gains.
At this time, there is little evidence to explain why this reaction occurs. In fact, we don’t even know for certain why the anticipation of gains, not the realization of gains, causes us to become so excited. I suspect that it’s because when we anticipate gains, we are overconfident or excessively optimistic. Such traits I identify as weaknesses. These weaknesses are prevalent in most investors because investing is a proud industry where everyone believes that he or she is correct and that he or she is making intelligent, well-thought-out decisions.
It is common sense that you wouldn’t purchase a stock expecting to lose, so the goal of investing is to return more than your initial investment. At the same time, no one really knows how the market will perform or if earnings for a particular company will continue to grow at a rate that is acceptable to investors. Therefore, when I purchase a stock, I don’t think of it as a get-rich investment or an investment for a quick gain. Rather, I see it as an investment of value. When I buy, I do assume that the stock will trade higher, but I try to eliminate the natural bias that arises from purchasing a stock, and I purchase with the understanding that the stock is undervalued at the time.
As I mentioned earlier, we are all somewhat biased toward the investments that we choose. I constantly remind myself that nothing in the market is guaranteed, and then I put myself in the best possible situation by buying stocks that are cheap compared with current fundamentals. The trick is not to expect but to plan for the worst and hope for the best by buying stocks that you know are currently cheap. Then eliminate as much emotion as possible using limit orders and emotionless trading. Basically, have a plan before you purchase the stock. Tell yourself that you are not buying until it reaches x price, and then you will set a limit order to sell once it reaches y price. This eliminates emotion and is based on fundamental analysis that disallows you from activating the chemicals in your brain associated with pleasure by simply limiting your involvement in the purchase and sale of the stock. In Chapter 15, I will discuss this process in detail, and you will see how I have used this strategy to eliminate the drawbacks of my own personality.
In The Little Book of Behavioral Investing, James Montier explains a common behavioral misstep of investors, based on an original study by Terrance Odean in Are Investors Reluctant to Realize Their Losses, which perfectly explains the way that we as investors perceive a loss and our misconception that a stock will “bounce back.” This is a problem that I often discuss. We are sometimes so confident in our knowledge that we never suspect that we could make a mistake or we believe that our investment decision is so good that although the stock is down, it will almost certainly rise at some point. Therefore, the results from Odean’s study makes sense. He examined the data from roughly 10,000 investment accounts from 1987 to 1993 and arrived at the conclusion that investors held losing stocks an average of 124 days versus holding a winning stock only 102 days. Further research indicated that retail investors are 1.7 times as likely to sell a stock with gains versus a stock with loses.
Investors are typically confident in their abilities and find it difficult to consider the potential for loss when they purchase a stock. Sometimes you will do all your homework with fundamental analysis and enter the position at the best possible price, but the stock still will fall and never appreciate in the set time you have allowed for the investment. Unfortunately, this is a reality of the stock market. Sometimes you are going to lose, and it doesn’t mean that you made a bad investment, but it validates the fact that it is impossible to be right 100 percent of the time.
Given our natural bias for a particular company that we like, it is very difficult to avoid the anticipation of gains. When we anticipate gains, dopamine is overloaded into our brains and clouds our cognitive reasoning. You would think that the same thing would occur with loss, and it would provide an equally stimulating experience. In reality, though, it is the opposite. Our brain actually becomes less active when faced with loss. In fact, the realization of loss was identified on the left hemisphere of the brain, whereas the response to winning was located on the right, further showing the distinction in how we identify both events.
To better understand our reactions to winning and losing, think back to the casino: Natalie was more than willing to believe that her winning was due to skill, but when she lost, she believed that it was due to outside forces and responded with complete opposite emotions. For example, after her big day at the roulette table, Natalie all of a sudden wanted to start going to the casino more often and always wanted to play roulette. However, her results were never the same, although her behavior had changed. She was no longer as nervous, and rather than placing the minimum $15 bet, she would bet $20 or $25, which she needed in order to provide the same reward she received during her winning streak.
Natalie is a good example of the process, but nowhere near as close an example as the couple we took to the casino following Natalie’s lucky day. This is so because Natalie is by nature more conservative and is the type of person who can’t stand to “blow money” that she could possibly give away to people who need it. Our friends who went to the casino with us, on the other hand, are much different. The man, who I’ll call Kevin, is more seeking of quick gains, the type of person who often buys and resells stocks or looks for a quick and easy way to make money. Therefore, he would be much more stimulated by winning and more likely to increase his level of risk taking to meet his pleasure needs.
To make a long story short, my wife and I and our two friends (one being Kevin) went to the casino to get dinner and play some slots. During dinner, Natalie explained to Kevin how she had won over $200 playing roulette and how she believed that it was due to some sense of skill (despite the fact that she’d not experienced the same level of success). I attempted to explain that she was wrong, but Kevin was hooked, and you could see his mouth watering and the excitement in his eyes at the pure thought of winning, not considering the potential for loss.
It’s also important to know that Kevin and his fianceé were in college and did not have a great deal of money, so we were taking them out for a good night on the town. I believe that we stayed at the casino for about three hours. Natalie and I used our strategy of putting winnings in one pocket and our bank in the other. Meanwhile we told Kevin and his fianceé about our strategy to avoid total loss, but they would not listen, and the emotions of the gamble took over. Kevin stayed at the roulette table, winning about 40 to 50 percent of the time, and by the time we left, he had lost more than $150, which is not a great deal of money, but when you’re in college, it’s a lot.
Almost immediately we noticed Kevin’s and his fianceé’s mindset change, and they were depressed to have lost the money. However, like many others, neither could accept the loss, and they were excited by the casino’s atmosphere. Therefore, they rationalized that if they went to another casino, perhaps they would do better. As a result, after we got back to our house, at midnight, Kevin and his fianceé left and did not return until 4:30 a.m., obviously having better results.
When they awoke the next day, at about 1:00 in the afternoon, Kevin couldn’t quit talking about his strategy on roulette that was a guaranteed win. He had won over $150 the night before and believed that his strategy would give him more money in the future. Remember, he is the type of person who chases quick money or the possibility of quick money.
Kevin’s strategy was to bet red or black and then also two-thirds of the table with two of the three rows. The red or black bets pay double, but when you bet one of the three rows, you get three times your bet. Thus, if you bet $15 on the first row (one-third of the board), you would win $45. Therefore, Kevin’s goal was to bet $15 on red or black and then $30 on two rows, therefore making his total bet $45 and increasing his chances of winning to almost 85 percent.
Immediately after I heard Kevin’s plan, I started to poke holes in his strategy, but just like the night before when he did not listen about only playing a certain amount of money (right pocket, left pocket), he did not listen this time. He did not realize that because of the amount he was betting, he would have to hit both the correct color and one of the two rows to earn 65 percent on his bet. Therefore, he is betting a large amount, $45, but could only win $30 best-case scenario. If one of his two rows wins, then he breaks even, and if red or black wins (and nothing else), then he loses $15.
Kevin’s winnings were a result of choosing both the correct color and one of the correct rows the night before, and because of his strategy, his chances of winning were greater, but not that much, and one loss results in a $45 hit. Kevin decided, against all advice, that his strategy was so solid that it was worth taking the day off, and rather than taking his winnings from the night before, he decided to go back and try to win more easy money. This behavior is one of the primary reasons that investors lose money. They may have large gains, but greed and the desire for more causes them to wait for even larger gains, and their confidence overshadows reason, which is what happened to Kevin.
The end result of Kevin’s strategy was that he not only lost all his winnings from the night before, but he also lost an additional $150. His excitement turned to depression because he’d already taken the day off and had lost all his gains. He not only continued to play his strategy, but because three total losses would be near $150, he also began to bet $25 and $35 on red or black, with his goal being to “win back” his money. This story brings truth to the expression that every loser in Vegas thinks they can do better, but the winners leave the table when they are up. But it is also a prime example of common investment mistakes. If you trade stocks, then you must acknowledge that you have a 50 percent chance of gaining or losing. As with poker, there is some skill involved in technical trading, but you also must acknowledge the losses and must take notice following those losses with the same intensity that you show when you gain. The only difference between trading the market and playing a roulette table is that the market does not have any consistencies. In roulette, you know the return when you pick a color. But you don’t know the return when you buy a stock to trade, and since trading requires riskier, more emotional behavior, the gamble must constantly evolve and become larger in order to achieve the same reward. In short, it is the process of not being able to accept responsibility for loss but being willing to accept full responsibility or credit for gains and then doing whatever it takes to repeat the behavior and to achieve the reward that is provided with this behavior.
The inability to accept loss and the anticipation of gains go hand in hand. You should have a proper exit strategy before you enter any position. However, with riskier investments such as IPOs and spur-of-the-moment purchases, it is impossible to develop an appropriate exit strategy. You must realize that the desire to buy promising penny stocks or IPOs may create the illusion of quick gains that in some cases may change your life but never actually provide the reward of large gains.
I know that your expected gains finally could allow you to purchase that boat you’ve always wanted. More than likely, though, you won’t return gains. If the buy does present gains, you most likely won’t sell the stock because your expectations are too high, and you want your anticipated gains. Therefore, you wait too long and don’t consider the possibility of loss. Once you do sell for a loss, you become desperate. Consequently, you start making riskier decisions just to make back the money you lost, and you lose even more money. It is a sick cycle, my friend, and it is the behavior of a compulsive gambler. Unfortunately, the market is full of compulsive gamblers, and it can be easy to follow the crowd, unless you can identify and avoid the behavior with well-thought-out and intelligent decisions.
One of my primary goals when I worked for the Department of Corrections was to give inmates both short-and long-term goals that they actually wanted to achieve. The reason this was so important is that addicts or people with addictive personalities have trouble delaying gratification. It is one of the reasons that drugs became a part of their life. They had trouble planning and achieving longterm goals because they only worried about satisfying the moment. Investors possess these traits as well; we always want the quick fix and want to buy the stock that is on the solid uptrend, but we do not think about the stock’s chances of falling. It is these patterns of behavior that create opportunity for value investors and allow us to see potential gains in areas that are undiscovered and undervalued.
Our behaviors are something we spend a lifetime creating. They are the result of cause and effect from the rewards provided from certain behaviors and our ability to learn from our mistakes. Investing can be very rewarding, but regardless of your success, it is most important to remain calm and act without a sense of emotion and/or urgency. Unfortunately, you can’t eliminate all emotion, nor can you eliminate all bias. However, you must identify which areas of your personality may become problematic and then avoid those situations like an alcoholic has to avoid places where drinking occurs.
Perhaps the most significant trap that plagues investors is the expectation of gains. After all, if you buy a stock, you expect it to return gains. There are simply too many investors with short-term day-trade philosophies that offer unrealistic goals. Such an expectation or, as I call it, sense of entitlement leads to emotional decisions and anticipation of immediate wealth. Consequently, these emotional decisions lead to a change in the investor’s behavior in which fundamental analysis becomes trend seeking, which ultimately leads to desperation and failure as an investor.
One of the ways that I have found to eliminate emotional purchasing and to keep rational goals is to limit my involvement in the trading of stocks. This means being active but also passive as an investor, as well as being able to avoid the tempting lures of the market’s momentum stocks. In Chapter 15, I will show you in detail from my own experience how to eliminate emotion by preparing for the sale of a stock before you buy it. Remember, one of the largest problems for investors is taking profits and waiting too long to sell. If your goal is to return profits and you are truly purchasing stocks of value, then you should return gains most of the time. By watching the stock on a daily basis or trying to play the trends, you are only gambling. If the only way to change your behavior is to avoid the behavior, then you must change the way you buy and sell stocks.