It is the universal goal of every honest investor to realize a profit on the things they choose to invest in. But many find success in this endeavor to be elusive. If they do succeed in making a profit, it is often a meager one.
In this post, I hope to offer a greater understanding of why investors fail. Remember, my eyes are ever on the prize of financial independence for you. The greatest risks to investors covered in this discussion tend to manifest more frequently and severely in speculative investments. Following my prescription of acquiring productive assets instead of taking the traditional financial planners’ path of mostly speculative assets will guard an investor from what I am about to discuss.
An Investor’s Two Biggest Enemies
Since the beginning of human existence, there have been two levers of power that have hung over our collective psyches, available to those wanting to manipulate the masses or undisciplined individuals into the desired response for good or ill. These levers are Fear and Greed. Today we have given greed a more modern moniker of Fear Of Missing Out (FOMO), so the modern person might claim it all really boils down to fear, but I consider these to be distinct and separate reflexes and will explain why later in this discussion.
Both were useful reflexes for our survival when our cave-dwelling ancestors needed prompting to action. Fear prompted our fight or flight response against threats from wild animals, each other, or adverse weather. Greed moved them to act to protect against starvation during the scarcities of winter, drought, and famine. These responses were actually essential to the survival of humanity in those early days, so one could argue they were good responses in the context of the time in which they lived.
We have come a long way from the days that instilled these instincts into each of us. In the Western world, a majority of citizens enjoy living in an age of abundance and safety relative to prior generations. That is not to say everyone lives this way, but it is fair to say anyone reading this blog with an eye toward investing has some decent measure of these two things in their life.
So, while fear may still be a good reflex, should you find yourself in a dark alley in a sketchy part of town some night, it is not such a helpful reflex in your investment decision-making.
Investor Enemy No. 1 - Fear
Let’s take a closer look at how fear drives investors to make poor choices. There are several places where fear can derail you from success:
(1) Fear of Failure, i.e., never stepping into investing in the first place. We hate to lose. More correctly, we fear failure. This fear has become especially acute in more recent generations. In the 1990s a shift of “good intentions” in parenting placed great concern on boosting children’s self-esteem and providing them a sense of safety: Trophies for every player in a league and “stranger danger” taught in schools. Both of these efforts had unintended outcomes. When one is accustomed to “success” without trying and over-values safety, taking on the risk of failure is no longer an acceptable option. This is not to say only more recent generations have this attitude. Fear of failure applies to some portion of every generation, but it is a more prevalent problem when Millennials and Gen Zs have been polled on their greatest roadblocks to success (41% vs. 24% for Gen Xers).
(2) The Impulse of Flight. You watch CNBC faithfully hoping to get a jump on the rest of the investing world for the stocks you hold in your portfolio. A news alert comes up and reports the CEO of company X, one of the stocks in your portfolio, has been placed on administrative leave. The stock is already reacting to the news, down 5% on the day. Big Rig Alert: This immediate effect is often because of computer algorithms that auto-trade stocks based on headlines instantaneously before you can even finish reading the words on the screen.
So, what do you do? Odds are high that you choose to flee from the stock too. Ironically, this impulse is in part fueled by a computer’s reaction to nothing more than a headline, but since you can easily exit the stock with a few clicks of the keyboard, you do so. By the time you’ve sold the stock, it is now down 10% on the day. Then you find out it was a false report or the reporting was misconstrued. The algorithms assure an instantaneous stock bounce (thus the flash boys win, selling high and buying low), but now you’re out of it, and getting back in means locking in a loss of at least 10%.
(3) The Herd Mentality. In the Bible, Jesus makes frequent references to people as sheep. Any time spent observing people in large numbers demonstrates it was a perfectly apt description. We have a tendency to want to be in sync with the crowd. This tendency goes back to the instinct that tells us there is safety in numbers, and so the “herd” reflex is to stay with the crowd as a means of protecting ourselves from danger.
When one turns to their favorite source for financial news, sees the market is down yet again and it seems everyone is selling, our nature is to want to sell too. The ease of doing so only increases the odds we will choose to take that action, and once sold, we feel a sense of relief to have joined the crowd in the sell-off. Such sell-offs can take every company's stock down, irrespective of the merits of the company. Some companies deserve better consideration, but in the midst of fear on the scale of herd mentality dynamics, they are all treated as one big threat to our financial security. In fact, it is often the highest flyers - companies who have soared for good reason - that see the more violent downturns in sell-offs, though nothing has objectively changed about the company’s profitability or its prospects.
Investor Enemy No. 2 - Greed
Now a look at greed. As I mentioned earlier, I do not equate Fear Of Missing Out as being a true reflection of greed. Greed is a curious aspect of our nature that keeps us from ever being content with what we have. There is a tendency to compare ourselves to those around us, and when someone has what we do not, envy can spur us to want that too. So, envy is often a catalyst for greed. But even when the things we want are attained, we have a propensity for devaluing them once possessed and shifting our focus to wanting something else. Greed is a slippery reflex, one that slithers and shifts our wants and desires once we attain each next thing. It works in just the same way with money. The person who desires nothing more than to be a millionaire, once there, realizes what they really want is to be a multi-millionaire, and so on.
The following are two examples of how investors can be prompted to act unwisely due to greed:
(1) Where there’s smoke there’s fire. When a particular investment begins to gain momentum, its success can sometimes become more a function of momentum than of any real merit on the part of the investment itself. For example: say a hundred investors see the value of an asset and decide to invest. These might be value investors who did their homework and, in their analysis, realized the metrics justified a higher value than it had at that time. After these initial investors jump in, it doubles. The doubling of the investment draws the attention of three hundred investors. They are the investors quick to spot a momentum play, and they jump in. The metrics might not be as strong as it was for the value investors, but now it is a right-priced stock with momentum. It doubles again. Now the smoke of an investment that has quadrupled in price in a short timeframe draws still more attention. Maybe now the stock is being talked up on CNBC. Following many marketers’ rule of thumb that any exposure is good exposure, though the commentators are questioning the valuation, ten thousand investors decide to throw a little coin at it. The stock triples.
This is the moment that greed kicks into high gear and what was smoke becomes fire. A mythos forms around why the stock is performing so well. Stories of dubious origination sprout up claiming the company is working on something BIG. Self-styled (amateur) analysts post thoughtful summaries of why this is just the beginning of an even bigger run, spurring twenty thousand “herd” investors to jump in. Some of the winners in the last round - so pleased with the performance - buy more of the same stock on margin (using money borrowed and backed by the shares the investor already owns). The big boys - hedge funds with deep pockets - see an opportunity to naked short the stock, meaning they sell shares they do not currently own. It’s not legal but the fines when getting caught are smaller than the profits to be earned, so some funds do it anyway.
Sometimes this practice backfires spectacularly, but usually, the selling of significant shares into the market by the big players puts pressure on the price of the stock and it begins to drop. The cycle of greed has now ended and tips into fear and the selling and stock price drops accelerate. The short sellers gladly buy up the deeply discounted stock to deliver those shares (remember, they didn't actually have them to sell in the first place) to those they sold to. When the cycle is complete, you have a few much richer big players, a lot of poorer “herd” investors, and a few mediocre winners who got in early and out soon enough to book a profit.
(2) The Rising Tide. This scenario is a little different. It involves not just one investment, but an entire segment of the market. The most recent spectacular example of the Rising Tide is when the Internet reached the tipping point and began to grow at an exponential rate. Its utility was easier to see by the day as more and more people found themselves communicating, socializing, surfing the web, and, most notably, buying products and services on the Internet. Marketing types at many companies big and small decided to begin promoting news stories about every activity and new initiative their company was doing on the Internet. This excited investors who, with little real analysis of the change, would snap up more shares of the company hoping it would become a player in this exploding venue.
Marketers took it even further, announcing name changes for companies to recast them as an “Internet” stock. They’d put an “e” or “i” in front of the company name, or “dot com” at the end of the name. These moves paired with the ongoing unparalleled expansion of the Internet drove investors into a frenzy. It is not an exaggeration to say in those days that throwing a dart at a newspaper page of Nasdaq market stocks (where most of these “up and coming stocks” were traded) yielded as good a portfolio of stocks - in terms of performance - as the portfolios recommended by most stock broker experts.
I recall a business trip to Las Vegas where a cab driver shared with me a hot stock tip he said he got from a girl who was a dancer at one of the Vegas casinos. That’s a true story! Of course, the big boys eventually stepped into the oversold market, did their short-selling routine and the now infamous dot.com bubble deflated 78% from its peak and left an unknown number of cab drivers, dancing girls, and everyday working stiffs with big investing losses. The Internet was the real deal, but too many investors failed to discern between those stocks that were legitimately positioned to profit from the Internet long-term and those just riding the coattails of the Internet’s success.
There Can Only Be One
Between Fear and Greed, one is the more powerful force. In Part II of this discussion, I’ll reveal which one that is and what steps you can take as an investor to tame the reflexes that prey on our potential success.
Until next time, may peace and prosperity be with you.
The Natural Economist
Next up: Part II - Which is worse, Fear or Greed?