Source: https://musingzebra.com/a-million-dollars-lesson/

In investing, knowing what not to do is more important than knowing what to do. But since we don’t have all the time in the world to make all the possible mistakes to figure out what not to do, the best way is to learn from other’s mistakes. 

In What I Learned Losing A Million Dollars, Jim Paul reflects on how his successes in life and career precipitates his downfall. 

The successes in my life had given me a false sense of omniscience and infallibility. The question was not whether I was going to make money. The question was how much money I was going to make. There was a total presumption of success; what had gone before would continue.

It is easy to get lucky in the stock market and mistaken luck as skill. Like rolling the same number on a dice 8 times in a row, it is hard to see how this can be due to luck after making a killing in the market for a number of consecutive years. Our linear thinking further strengthens this belief. If we have done well at certain domains of our lives, say a successful career as a surgeon or good with kids, we naturally believe those successes are transferable to the stock market. Besides, the stock market follows a scaling law: a one-day fall of 1% happens more often than a 5% fall, which is then more often than a 10% fall and so on. It’s easier to recall a recent event than distant ones, we are confident the market will continue its current trajectory and underestimate the chance of a huge fall. Further give us an illusion of control, overconfidence, and encourage risk-taking.

Overconfidence is more than just being cocksure of oneself; it becomes ego. What happens when you bring ego into the market? You personalized the market and internalize your position. You become more interested in being right than making good decisions. This is the key reason why people hold on to a losing position longer than they should. 

All losses are treated as failure. Loss has a negative connotation. It is easy to equate losing money in the market with being wrong. In doing so, you take what had been a decision about money (external) and make it a matter of reputation and pride (internal). An example of personalizing market positions is people’s tendency to exit profitable positions and keep unprofitable positions. It’s as if profits and losses were a reflection of their intelligence or self-worth; if they take the loss it will make them feel stupid or wrong. They confuse net worth with self-worth.

This works both ways. In a winning position, we tell ourselves “I’m right” to shore up our ego. In a losing position, we justify our decision by constructing narratives such as “it is a bullish correction” or “it is going to bounce back”. But they’re the same: we rationalize to preserve our pride and ego. 

The reason why we internalized position is that the stock market is a continuous event. Unlike a game of soccer or blackjack where there are a start and an end, a position in the market can remain open indefinitely. 

Losses from continuous processes are much more prone to become internalized because, like all internal loses, there is no predetermined ending point. The participant gets to continuously make and remake decisions that can affect how much money he makes or loses.

Because a losing market position is a continuous process, nothing forces you to acknowledge it as a loss. So as long as your money holds out, you can continue to kid yourself that the position is a winner than just hasn’t gone your way yet. The position may be losing money, but you tell yourself it’s not a loss because you haven’t closed the position yet.

The psychology of internalizing losses also illuminates the characteristics of risk. Just as not all casino games are gambling, not all financial investments are investing. Risk is not determined by the activity, rather, it comes from the individual. 

A closer examination reveals that what determines whether someone is engaging in created or inherent risk is not the activity itself but the characteristics the person exhibits when engaging in the activity. 

If a person approaches a business risk or risk in the financial market for excitement, then he is gambling—regardless of how much control he supposedly has over the outcome. 

Character drives behavior, behavior drives risk. We often measure risk based on whether we’re in the market or on the sideline. That is, it is only risky when our money is in the market, not if we had exited all our positions. But that’s only a small part of risk: market risk. If the reason for staying on the sideline is driven by excitement, whether that’s by greed or fear, that is gambling. And that person will always be ‘at risk’ even if he stashes his money under the mattress. 

Moreover, when you make decisions driven by excitement and impulse, you become the ‘crowd’.

Individual acts after reasoning, deliberation, and analysis; a crowd acts on feelings, emotions, and impulses. An individual will think out his opinions whereas a crowd is swayed by emotional viewpoints rather than by reasoning. In the crowd, emotional and thoughtless opinions spread widely via imitation and contagion.

It is not a function of a quantity of individuals that determines if a psychological crowd has formed. Rather, it is a function of the characteristics displayed. If a person is exhibiting these characteristics, then he is part of a psychological crowd and is making crowd trades. 

A majority of the reasons why people lose money in the market is because of crowd trade, gambling, internalism, and overconfidence. How can we avoid these mistakes? Jim Paul offered a five-step decision-making process:

1. Decide what type of participant you’re going to be
2. Select a method of analysis
3. Develop rules
4. Establish controls
5. Formulate a plan

Decide what type of participant you’re going to be

This seems elementary but most people don’t know what they want to be. They tell you they’re long-term investors yet engage in ‘punting’ or check their portfolio a few times a day. The danger arises when we change our story based on market sentiment and price. I once heard a person profess one of his stock is going to break new high in the coming week because of bullish sentiment. When it didn’t, he declares he is in ‘for the long-haul.’

The plan you develop must be consistent with the characteristics and time horizon of the type of participant you choose to be. Changing your initial time horizon in the middle of a trade changes the type of participant you are and is almost as dangerous as betting or gambling in the market. 

Select a method of analysis

The method of analysis can be broadly categorized into fundamental analysis and technical analysis. Each consists of many indicators. Selecting a method of analysis prevents you from jumping “back and forth among several methods in search of supporting evidence to justify holding onto a market position. Because there are so many ways to analyse the market, you will inevitably find some indicator from some method of analysis that can be used to justify holding a position.” 

Develop rules

Rules are similar to a checklist. It prevents you from making silly mistakes such as engage in FOMO or panic selling. Method of analysis is just analysis, it doesn’t tell you what to do or what not to do. To translate that into an actionable plan, “You must develop parameters that will define opportunities and determine how and when you will act. Your homework determines what parameters or conditions define an opportunity, and your rules are the ‘if…then’ statements that implement your analysis.”

Establish controls

Control means have an exit plan. And you need to have an exit plan before entering a position, not after. Otherwise, you’ll be changing your exit plan based on the market narratives and price influence. Ask yourself: What do I need to see to change my mind (to exit this position)? 

If you wait until after the position is established to choose your exit point or being moving the stop to allow more room for losses or alter the fundamental factors you monitor in your decision making, then you 1) internalize the loss because you don’t want to lose face, 2) bet or gamble on the position because you want to be right, and 3) make crowd trades because you’re making emotional decisions. As a result, you will lose considerably more money than you can afford. 

Formulate a Plan

Just as there isn’t a set formula on how to be a successful investor, there isn’t a set plan on how not to lose money. But a good plan “is a script of what you expect to happen based on your particular method of analysis and provides a clear course of action if it doesn’t happen; you have prepared for different scenarios and know how you will react to each of them. This doesn’t mean you’re predicting the future. It means you know ahead of time what alternative courses of action you will take if event A, B, or C happens.”

In other words, negative thinking. Investing is all about managing risk. And the only way to manage risk is to consider as many possible outcomes as possible in advance and know what you’re going to do when each of those scenarios happens. 

Notes

Paul, J. (2013). What I Learned Losing A Million Dollars: Columbia Business School Publishing