In late April 2000, my phone rang. It was Andy, my broker, offering me a chance to get in on an IPO. Was this Glengarry Glen Ross chance going to make me money? Hardly. The stock Andy was offering was in AT&T wireless, which trades under the stock symbol AWE. I could buy the stock at the IPO price of $29.50 per share. I did not buy.
Part of the reason that I did not buy was a story in the great investing book Reminiscences of a Stock Operator.13 The book is filled with the trading exploits of a character based on the famous speculator Jesse Livermore. In one escapade, our hero receives a stock tip, listens carefully, and then makes money by doing exactly the opposite.
I thought of this story when Andy called with his AWE stock. Why was he calling me for this IPO when he had never called for any other stock offerings? I could think of many reasons for this unique offer, but none of them suggested that I would make money from buying this IPO. In fact, if I’d been a top gun trader, I would have bet against the stock by selling it short. Being a bit more cautious, however, I simply declined the offer to buy, and watched the stock carefully.
What happened to my only chance to play in the IPO game? The stock essentially went straight down. After a very brief and small rise above the offering price, the stock sank to under $5. (By the end of the movie, the Glengarry Glen Ross leads are revealed to be worthless; so in some sense my opportunity did mirror that of the salespeople in the movie.)
One lesson from this experience is to not take tips from anyone. Interestingly, this extends to even taking tips from ourselves. How is it even possible to give ourselves a tip? And why should we be skeptical of our own tips?
Recall that it is useful to think of the brain not as one cohesive entity, but rather as a society of mind (to use MIT professor Marvin Minsky’s phrase) having different, and sometimes competing goals. The more thoughtful, cognitive parts reside in the prefrontal cortex, while the lizard brain lives elsewhere. Recall also that recent studies in neuroscience implicate the lizard brain in some of the behaviors that tend to cost us money.
When we get an urge to make a trade, it may be the lizard brain providing us with a tip. While the lizard brain may have led our ancestors to big game, it is not likely to make us rich. So when we get a hot tip from ourselves in the form of a trading idea, we should treat it with suspicion. Is the idea based on good, unemotional analysis? Or does it arise magically from an unknown place?
Here’s one clue that I have found useful to discovering the source. If I feel that there is a pressing need to trade now—that this is a fleeting and golden chance—then I suspect the lizard brain is at work. In all cases (whether the urge is strong or not), I wait at least one week between a trading idea and its implementation. Occasionally, this rule will cause me to miss a great trade, but it also prevents me from making a lot of bad decisions.
Conclusion: Never trade on other people’s tips. Treat your own ideas for trades with some skepticism. Never trade impulsively, as you might be falling for a bad tip from the lizard brain. Always include a significant delay between an investment idea and an actual trade.
Lesson #3: Losers Average Losers
In Chapter 2 we discussed one of the two handwritten signs that I saw over Paul Tudor Jones II’s desk in 1987. The second note said, “Losers average losers.”
What does this mean? Let’s analyze it in three steps. First, what is averaging? Second, what does it mean to average a loser? Third, why is it that losers average losers?
Averaging an investment means adding to an existing position. For example, I started buying Microsoft stock in the early 1990s. Taking into account all the stock splits, the price I paid was about $2/share. Over the next few years, I bought more of the stock at progressively higher prices (it eventually topped out at $60). As I bought more, the average price that I had paid for my Microsoft stock changed. In particular, my average price rose as I combined more expensive stock with the original buy at $2. Increasing the size of an existing investment is averaging.
Averaging losers is buying more of an investment that has gone down since the original purchase. If the price of Microsoft had dropped, and I had bought more at a lower price, then I would have been averaging my purchases on one of the “losers” in my portfolio.
“Losers average losers” means it is the bad investors (i.e., the losers) who buy more as an investment declines. Paul’s note essentially means that adding to a losing investment is throwing good money after bad. This “losers average losers” is one of the most famous lessons in all trading. In fact, it is the number one lesson cited in Reminiscences of a Stock Operator:
I did precisely the wrong thing. The cotton showed me a loss and I kept it. The wheat showed me a profit and I sold it out. Of all the speculative blunders there are few greater than trying to average a losing game. Always sell what shows you a loss and keep what shows you a profit.
The idea that losers average losers is not news (Reminiscences was first published in 1923). What is new is the link to the science of irrationality. Professor Kahneman has documented the irrational manner in which human psychology handles losses. As we saw in Chapter 2, our behavior becomes even more irrational when we are confronted with taking a loss. We become emotional risk takers, willing to bet the house in order to salvage our pride. This instinctual desire to avoid losses, paradoxically, tends to create even more losses.
Even experienced traders must fight the tendency to average losers. I recall a related incident when I was working at Goldman Sachs & Co. The boss of the corporate bond area was visiting each trader to review buy and sell decisions. The partner became enraged when looking at one trader’s list of buys and sells, and threw it in the garbage (nowadays this is all done on computer, but in 1987 there were paper copies). The partner said, “You’ve sold all your winners, and you’ve kept all of your losers. I want you to sell every one of these dogs before the day is over, or don’t come in tomorrow.”
Even great and experienced traders must fight the impulse to hang onto and average into losers. The Goldman Sachs & Co. trader guilty of this cardinal sin was a veteran with about eight years’ experience and was probably making more than a million dollars a year. In fact, the “losers average losers” sign above Paul Tudor Jones’s desk suggests that even he felt the need for a reminder to avoid this mistake.
Conclusion: Never average losers. Buy more of an investment only when (and if) it increases in value.
Lesson #4: Do Not Dollar-Cost Average
So losers average losers. Those who agree with this statement should not invest by “dollar-cost averaging.” What is dollar-cost averaging, and why is it a form of averaging losers?
Here’s how an article on the Motley Fool website describes dollar-cost averaging:
Dollar-cost averaging can be a good way to protect yourself from a volatile market. It’s the practice of accumulating shares in a stock over time by investing a certain dollar amount regularly, through up and down periods . . . The beauty of this system is that when the stock slumps you’re buying more, and when it’s pricier you’re buying less.
The conventional wisdom suggests that dollar-cost averaging is a great way to invest. It often takes the form of a payroll withdrawal that is invested into stocks. Such payroll purchases are a form of dollar-cost averaging because the same numbers of dollars are invested in each period.
Sound reasonable? In fact, dollar-cost averaging is a profitable strategy as long as the money is invested into something that goes up in price persistently. In bull markets, every drop in price is an opportunity, and as the Motley Fool suggests, the “beauty” is that the investor scoops up more shares during “pullbacks.”
While dollar-cost averaging works in bull markets, it is not profitable in long-term declines. Imagine, for example, what would have happened to an investor whose dollar-cost averaged into eToys stock. Each month, as the stock price of eToys fell, the investor would be buying more shares for the same dollar amount.
As the Motley Fool piece sugges
ts, it is true that “when the stock slumps you’re buying more.” That’s great except for the fact that eToys filed for bankruptcy; at which point the shares became worth zero.
Dollar-cost averaging doesn’t work well for declining investments. The Japanese Nikkei peaked over 40,000 in 1989, and 15 years later it sits at around 12,000. So an investor who “yen-cost averaged” into Japanese stocks over the last 15 years would have been averaging losers; that is, owning more and more of a declining investment.
Even if you are optimistic that Japanese stocks will rise from current levels, you would be better off buying now. You could buy today at a much lower price than you would have paid by averaging, and you could have avoided 15 depressing, losing years.
Averaging into a declining market is a form of throwing good money after bad. If this is true, why is dollar-cost averaging so popular? The answer is that a lizard brain that has lived its entire life in a bull market loves dollar-cost averaging. In fact, the backward-looking lizard brain loves whatever has worked in the past.
In the United States, dollar-cost averaging into stocks has always paid off in the “long run.” That is because throughout history U.S. stocks have always eventually recovered and gone on to new highs. In what has been a 200-year bull market in U.S. stocks, marked by some extreme pullbacks, dollar-cost averaging has worked well. It will not be profitable, however, if stocks enter a persistent decline. Price declines in secular bear markets are not pullbacks, they are just setbacks on the way to more declines.
Dollar-cost averaging is a bull market strategy. It is the equivalent of being loaded for squirrel. As long as there are no vicious bears, then being loaded for squirrel is perfect. Thus, dollar-cost averaging into U.S. stocks is a form of investing by looking in the rearview mirror. It has been a great strategy throughout U.S. history, but that does not mean that it will be a profitable strategy in the future.
Conclusion: Do not dollar-cost average. Unless you have some secret knowledge that we are not in a bear market, dollar-cost averaging can be a form of averaging losers. Remember: Losers average losers.
Lesson #5: Do Not Open Your Mutual Fund Statements
In the closing credits of Austin Powers, Mike Myers in the title role is seen taking pictures of minx-like Vanessa (played by Elizabeth Hurley). As he takes photo after photo, Powers snaps his fingers while saying, “ignore this, ignore this, ignore me doing this.” The joke is that it is even harder to ignore his snapping fingers when instructed to do so. In the context of photography, this little trick helps keep the model at ease and looking natural.
When it comes to investing, our inability to ignore extraneous information costs us money. With modern media and technology it is possible to get almost instantaneous information. Financial networks in the form of CNBC and Bloomberg TV allow everyone to keep up with breaking news. It is even possible for individual investors to listen in on some companies’ earnings calls, right along with Wall Street professionals.
In earlier eras it took a long time for information to reach investors. Consider, for example, the effect of the battle of Waterloo on British financial markets in 1815. Early reports of the battle suggested that Napoleon was winning, and this caused the British markets to fall precipitously.
While the market was plummeting and sellers were panicking, Nathan Meyer Rothschild was calmly buying. Several days later, the news of Napoleon’s defeat reached London and markets soared. This netted Rothschild some handy gains.14
What made Rothschild buy when others sold? He had advance information provided via the unlikely route of trained carrier pigeons that flew across the English Channel. Thus, Rothschild got word of the French defeat several days ahead of others and was able to make a financial killing.
Can we all be Rothschilds by watching CNBC and listening in on earnings calls? The answer for most people is no. In spite of regulations making it harder for firms to release information selectively, by the time news is available to most people, it is too late to make profitable trades.
“Wake up will you, pal? If you’re not inside, you’re outside.” So says Gordon Gekko (played by Michael Douglas) to Bud Fox (Charlie Sheen’s character) in Wall Street. Only those on the inside can trade profitably on news; if you are not sure if you are on the inside, then you are not.
The worst thing people can do is try to trade on news. Perhaps the second worst thing we can do is to even listen to that news. People find it difficult to ignore information.
A famous experiment by Professors Kahneman and Tversky shows the effect of useless information on analysis. In the experiment, people were asked to estimate the percentage of African countries in the United Nations. Before their guess, a random number was generated—in front of the participants—by the spin of a roulette-like wheel. If people were rational, the useless information from a random spin of a wheel would not alter their analysis. In fact, the people in this study were not able to ignore the information. Those people who saw a high number on the wheel had higher guesses for the percentage of African countries in the U.N. than those who saw low numbers on the wheel.15
We are influenced by irrelevant information. This “anchoring” effect has been demonstrated in many different experiments. Anchoring, for example, is one good reason to make the first offer in a negotiation. No matter how absurd that first number, it often influences the final outcome.
Have you ever made a losing trade because of some talking head on TV, even when you disagreed with the analysis? If so, you know how hard it is to ignore a message, and how costly listening can be.
Ignoring the news on the TV is one solid suggestion. It might even be useful to not open your own mutual fund statements. There is evidence that the more frequently people look at their investing performance, the worse they do.16 When we see losses, we tend to make emotional decisions to exit positions. As we’ve learned, most trades are bad ideas, and emotional trades are the worst.
For those who can’t ignore information, the answer is to avoid it. A simple rule is to align your rate of information acquisition with your trading horizon. If you are a day trader, then by all means have the TV on and watch streaming, real-time stock quotes. If, however, you are going to make a few, unemotional adjustments to your portfolio per year, then I suggest that you avoid as much information as possible.
I suspect that an investor, who just read annual reports, or even a farmer’s almanac, would do better than one plugged into nightly conference calls of corporate earnings.
Conclusion: Keep your financial news flow consistent with your decision time frame. As much as possible, turn off the TV during the day, and don’t look at your portfolio.
Lesson #6: Spin Control for Yourself
Nassim Nicholas Taleb, my friend, and the author of Fooled by Randomness, tells a story about one of his former clients. A Swiss firm hired Nassim’s firm to put on a hedged position. The trade involved one Swiss investment paired with a non-Swiss investment.
The bet went on for some time, and it was very profitable. The clients, however, were not happy. They were making money overall, but the gain came by making more on the non-Swiss investment than they were losing on the Swiss investment. In cartoon terms, the payoff to the trade looked like:
Seeing the loss, particularly on the Swiss investment, ate away at the clients. Nassim tried to explain that the important thing was to make money overall. Nothing worked to assuage the clients until Nassim started just reporting the position as:
Now the client didn’t have to see that offensive “LOSS” and was happy. This may seem silly, but Professor Richard Thaler has shown that most people exhibit some form of this irrationality in what he calls mental accounting.17 We might, for example, be willing to borrow money on our credit cards at 18% while keeping a savings account that earns 2%. A rational investor wouldn’t keep such separate accounts, but rather would pay off the credit card debt with money in the savings account.
Even when there are no real accounts, people tend to keep se
parate mental accounts for their money, and this can create costly irrationalities. For example, I was out one evening shopping with Patricia. She found some costly cosmetic cream at the swanky store called Sephora. The cream cost $135 for a small tube.
“Are you going to buy the cream?” I asked. Patricia said yes, but then added, “I’ve spent too much money today. I’ll come back tomorrow morning and buy it.” Patricia kept a mental account for each day’s spending. This informal accounting system caused her to spend extra time, use extra gas, and pay an additional parking fee to acquire what she could have purchased immediately.
Mean Markets and Lizard Brains Page 27