Like all people, I tend to maintain mental accounts, and it has hurt my investment performance. Beginning in early 2002, I started buying stock in some gold mining companies. I thought that the Federal Reserve’s easy money policy might lead to a rise in gold prices, which in turn would increase the profits of gold mining companies. Accordingly, I invested a small amount in these stocks.
How did I do on my gold investment? Since my initial purchase, the price of gold has risen by more than 50%, and many gold mining stocks have doubled. So I was absolutely correct with my decision to buy gold. Unfortunately, I made absolutely zero on my investment.
Why did my trading so completely fail my analysis? The answer was that I was buying gold stocks in an account that had nothing else in it except for some inflation-protected bonds. Gold mining stocks can be pretty volatile. So whenever gold declined, I saw this account shrink dramatically in value. This made me feel like an idiot, and I tended to sell the stocks at exactly the wrong time.
I was suffering from a form of mental accounting. Gold is a hedge against inflation. Most of us will be far better off in a world where gold prices are low. So in periods when gold was dropping, my prospects were improving. When gold went down in price, my overall position looked like:
So I should have been happy when gold went down. The solution for me is the same as the solution for Nassim’s clients. I now make sure that I look at my overall position. In the past, I had tended to look at each account separately. Now I force myself to use financial software to look at my total position.
So the lesson is we need to perform some “spin control” even for ourselves. We have to guard against goading our lizard brain to become active (and destructive). That means we should anticipate what sort of information would push us toward emotional decisions.
Conclusion: Look at your financial position in an aggregate fashion. In particular, be sure to combine any defensive positions with other investments that are being protected.
Lesson #7: When to Go “All In”
My buddy Chris, the MIT rocket scientist whom we met a couple of times, is a world-class Ultimate Frisbee player. This rapidly growing sport combines elements of soccer and American football.
Chris was a key member on the Boston-based team “Death or Glory” (a.k.a. “DoG”) that had a dynastic hold over the sport both in the United States and internationally for many years. In the world championship in 1996 Chris scored eight goals as DoG defeated Sweden 21 to 13, with seven of these goals being almost full field passes, the equivalent of a “long bomb” in football.
How did Chris become one of the dominant offensive players in the world? Interestingly, although scoring requires outrunning the defender, Chris’s success is not the result of speed. Although Chris is speedy, he often plays against others who are faster. Somehow he is able to score consistently on faster defenders and he dominates competitors with equal speed.
I asked Chris his secret. How do you outrun people who are faster than you? His answer, “I maintain the ability to make at least two different moves. When I get a slight advantage, I commit completely.”
At almost all times, Chris is not running at full speed. Rather, he is jockeying for position, and carefully watching for an opening. This can come in some subtle form such as noting that the defender is leaning in such a way so as to be unable to react to a move in a certain direction. At that point, Chris is all in, sprinting at full speed.
In contrast, less experienced players are often running hard almost all the time. They look like they are doing well, but they do not score very often. These less successful players expend lots of effort and receive little reward.
There are some similar themes in investing. Many people tend to be all in, all the time. By this I mean that they have maximum capital at risk every day. In fact, the standard advice from Wall Street is to invest most money in stocks. An investor who follows this advice is fully committed to a risky course all the time.
In bull markets, being “all in” is very profitable, but problems surface when markets decline. Remember that Chris always maintains at least two options for his move. In contrast, investors who constantly put all their money at risk are not in a position to buy more at moments of irrationally low prices. By being fully committed all the time, investors remove the ability to buy more—they no longer have two viable options.
Being persistently “all in” financially has costs beyond just missing buying opportunities. In fact, it increases the likelihood that the lizard brain will activate precisely at the wrong time. This tends to lead to emotional “puke-outs” where investors sell during buying opportunities.
This suggests that investors should maintain a financial reserve, and should only rarely and temporarily be “all in.” Such an investing philosophy allows one to have the ability to buy or sell at any given time depending on the conditions.
There are some similar lessons to be drawn from competitive poker. The World Series of Poker has “no-limit” rules allowing players to go “all in” at any time. My observation is that there is a systematic difference between great players and good players related precisely to the decision of when to be fully committed. The great players tend to go all in with hands where they have a good chance to win. Other players seem to more often get trapped into going all in with worse chances to win.
A key to winning at poker is to know when to “lay down” a hand, that is, to quit playing, even with a good hand, rather than bet more money. The great players will sometimes lay down even solid hands. Better to lose a few dollars and stay in the game. Bad poker players get trapped going all in when they shouldn’t.
Conclusion: Keep your investment position conservative enough so that you preserve both options of increased risk or decreased risk should others panic and present you with an opportunity. Choose the time to go “all in” carefully and scale down quickly.
Lesson #8: Do Not Get the Key to the Mini Bar
When I check into a hotel, I never get the key to the mini bar. Without the key, I don’t need willpower to avoid any late-night temptation to devour junk food. I have found that most temptations are better avoided than resisted.
I’ve noticed that some hotels no longer have mini bars, but instead they lay the food out on top of a table. Thus, the “don’t get the key” defense doesn’t work. In such cases, I call down to the front desk and have them remove the food.
I once arrived at one such devious hotel so late at night that I wanted to go to sleep immediately and not wait for someone to remove the food. As a partial preventative measure, I put a towel over the chocolate bars and other treats. While I still knew the junk food was in my room, at least I couldn’t see it.
As we have seen, our investing instincts are out of sync with market opportunity. The investments that feel good are precisely those that are most likely to cost us money, and vice versa. This leads to the paradoxical situation that we sometimes gain by having fewer options. Usually, having more options is better, but when our instincts lead us to bad choices—as with junk food in the mini bar or with emotional investing decisions—we can make ourselves better off precisely by limiting our alternatives.
This “less or more” insight into self-control has become closely associated with the story of Odysseus and the Sirens. On his way home from the Trojan War, Odysseus had to sail past the Island of Sirens. These maidens’ song was so beautiful that sailors approached them and were killed as their ships crashed on the rocks surrounding the island.
The goddess Circe warns Odysseus of the danger and provides him with a solution in this passage of The Odyssey:
If any one unwarily draws in too close and hears the singing of the Sirens, his wife and children will never welcome him home again, for they sit in a green field and warble him to death with the sweetness of their song . . . but if you like you can listen yourself, for you may get the men to bind you as you stand upright on a cross-piece half way up the mast, and they must lash the rope’s ends to the m
ast itself, that you may have the pleasure of listening. If you beg and pray the men to unloose you, then they must bind you faster.18
By following Circe’s advice, Odysseus survives the Sirens. He has himself strapped to the mast, and he commands everyone else on the ship to put wax in their ears so that they cannot be tempted by the Sirens. Because Odysseus is unable to control his ship or his men, he hears the Sirens, but is unable to approach their deadly shore. He achieves his goal precisely because he has limited his options. By tying his hands, Odysseus gets what he wants.
Inspired by this story, “mast-strapping” is used in the scientific literature on self-control to explain how having fewer options can sometimes lead to a better outcome. If we didn’t have self-control problems, then more options would always be better.
For many people, financial mast-strapping can be a valuable tool. One of the primary problems in investing is our own desire to trade too much. Almost everyone seems to suffer from this problem, and so do I. Even with all of my knowledge that trading on impulse is bad, I still feel the tug every time I watch a market.
Because I like to trade too much, I have done some mast-strapping to constrain my trading. The first thing I did was lock up the bulk of my family’s financial assets in a full-service brokerage account that charges $100 a trade. Why pay $100 for something that can be bought for far less? For me, the answer is that $100 works to reduce my costly trading.
Originally, I also kept a small amount in a discount firm’s account that charges $5 a trade. When the urge to trade struck me, I would indulge it, but only in this “small account” with the low commissions. This setup prevented me from overtrading most of our money. It was not, however, a perfect solution.
The Waco Kid (played by Gene Wilder) in Blazing Saddles had a similar problem to mine. While playing chess with Sheriff Bart of Rock Ridge (played by Cleavon Little), Wilder says, “I used to be the Waco Kid.” The sheriff asks, why “Used to be”? In response, Wilder holds out his right hand, which is rock steady. The sheriff says, “that looks fine,” to which the Waco Kid raises his other arm which is uncontrollably shaky, and says, “Yes, but I shoot with my left.”
My first mast-strapping solution still had me doing the equivalent of shooting with my left. I did far too much trading in my “little” account. It didn’t cost me any significant money, but I spent so much time on the account that I was probably making minimum wage for my efforts. After about a year of this experiment, I closed the smaller account. This more secure mast-strapping has, so far, been a total success. With no ability to trade cheaply, I haven’t traded impulsively.
I suggest that almost everyone, except for the top guns of trading, structure their world so that they cannot trade impulsively. The exact setup will vary for each person. Many people would still trade even at a cost of $100 a trade, so the solution that works for me won’t work for everyone.
A pervasive problem with our efforts to improve by mast-strapping is that there’s usually someone who would profit from untying us. Just as hotels seek to profit by leaving candy bars on the counter, there will always be firms that are happy to help us trade. We need to be crafty to construct our finances so that we won’t be tempted to make bad decisions.
I helped my friend Doug (the millionaire surfer) quit smoking. He agreed that if he smoked even one puff of a cigarette, he would have to pay me $100. Furthermore, immediately after that first puff, he would have to call me to acknowledge defeat. Our agreement was set up for one year, and Doug made it for the entire year without a smoke.
Why did this silly arrangement work to get Doug to quit? The answer is that it tapped into Doug’s psyche in the right way. He and I were a bit competitive, and so the prospect of paying me even a nominal sum was loathsome. Furthermore, Doug is honest enough that he wouldn’t cheat and lie about smoking. Finally, the need to call and immediately acknowledge defeat was a potent deterrent.
The right answer for everyone is to avoid emotional trades. The way to accomplish that is to make structural arrangements so that emotional trades are not possible. The details of the correct form of financial mast-strapping will vary for each individual.
Conclusion: Those who trade too much should arrange their finances so that impulsive trades are not possible. Remove temptation; do not expect to resist it.
Do Not Trade in the Red Zone
“Happy families are all alike; every unhappy family is unhappy in its own way.” So begins Tolstoy’s Anna Karenina. Similarly, successful traders avoid making self-destructive investment decisions. The specifics are idiosyncratic; the general lesson is to constrain the lizard brain that lurks within each of us.
All of the tips I’ve suggested can be understood as efforts to get control back to the investors’ rational side and away from that lizard brain. While the lizard brain is great for lizard-like activities like finding food and shade, in financial markets, our instincts are the enemy.
My friend David the oil trader has learned how to avoid such mistakes on his way to a lucrative trading career. In Chapter 4 we heard one of David’s secrets is that “he knows when the buying is real.” I learned another of David’s secrets one day in the 1980s. In order to profit from an anticipated rise in oil, I bought a single oil futures contract, which represented 1,000 barrels of oil. For every penny’s rise in the price of oil, I stood to make $10.
Almost immediately after my purchase, however, the price of oil started to decline. My losses began to mount: $10, $30, $70, and more. This wasn’t any fun at all. Furthermore, because I was a student, these amounts became a significant portion of my net worth at the time. I took the pain of my losing position for about 30 minutes, by which time the loss exceeded $200. I turned to David and said, “I’ve got to get out.” He said, “I got you out a long time ago, I just wanted to see how much pain you could stand.”
Over the years I’ve learned that David almost always exits his losing positions very quickly—just as he got me out of my trade almost immediately. He’d rather take a quick and small loss instead of letting the position eat away at him financially and emotionally. He summarizes his philosophy by saying, “I don’t trade in the red zone.” By that he means that losing trades (those in the red zone) are exited very quickly, while he’s willing to ride his profits (trades that are in the black) for much longer.
Don’t trade in the red zone.
While David interprets this strategy literally to exit losing positions, I interpret it more broadly. I suggest that people not trade in the emotional red zone. What’s the definition of a psychologically defined zone? The answer can be drawn from the legal efforts to restrain pornography. In the 1964 Supreme Court case Jacobellis v. Ohio, Justice Potter Stewart wrote that, he could not define hard-core pornography, but stated “I know it when I see it.”19
Similarly, there is no objective definition of the emotional red zone, but I think we know it when it happens to us. If an investment is eating away at us, we should consider exiting. (Such considerations should, of course, be done in an unemotional manner.) “Use the Force, Luke. Let go.” The spirit of Obi Wan Kenobi suggests that Luke will know the right answer himself. Similarly, the specifics of avoiding the red zone are different for each person. The result, however, should be the same for all.
An investor who avoids the red zone, should, for example, be able to (1) go on vacation for weeks and not look at the markets, (2) increase or decrease any position, (3) take large price changes in all markets without having to buy or sell anything, and (4) sleep without thinking about investments.
Those who can develop such a no-red-zone system can never be forced by their emotions nor by market dynamics to make a decision. The first step to making money is not “plastics” but to avoid letting the lizard brain make emotional and costly investment decisions. This is not easy because, like Michael Jordan, the lizard brain can’t be stopped, “just contained.” Those who contain the lizard brain will have taken the first step toward profiting from mean markets
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chapter eleven
TIMELY ADVICE Investing in the Meanest of Markets
A Generation of Rewarding Risk
In the introduction we met Adam, my former Harvard Business School student who asked, “Where should I invest my money?” In the early 1980s, I grappled with the same question. At the time, I lived in southern California and did a lot of surfing with my buddy Gary. Surfers spend far more time bobbing around in the ocean waiting for waves than actually riding them. Gary and I filled our spare time with a debate about how to make money; I argued that stocks were the best investment, while Gary favored real estate.
I loved stocks in the early 1980s because they were amazingly cheap! The Dow Jones Industrial Average sat near 1,000, and fantastic companies had single-digit price-to-earnings ratios. Gary’s love of real estate was based on supply and demand. There is a limited supply of beach real estate and, over time, essentially an unlimited demand by people who want to soak up the sun.
Mean Markets and Lizard Brains Page 28