Do you like taking unnecessary risks? With money? I am not sure about your answer but mine is that I don’t.
Ofcourse we cannot eliminate the risks in stock market investing. But lower the risks are, better I feel. In previous post about why being smart is not necessary to be rich, I explained why having a super IQ + intelligence might not protect your investments.
We need to understand that we can afford not to be a great investor. But we cannot afford to be a bad one.
The downside of being bad are pretty, bad. There is no need to take unnecessary risks if you don’t know what exactly is being offered in a deal. You can always choose to walk out of a deal you don’t understand fully. Instead, take the 2nd best strategy if that works for you more than the best one.
I know many cases where people have lost all money in stock markets. Then there are those who are waiting to recover money lost in stocks, even after years (and in rare cases, decade). Even the financial companies at times (rather most of the times) try to fool you. Read thisfor a real-life incident.
And who can forget the IPOs? Designed specifically to not-benefit only one category of people – new investors. 🙂
The promoters know more about their companies than the small investors. They only come out with IPOs when they know that they will be able to sell at prices, which are higher than actual intrinsic value. Now when the prices correct in line with actual value, the small investors get hurt. Then promoters come back with buybacks, open offers and delisting proposals. So all in all, its quite unfair. But people still take the IPO route when they see any recent trend of IPOs doing well.
In secondary markets, most investors participate with the wrong mentality. With share prices going up and down on a daily basis, there is an urge to act and benefit from volatility. But most investors lack the capability to make the right decisions under such levels of uncertainty. They let emotions take control of their portfolio and end up ruining it.
Another reason why some people always end up losing money is that they bet something important to get something unimportant.
Lets take an example.
Suppose you have to send your child to college in 5 years. You know that you will need Rs 15 lacs for that after 5 years. You have already saved up Rs 10 lac and are also regularly saving Rs 7000 a month. This will easily let you achieve the target of Rs 15 lacs in 5 years, even if you don’t earn anything on Rs 10 lac that you have already saved.
But your high-flying, high IQ financial advisor tells you that a particular sector is expected to do well in the coming years. And you can benefit from this once-in-a-lifetime-opportunity by investing in some sectoral mutual fund. You think about it and invest the already accumulated Rs 10 lacs in the sector fund.
Unfortunately, the sector doesn’t turn out to be a once-in-a-lifetime-opportunity and your investment goes down to Rs 7 lacs after 5 years.
You gambled because of your greed, ignorance or whatever. You risked something important for something that was not.
Buffett once used the example of Long Term Capital Management (LTCM) to explain about taking unnecessary risks. This is what he had to say (emphasis mine):
“…If you take the 16 of them (LTCM’s people), they probably have the highest average IQ of any 16 people working together in one business in the country, including Microsoft or whoever you want to name – so incredible is the amount of intellect in that room.
Now if you combine that with the fact that those 16 have had extensive experience in the field in which they operate. I mean, this is not a bunch of guys who made their money selling men’s clothing and all of the sudden went to the security business or anything. They had, in aggregate, probably 350 or 400 years of experience doing exactly what they were doing.
And then you throw in the third factor: that most of them had virtually all of their very substantial net worth in the business.
They have their own money tied up, hundreds of hundred of millions of dollars of their own money tied up, a super high intellect, they were working in a field they knew, and they went broke.
And that to me is absolutely fascinating.
If I write a book, it’s going to be called “Why do smart people do dumb things?
To make the money they didn’t have and they didn’t need, they risked what they did have and did need – that’s foolish, that’s just plain foolish.
If you risk something that is important to you for something that is unimportant to you, it just does not make any sense.
I don’t care whether the odds are 100 to 1 that you succeed, or 1000 to 1 that you succeed.
If you hand me a gun with a thousand chambers or a million chambers, and there is a bullet in one chamber and you said ‘put it to your temple and pull it’, I’m not going to pull it. You can name any sum you want.
It doesn’t do anything for me on the upside, and I think the downsize is fairly clear.
I’m not interested in that kind of a game, and yet people do it financially without thinking about it very much.
It’s like Henry Kauffman said the other day – the people going broke in these situations are just two types: the ones who know nothing, and the ones who know everything.”
Coming back to the example of funding your child’s education, you can easily blame bad luck for getting screwed up.
But is it really bad luck? I don’t think so.
It’s rather a case of what this quote by DW Jerrold says:
Some people are so fond of bad luck that they run halfway to meet it. 🙂
So what is it that takes to save your money from yourself?
There is no set formula to not lose money. Also being smart is a good thing. But don’t be over smart when it comes to money matters. Don’t do stupid things because you are greedy or impatient.
There are things you don’t know and more importantly, there are things that you don’t know that you don’t know! That is where the biggest risks lie. Make buffers for such unknown-unknowns. Also make buffers for known-unknowns like death.
Be aware of the potential downsides of your decisions. The potential upside is totally irrelevant if the downside is bankruptcy or death (as in case of Buffett’s gun example).
And as David Houke of Alpha Architect says, there are certain bets, regardless of how asymmetric they may appear, that should be beyond consideration by a reasonable and prudent actor. The second thing that can protect you is an awareness of what the potential monetary upside actually means to you, in practical terms.
The second point is really important.
What is that you are after? Does taking the additional risk actually help you in any other way apart from adding some extra money to your wallet? What is the true effect of additional returns on you and your life circumstances? It’s a question worth asking.