What I learned by loosing a million dollar
An insight to Jim Paul , how he made billions, then bankruptcy with came back like a roaring lion. More importantly a short book with loads of behavioural finance, I am heavily biased with this books…must have gone through more than 9 times in last 3 months!
The book will blow your head off, a speculator/investor and his lessons with action plan!
Here are key lessons in case you are still not convinced:
Differentiating between external and internal loss
Some losses are internal such as self esteem and control, your love or even your mind. Other hand external losses arise due to game, content, bet etc. External losses are objective where as internal losses are subjective. The catch is you how you interpret, when you loose in market its an objective loss; majority of people make it as subjective loss. And ego is foremost reason behind making objective to subjective loss.
We tend to regard loss, wrong, bad or failure as a crime. But if you look at road side vendor in morning or night when he opens shop or wind up for the day, you will find throwing out the products are not saleable ….that’s loss; inevitable part of life.
Then key is why do we make external losses as internal? Participating in market place is not about right or wrong nor even defeat but making decisions. Decision making is a conclusion after careful consideration, choice between alternatives not between right and wrong. We think loosing money in market is wrong, make it as matter of reputation and pride. That’s where we bring ego to decision making which turns objective loss to subjective loss.
How do I know it’s an internal loss? Jesse Livermore the greatest trader ever lived in world gives some indication to stages we go through when we have internal loss.
Stage 1 is denial- no way, I cant be wrong. I will try more trades to justify myself correct.
Stage 2 is anger- if I cant contain denial then it’s replaced with anger and displayed in all
directions, with family, office and everywhere else by started venting frustrations.
Stage 3 is bargaining- unable to manage anger we turn to god, please bring back my cost price. I will sell and runaway!
Stage 4 is depression- it’s a pervasive feeling of sadness, distancing yourself from loved ones.
Final stage is acceptance- finally we admit inevitable and accept the loss or book it.
And these stages doesn’t happen only when you are sitting in loss, even during profit time as well. For example price moved from 40 to 80 and slip back to 60. We get married to the price of 80 and rue over loss and somehow pray to god ….please bring back to 80.
Knowing discrete events and continuous process
Discrete event is one which has a defined ending point e.g. you bet on a cricket match. If you don’t win the matter ended as soon as match is finished and result declared. A continuous process is an activity not having defined end. Like stock market, where another battle resume next day from where it left……goes on and goes on. Losses from continuous process get internalised as we get to chance fight another meaningless battle.
Take an example, I buy a stock at 50, expecting a 20% gain ore more. Instead of going upwards it fall to 40. This is where market gives me an opportunity to ask me it can still go up and there are so many examples where stock came back strongly. I kept on buying, stock falls further; beyond a loss I took at as matter of prestige and that’s precisely market strikes you.
Now let’s understand what is investing, trading, speculating.
Investing is parting with capital in expectation of safety of principal and return on capital in the form of dividend, capital appreciation. Because the returns are periodic payments like dividends it requires separation of capital from us. Basically investing is a long term horizon.
Trading is where a dealer makes money from bid and offer spread. They stay net flat (nor long or short).
Speculating is buying for resale, parting with capital in expectation of capital appreciation not dividend.
Betting is an agreement between 2 parties where one goes wrong and compensate the other.
Gambling though sounds like betting is actually is playing a game for excitement for money involved. These people come for entertainment not money.
Psychological fallacies
Fallacies held in popular beliefs have a catastrophic effect in continuous process events.
First one is tendency to overvalue a high gain of low probability and undervalue high gain with a low probability. Next is interpret probability of successive events as additive than multiplicative. Then we think law of averages where we interpret after some failures success is bound to come. Lastly we have a habit to over estimate the outcome of these random events.
There are 2 kinds of reward one is profit or money, second is recognition. Market is for profit motive. No point in congratulating yourself after pricing is going up or going into slumber after pricing is driving down!
I am not among crowd
A popular misconception as we tend to feel we are not among crowd, we are exceptional. The fact is we are faces among crowd who needs to behave in a manner beneficial to self interest. Whether the behaviour is in line with crowd expectation or not doesn’t matter.
Emotions are not bad but when they start affecting decision making it becomes major pain. When someone says don’t follow the crowd first lets understand what a crowd is. Crowd is not a mad fool, after all people are like you and me. They react to patterns such as displacement like war etc, Or opportunities in sector and economy or credit expansion. Sometime all patterns take over human as euphoria leading to irrational investment decision making.
Another side of crowd is , when we are among crowd we feel safe… a sense of invincible power. Some time you get hypnotised by price changes, tv commentaries etc. These are crowd behaviour you need to avoid.
Ok this is a petty much platform for behavioural finance, how do we manage such illusions and emotions then.
Rules and tools that doesn’t fool you
Future is uncertain, never completely reveal to us. We have to accept choices either investing or speculating. Investor knows everything he needs to know while putting a money. He built margin of safety to his calculation to eliminate fringes if any of uncertainty. On other hand a speculator doesn’t have the advantage of investor but has some knowledge about what determines the outcome of his activity. It’s the application of intellectual examination and analysis of uncertain future.
Successful investing is combination of investing and speculating skills. Speculation is a forethought and demands reasons for decision making. He thinks before acts! Even investment god Warren Buffett is 60% investor and 40% speculator. Now we can correlate when we don’t get answers to many checklist questions , yet we have to take a decision and move on.
Speculation does require a PLAN. Plan is a method need to be worked out before hand before accomplishment of objective, not to think and act simultaneously. Without a plan either you are bettor or gambler.
To make an effective decision making in investing process is 1. decide what type of participant are you going to be - investor or speculator? 2. Select a method of analysis 3. develop rules 4. establish controls 5. formulate a plan.
To me if some one asks a plan, this is what I think.
If I don’t have a plan in hand then I haven’t thought things out ahead of time. And by default I am betting and gambling. Both of these involve ego that means I am personalising market. Without a mental effort and plan my conscious is out of control, emotions are ruling me and I am part of crowd who are making emotional decisions.