CHAPTER 1
Stop Making Investment Mistakes
It was when I found out I could make mistakes that I knew I was on to something. —Ornette Coleman
Not Quite a 12-Step Program
We all make mistakes and, as with every hangover, we emphatically and fruitlessly vow never to do it again. But I promise that you will. The end.
Just kidding.
Innate human tendencies were meant to help us survive the wilderness, not make investment decisions. And yet, those are the tools we rely on today for complicated reasoning. No wonder investing hasn't been seamless. Not totally wrong, but not totally right either. Recognition and acknowledgement are the first steps in any 12-step program for change. You don't know what you don't know, and if you aren't aware in the first place, you can't make a decision to affect change. If you soberly knew a way to make intelligent investment decisions, you would. If it only took a bit of understanding to be more profitable, you'd do that too.
This is not a book telling you to spend less and save more, but one that provides all smart things to do while you are saving and once you have a nest egg. Whether you read it cover to cover or you select individual sections that will help you when you need them most, I hope you will keep a well-worn copy next to your investment account statements.
Play it Again, Sam
Both men and women harbour cognitive biases that influence our behaviour. The way each of us reacts is alarmingly predictable and consistent. Predictable and consistent. The good news is that you're not alone. The propensity to make errors with money and investing is well documented through a growing body of study called behavioural finance.
Luckily, cognitive biases are nothing more than tricks and shortcuts that our brains use to help us make quick decisions and be more efficient in our lives. Unfortunately, these pre-fab decision trees don't necessarily add value to the financial outcomes at hand.
The plight of the human condition leaves no one behind. Over the years, these biases have taken hold regardless of race, education, gender or socioeconomic status. Decision errors are made and repeated with great regularity. Rational financial decisions are much easier to make once you understand the reasoning behind these biases and are able to recognize the predispositions. If you're already entrenched in the belief that each of us operates as a free decision maker, you won't need convincing that experience is the sum of mistakes that we don't need to repeat. Ultimately, it would be ideal to enhance your financial situation with the least amount of effort on your part. To do that, we need to lay out some groundwork.
Possibly the most important piece to understand is the notion that investment markets are efficient. This idea gained popularity in the 1950s. To be brief, the efficient market hypothesis maintains that stock market prices are random and fair. Essentially, it contends that there are enough rational people buying and selling stocks and other securities that the market will determine a fair price simply through the buying and selling of the securities. If the price are too high, no rational person would buy. If it's too low, no one would sell.
When stock prices get out of whack, sellers eagerly dump overpriced securities, driving prices down, and buyers then snap up underpriced ones with earnest, forcing fair values. Imagine a passerby frantically rapping on your door, offering to purchase the gargoyle peering over your eaves for twice what you bought it for. You'd be a fool not to sell it. The passerby must have different information about the value of the statue of course, or she rationally would not purchase the ugly beast against her financial best interest. If there were a crowd outside your home, some selling gargoyles and some buying, you could reasonably assume that the average agreeable price of the transactions represents a fair market value for the statues.
The second part of the efficient market hypothesis (you'll have a few great phrases to throw around the coffee shop by the last chapter!) is that the prices of stocks and bonds reflect all information that buyers and sellers have. For example, when a company announces its earnings, the investing public analyzes the new information (very quickly!) to determine the fair market value of the shares. Assume that the company's reported earnings came in lower than expected. Obviously, investors who value the share price relative to the earnings would sell the shares at current levels. You'd be as much a fool as the homeowner with the gargoyle not to. In turn, the sheer interest in selling the shares at the inflated levels and the diminished interest in buying the relatively high priced shares drives the share prices lower on the market. Once the shares are at the fair market value, the opportunity to profit on the difference no longer exists.
This oversimplification is to illustrate what drives market prices up or down. In practice, there are multiple facets affecting the perceived value of any stock, bond or gargoyle, much of which is disputed among market participants. For every transaction, there's someone willing to buy and someone willing to sell at an agreed price, both believing that it's good value and that the counterparty is a little crazy. That's what's fun about this. The differences of opinion are what keep markets humming and prices continually adjusting to find the fair value. It's been said that it's only a fair trade when both parties consider the other to have received the better deal.
In real life, it's more complicated than just analyzing new earnings information every 3 months. Consider the influences of global economic growth, new competitors, interest rates and changes in the price of supplies or wages that can fluctuate minute by minute. Beyond the hard data, subjective factors equally influence the prices of everything. The complexity of analysis is as thick and deep as there are opinions. There are at least two opposing viewpoints every time a transaction happens. Sometimes a stock will trade at a price that is 10 times the value of the earnings per share and sometimes at a price that is 16 times. It's the aggregate opinion that determines who is right and who is less right.
At first glance, the theory makes sense, but what the efficient market hypothesis doesn't account for is the fact that people are not always rational. Just ask any divorce lawyer. Despite this fissure, the theory's premise doesn't need to be thrown out with the bathwater. It's a reminder that we do not operate like machines....
