Much of financial theory is based on the idea that markets are ‘efficient’.
At the heart of this idea is that human beings always act to maximise their profits. They know everything there is to know about whatever they plan to invest in.
Their every action is a considered, calculated decision that will lead to the most profit, based on the available information at the time.
Clearly, this is utter, utter drivel.
Markets are created by the actions of human beings. Human beings are complicated things. We panic. We get greedy. And sometimes we do apparently irrational things, such as selling a perfectly sound asset, for rational reasons – because we’re getting divorced, say.
Some academics are starting to get to grips with this idea. The much-hyped field of ‘behavioural economics’ is a classic case of economists scrambling to catch up with what people already know: that when it comes to investing, we are often our own worst enemies.
We are terrible at understanding statistics. We hate losing money so much that we’ll throw good money after bad in the hope of getting it back.
Even our bodies undermine us. One recent study looked at testosterone levels on a trading floor. When levels are high, traders become over-confident. But when they take a real kicking in the markets, another hormone makes them overly fearful.
Rational? Efficient? You must be joking.
Profiting from market mood swings
The good news is that all this presents an opportunity for investors like you and me. If markets were efficient, there’d be no point in us trying to beat them because every price would be ‘correct’ at all times.
But thankfully, as Benjamin Graham, the ‘father’ of value investing put it, ‘Mr Market’ is in fact incredibly moody. When he’s feeling good, he’ll pay you generous prices for your stocks. When he’s feeling gloomy, he’ll sell you his stocks at any price he can get them away for.
So the key is to know what stock (or other asset) you want to buy, and the price you want to pay for it. Then wait until Mr Market offers it to you at that price.
Sounds easy. There’s just one problem: you’re human as well. And if you spend any amount of time investing on your own behalf, you’ll rapidly recognise how all these emotions affect you too.
There’s the part of your brain that thinks ‘rationally’, for want of a better word. It ‘knows’ what you should do when you invest. It knows you should have a sensible plan. It knows you should ‘buy low and sell high’. It knows you shouldn’t chase losing bets or close winners too early.
But then there’s the other part. Let’s call it your gut, to save confusion. Your gut thinks it knows best. Sadly it doesn’t. Your gut panics when it sees a stock you’re thinking of buying going up. It wrestles the controls from your brain and makes you hit the ‘buy’ button.
When the same stock is plunging days later, it’s your gut that will tell you to ignore it, because it’s bound to rebound. When it fails to do so, it’s your gut that will panic and tell you to sell it just at the point of maximum loss.
In short, your gut is the enemy. How do you beat it?
Your best investment yet – a notebook
There are a number of things you can do to stop your gut from taking over when you’re investing. But the key is to slow your investment process down. You need to force yourself to think before you act, rather than the other way about.
The best way to do that is to take the time to write down your reasoning behind buying or selling an investment before you do it.
This sounds dull (not to mention low-tech). But it works.
Firstly, it forces you to consider your investments properly. So it stops you from taking impulsive bets, which are the ones most likely to go wrong.
Secondly, if you write down why you are buying, and why you are selling, you’ll start to spot where you are going wrong.
Don’t just take my word for it. In Jack D Schwager’s excellent book Hedge Fund Wizards, Ray Dalio, one of the single most successful hedge fund managers of all time, tells how he started developing his investment skills.
“Beginning around 1980, I developed a discipline that whenever I put on a trade, I would write down the reasons on a pad. When I liquidated the trade, I would look at what actually happened and compare it with my reasoning and expectations when I put on the trade.”
What to do now
Simple – get yourself a notebook and a pen for making a record of your investments. I’ll look at the sorts of things you should be writing down in more detail later in the series.
At a minimum, it should include: what you’re buying; the price you’re buying at; the dealing charges; and a one-line sentence on your rationale for buying it.
But the most important thing is to get into the habit of stopping to physically write down your trade before you make it. That way, you’ll always short-circuit your gut.
You’ll still make mistakes – we all do. But you won’t make as many stupid ones.