Last week US brokerage firm MF Global blew up. And just like Belgian bank, Dexia, before it, the finger of blame is pointing directly at the European debt markets.
MF lost the lot gambling on peripheral European bonds. Worse, it's said that it's to be investigated to see if it used client money to trade its way out of the hole it found itself in.
You may well wonder how on earth professional investors can put themselves in a position where they can bust the bank. It's reminiscent of the takedown of Barings bank by Nick Leeson, or Long Term Capital Management (LTCM) which was run by some of the top names in the business.
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What pushes these guys over the edge? In a word, hope.
Hope is an admirable sentiment. It keeps you from giving up. But when it comes to investment, hope is a dangerous thing. Sound investment reasoning gives way to hope. And when all you've got left is hope, then you have to realise it's time to get out of the trade.
Don't ignore the big picture
MF Global used to be a brokerage firm. It acted for clients and got their commissions. But when ex-Goldman Sachs CEO Jon Corzine took the reins, he had a bright idea: "Why not trade on our own account?" He wanted to create a mini-Goldmans making oodles of money for his firm and undoubtedly for himself.
One of its biggest positions was in European bonds Ooops!
But the position in Europe has been deteriorating for well over two years now. The economic backdrop for Europe has been dreadful. How did the traders miss the big picture?
It's the dreaded 'H' word. Hope is very powerful. It blinds investors to the obvious truths that are there for everyone to see. Europe was and is divided in both economic and political terms and the cracks in the bond markets were almost bound to widen.
But once the traders were committed to their trade, they clearly ignored the worsening macro-economic picture. They hoped for a change in their fortunes. They hoped the authorities would come together with a credible plan to keep things together. They hoped that the peripheral nations would make good on promises of austerity and the sale of national assets to balance the books.
Hope distorts your view of the big picture. It twists your view of reality. And it can obscure your view of the detail too. It doesn't matter if you're investing in a nation by way of its sovereign debt, or in individual stocks. It's always the fundamentals that you need to keep a close eye on.
When you buy a stock, it's presumably because you expect the business fundamentals to improve. You expect to see turnover and profits increasing over time. In the case of euro debt, investors were expecting costs to come down ie through austerity.
But of course you're not always going to get what you want. And when you're presented with disappointing results, it's incredibly important that you dig deep and find out why. Unless you're very certain that it's a one-off disappointment, then it's time to dump the stock.
Don't allow hope to tell you that things will get better. Hope does not make the case for an investment.
In the old days of musket-toting warfare, "the forlorn hope" was a name given to a batch of soldiers that were put together to attack a well-defended position. Effectively, they were cannon fodder most would end up dead or wounded. Why do it? Well, should they survive, these soldiers were offered money and promotion.
Hope makes for a lazy investor
And with investment, it's easy to get sucked into a similar forlorn hope. You stick with an investment even though it's likely to leave you dead, or wounded. You do it for the outside chance that it's going to make you a lot of money. For the boys in the big banks that are trading with other people's money, you can see why they do it. Of course it's not right, but it kind of makes sense.
If the guys at MF Global turned out to be right, they'd have probably made fortunes.
But if things went wrong, as they were highly likely to, then at least it wasn't their own money at risk.
Outside the investment universe hope is a magnificent thing. It can make you work hard and achieve great things. Paradoxically, when it comes to investment, it'll do the opposite. Hope can make for lazy and sloppy investment decisions. It'll keep you in bad trades and may even provoke you to double-up on them.
Unlike the banks, for us private investors, we're dealing with our own money. And when you're dealing with your own money, then there's no room for hope.
If you can't justify holding a stock on its fundamentals, then the chances are you're holding it in the hope of a turnaround. Find out those investments and dump them.
This article is taken from the free investment email The Right side. Sign up to The Right Side here.
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