all over. Your head is throbbing. One minute you are
sweating like you have been playing tennis for an
hour, the next you are shivering. We are all too familiar
with the symptoms of the flu. When it hits us there
is little we can do except grin and bear it until
Not so clear are the symptoms of chronic
diseases. We have the vague feeling that something
is not quite right. Less energy, slight twinges. All actions take more effort, and the results rarely
meet our expectations.
The same difference exists in the share
market. On the one hand, we have acute illnesses like
the collapse of Enron or WorldCom In the USA or HIH
and One-Tel in Australia. When you are hit by it,
there is little you can do except bear the pain.
On the other hand, just as with our
physiology, there are also chronic diseases in investing.
These can be even more damaging to your investment
health than acute diseases.
The symptoms are often a vague feeling
that something is wrong. Or, more seriously, we may
not even know that we have been infected. But the
chronic diseases of investing eat away at your investing
success, day after day, week after week, year after
No matter how hard you try, your returns
are just not what you hoped or expected.
As for medical chronic diseases, there
are many classes of chronic investment diseases. I
am just going to mention the diseases in one of these
classes, the behavioral chronic diseases of investing.
I shall mention six of these, namely
Get-Evenitis, Consolidatus Profitus, Tradophilia,
King Kong Syndrome, Lotto Syndrome, and Success Addiction.
The basis of all these diseases is fuzzy
thinking. So, before explaining the diseases, I would
like to give an example of fuzzy thinking.
You are going to be given two scenarios
and in each scenario you will be given two alternatives.
Choose one of the alternatives in each scenario. Don't
spend too much time on it. Just choose the alternative
that first comes to your mind.
Scenario 1 In addition to whatever
you own, you have been given $1,000. Which of the
following two alternatives would you choose?
A1: A sure gain of a further
B1: A 50% chance to gain a further
$1,000 and a 50% chance to gain nothing.
Remember what your choice was. Better
yet, write it down and try to put it out of your mind.
Scenario 2 In addition to whatever
you own, you have been given $2,000. Which of the
following two alternatives would you choose?
A2: A sure loss of $500,
B2: A 50% chance to lose $1,000 and a 50%
chance to lose nothing.
What was your choice this time? Were
your two choices the same or different?
Don't read on until you have made your
Did you think the two scenarios were
different or the same? It comes as a surprise to most
people to learn that technically they have exactly
the same cash flows.
In both cases if you choose the first
alternative you have a sure gain of $1,500. For example,
in Scenario 1 the first alternative is $1000 + $500
= $1,500 and in Scenario 2 the first alternative is
$2,000 - $500 = $1,500.
An analysis of the second alternative
in both Scenarios gives a 50/50 chance of gaining
$2,000 or of gaining $1,000.
Even though technically the same, most
people choose the first alternative in Scenario 1
and the second alternative in Scenario 2. (When these
scenarios were presented to two groups of subjects
by researchers Kahneman and Tversky in 1979, they
found that 84% of the subjects chose A1 in the first
scenario while 69% chose B2 in the second scenario.)
The explanation for this is that in
the first scenario people favored the first choice
because they did not want to gamble when the expected
return of $500 for the gamble was the same as the
guaranteed return of $500 for the sure profit.
In the second scenario, people favored
the gambling alternative because they saw it as a
way of avoiding the sure loss of the first alternative.
Another way of explaining this is that
people do not like to lose and will often gamble to
avoid this occurrence. On the other side, people are
less likely to adopt a gambling strategy in the hope
of making an excess profit.
What happens when you buy a stock and it drops
by 30 percent? Do you sell or do you hang on hoping
that it will come back to its original price? If you
usually hang on, then you may be suffering from get-evenitis,
a highly contagious disease particularly among males.
If you buy XYZ for $20 and it drops
to $12, you now own a $12 stock. It does not matter
how it arrived at this price. The question now becomes,
"If I had $12, would I buy a unit of XYZ or would
I buy something else?" If the answer is to buy
XYZ, then hang on to it. Otherwise sell it. Unfortunately
our ego will goad us into all sorts of rationalizations
why we should not sell at a loss.
We want to be able to say, "It's
only a paper loss. Don't worry. It will come back."
Worse than having our teeth pulled is being forced
to utter "I made a mistake." Even "There
was a downturn in the market which caused XYZ to go
south" is hard for most of us to say. Just as
in real life, sometimes we have to face our mistakes
and accept a loss before we can move on.
In 1995 Nicholas Leeson became famous
for causing the collapse of Barings Bank, his employer.
Over the previous years he had some serious losses.
Instead of admitting them, in his own words, he "gambled
on the stock market to reverse his mistakes and save
the bank." But things just got worse and he ended
up losing US$1.4 billion.
It is unlikely that any of us are going
to catch such an acute case of get-evenitis. More
likely it will be a low-grade infection that eats
away at our investing profits.
Get-evenitis has an associated disease called
consolidatus profitus. Where you see one, you usually
see the other. Sufferers of consolidatus profitus
are often heard intoning "You can't lose money
by taking a profit."
You may not lose money for that particular
stock, but in the end what makes the difference is
what we do with our profits. What if we put the money
from the sale into a stock that is a major underperformer?
We may be able to say that we made a profit on a particular
stock. What we are not saying is that our portfolio
went down because of the way we spent the profits.
If ABC goes from $20 to $30, then you
now own a $30 stock. In the same way that you examined
the loser above, think what you would do with $30.
If you would buy ABC for $30, then keep the stock.
If not, then sell it.
Of course, in real life things are a
bit more complicated since we have to take into account
transaction costs and taxes. But I think the general
idea is clear-evaluate your stocks on what return
you expect to get from them in the future, not on
what they have done in the past.
Just how widespread are these diseases
follows from a large-scale study carried out by Terrance
Odean of the University of California in Davis. Reporting
in the Journal of Finance, 1998, he found that people
tended to sell winners and put the money into stocks
that performed less well. Overall he found that people
would have been better to sell their losers and keep
their winners. Instead, they did the opposite, namely
they kept their losers and sold their winners.
To get a rough idea of the size of the
losses, imagine an investor that has two stocks to
sell, one a past winner and the other a past loser.
Using data from Odean's study, the average return
on the past winner over the next year was 2.4 percent
above the market average compared to a 1 percent loss
on the past loser.
This means that holding on to your winner
would put you 2.4 percent ahead of the market during
the next year. In contrast, holding on to the loser
would put you 1 percent behind the market. But this
is just what the average investor did. On average,
investors choose to sell their winners more often
than their losers.
This is an infatuation with the thrill of trading.
Barber and O'Dean showed that there is a inverse correlation
between the number of trades a person made each year
and how well he or she performed in the market. In
other words, on average the more trading the lower
the profit even when the transaction cost are taken
King Kong Syndrome
In July 1993, Robert Citron, the treasurer of
Orange County, California, predicted that interest
rates would not rise. When asked how he knew this,
he replied, "I am one of the largest investors
in America. I know these things." Within a little
over a year it was public knowledge that Citron was
deluding himself. His prediction of how interest rates
would move was wrong, his error causing the Orange
County Investment Pool to lose $2 billion forcing
the County into bankruptcy.
This is an extreme example of what I
call the King Kong syndrome, the disease of arrogance
State run lotteries hit on a goldmine when they
allowed the participants to choose their own numbers
rather than be simply given a ticket. With this small
change in the way people can choose their tickets
they now feel in control. They can choose their own
numbers and so have the illusion of increasing their
chances of winning. This illusion of control, as it
is referred to by the psychologists, leads to overconfidence.
We see examples of this illusion of
control in people collecting all sorts of financial
data whereas there is no evidence that much of this
data has anything to do with share performance.
Our irrational love of success can cause us not
to face the fact that we may have made a mistake.
We all have these investment diseases to varying
degrees and perhaps it is impossible to be completely
free of them. One of the best ways I know of strengthening
our immune systems so that the diseases are kept at
a tolerable level is to keep a stock book. Before
you buy a stock in a company write down some of its
key features with particular emphasis on those things
that you consider most important for your decision
Peter Lynch was a great advocate of
recording his thoughts on different companies. When
he was the manager of the Fidelity Magellan Fund,
Lynch kept a series of notebooks in which he wrote
down information on companies that he analyzed or
visited. He also required that his advisors be able
to make brief presentations on any companies that
they thought should be considered for the fund. Perhaps
you could try this with your spouse or a friend.
A pilot friend of mine says that his
rule for when there is a difficult situation is to
"put your seat back a few notches." This
means to sit back and try to take a calm and more
dispassionate view. This seems like pretty good advice
to follow each time we are about to buy, or sell,
another share. This is the advantage of the Conscious
Investor. It provides proven steps to locate quality
companies at excellent prices while at the same time
filtering out the over-priced and speculative companies.