Bankrupt investor Walter Thornton tries to sell his luxury roadster for $100 cash on the streets of … [+]
Getting rich seems easy, while making a small fortune is simple—just start with a larger one. Sounds absurd, right? This dichotomy, as strange as it sounds, is what propels us into the obscure realm of financial blunders.
You may wonder why it’s important to dwell on loss. We will turn our attention away from the dogged quest for profit and instead master the finer points of financial mismanagement, avoiding traps, and learning from our mistakes. Starting with risk.
I have been through the ups and downs of the market on many occasions, from busy trading floors to high-stakes boardrooms, over my thirty years as a trader, portfolio manager, experienced investor, and advisor to important decision-makers. My life’s work has been to unearth hidden company value and not only realize it for investors and clients, but also for myself.
Nevertheless, we are changing gears. Our focus here is on personal rebalancing and the art of avoiding financial disaster.
The Stock Market As An Ocean
Imagine the stock market as an expansive ocean, where the tranquility of calm waters can, without warning, give way to stormy turbulence. The unforeseeable—natural disasters, political upheaval, or the most recent market rumors—shape this sea of finance’s currents, sending waves or powerful tsunamis across the financial landscape.
Even the slightest news can disturb this ocean, be it a minor adjustment in interest rates or a groundbreaking innovation, underscoring the market’s acute sensitivity to global happenings, investor sentiment, and the fortunes of companies. Amid these waves swim the swift currents of high-frequency trading and the rare, unforeseeable ‘black swan’ events, each layer adding complexity and unpredictability.
Yet, it is within this very ebb and flow that the greatest opportunities—and the gravest risks—lie. Here, we set sail into the market’s rougher tides, delving into how fortunes can swiftly change and, more critically, how to steer through financial storms without foundering. Let us explore three common ways investors lose money, and how understanding these pitfalls can better prepare us for the tumultuous journey ahead.
The Allure And Illusion Of Following Trends
In 1841, Charles Mackay wrote one of my favorite all time classic books; ‘Extraordinary Popular Delusions and the Madness of Crowds’. This book is a journey into the human mind and the emotions we all experience, uncovering the roots of mass hysteria. Why do intelligent people fall for absurd beliefs? Through tales of the South Sea Bubble, the Tulip Mania—where flowers were valued above gold—and the Mississippi Scheme, Mackay reveals a pattern of collective folly leading to financial ruin. History, as he shows, has a habit of repeating itself. We’re often fooled, misled by the very markets we trust. Remember, markets were built on deception, not gain. This is not just history; it’s a lesson for today, a warning that the madness of crowds is alive and well, and why you, sitting here reading this, should care.
The Charismatic Leader
In a story straight out of “Extraordinary Popular Delusions and the Madness of Crowds,” we rewind to November 2022 and see the collapse of FTX, a massive cryptocurrency exchange, and its creator, Sam Bankman-Fried. Once heralded as a crypto wunderkind, Bankman-Fried presided over FTX’s monumental collapse because of his careless handling of client assets, which caused a panic withdrawal that the platform was unable to withstand. Due to the massive losses suffered by investors and the subsequent damage to the integrity of the cryptocurrency industry, this collapse will go down in history as a dark chapter in financial follies.
Like the timeless cautions expressed in Charles Mackay’s work, this tale illustrates how the temptation of large profits, and the charisma of an apparently forward-thinking leader may cause even the most astute individuals to lose sight of reality. The stunning ascent and fall of Bankman-Fried is a sobering reminder that no amount of brainpower can withstand the overwhelming flow of popular illusion. Once again, the craziness of the crowd’s spares no one, as notable personalities and astute investors like Tom Brady and Softbank were swept up in the frenzy. A cautionary tale for our times, this narrative of a company’s decline highlights the ageless validity of Mackay’s lessons.
NEW YORK, NY – DECEMBER 22: FTX founder Sam Bankman-Fried leaves Manhattan Federal Court after his … [+]
Groupthink
The tragic stories of Wirecard and Luckin Coffee bring groupthink and its financial dangers to life, showcasing a psychological trap that causes even the most intelligent people to commit collective mistakes. After promising a 500% profit gain by 2025, the once-glowing German stock market jewel Wirecard fell abruptly in 2020, with a €1.9 billion hole in its accounting, causing one of the biggest financial crashes in Germany and leading to the CEO’s arrest for fraud.
Then there’s Luckin Coffee, a Chinese brand that gained traction on NASDAQ
NASDAQ
Herd Mentality
Think about this: In September 2020, a remarkable story comes to light, exemplifying the ‘herd mentality’ that can overrun the stock market. Introducing Nikola Motors, Trevor Milton’s 2014 dream that would transform the car business with electric and hydrogen-powered cars. Nikola didn’t merely sell cars; it sold a vision for the future, and investors from all over the globe were ready to partake in this revolutionary adventure.
But a very different reality lay beneath the veneer of innovation and astronomically high valuations. The Nikola One truck, which appeared to be an engineering marvel in a promotional video, was actually just coasting downhill thanks to gravity rather than cutting-edge technology.
The shocking news served as a harsh wake-up call about the perils of investing in a herd mentality. Without solid evidence, even the most promising initiatives might be little more than mirages; the trust and investments of many, especially retail investors, were left to face the harsh reality as the truck went downhill. In the haste to invest, we must not lose sight of reality; this incident serves as a lesson on the crucial requirement of due diligence, more than it does as a cautionary tale about a corporation.
These four examples attracted huge investor money.
Emotional Investing
Picture yourself navigating the financial world when emotions, rather than rationality, are in charge. When investors let their emotions guide their investment decisions, they may make hasty trades based on rumors rather than data. Scientific studies have shown that following this course of action usually results in more disappointment than satisfaction. The real kicker, though, is that being a successful investor is all about more than simply numbers; it’s also about knowing and controlling your own thoughts. A global epidemic of social boredom marked the years 2020 and 2021. During the COVID outbreak, we met. Concerns about the public’s mental health and wellness led to restrictions on travel, sports, and other forms of physical exercise. New cars, toys, furniture, appliances, and pets were among the items purchased by irate consumers. All driven by stimulus checks and cheap or free loans from the government. Because live sports betting was not an option, the smaller investor started focusing on the stock market instead. At the time, one of the main motivating factors was a lack of respect for conventional wisdom. While long-term investors like Warren Buffett exercised caution when the epidemic first broke out, unknown social media celebrities didn’t.
The bias of seeking out or interpreting data in a manner that supports one’s previous views or theories is called confirmation bias. When investors see stories or statistics that back up their investments or market opinions, they may ignore stories or data that show the opposite.
The overconfidence bias causes investors to take unnecessary risks in trading or predicting outcomes because they believe they are more capable than they actually are. There is a risk that investors will put too much faith in their own expertise, control, and ability to predict how the market will behave. Many take their confidence in expertise.
Too much weight given to the initial piece of data (the “anchor”) seen when making a choice is known as anchoring bias. What this means for investors is that past performance may matter more than present or future fundamentals when deciding whether to buy a stock. A common trait amongst newbies and professionals alike.
The principle that individuals would rather not lose money than earn the same amount is known as loss aversion. As a result, investors may “lock in” gains by selling winning stocks too soon and holding losing stocks for too long in the hopes of breaking even.
Where do you stand? It is derived from two main places: rigorous conduct and astute analysis. Recognizing and overcoming one’s own prejudices is just as important as knowing one’s numbers. When investors let their preconceptions influence their decisions, the market becomes a psychological battleground. The key to success may lie in recognizing these biases and acting accordingly.
There is, however, a catch. Your inherent biases are a part of being human, just like everyone else’s. Keeping cognitive mistakes at bay requires a delicate balancing act between being optimistic during booms and pessimistic during busts. Recognizing and controlling your biases, along with combining analytical rigor and behavioral discipline, will help you win more. It’s about more than just outperforming the market; it’s about outperforming yourself.
The Lack Of Research
In our quest for quick wins in the stock market, we often overlook the wisdom of patience. Consider Warren Buffett, the embodiment of investing patience. He’s not chasing the fast buck; he’s searching for value—companies undervalued but rich in long-term potential. Steady profits, positive cash flow, minimal debt. Simple, yet profound. His method? is diligence. He dives deep into a company’s essence, beyond the numbers, to its core operations and leadership. The message? Slow down. Look closer. The secret to investment success doesn’t lie in the speed of your decisions but in their depth and understanding. Let’s not be hasty investors but wise ones, learning from the maestro himself.
Conclusion
In the dance with the markets, embrace humility as your shield. The market, a cunning teacher, favors the humble and the curious. Each investment tells a story of risk and reward, demanding your keen insight. Ask yourself: Are you chasing trends or guided by knowledge? Let your research lead the way, arm yourself with understanding, not just hope. In this ever-changing game, remember, certainty is the greatest illusion.
As you move forward, recognize that the market’s greatest trick is disguising risks as opportunities. Start with the risks, let wisdom light your path to informed decisions. In a world of illusions, your clarity is your most powerful tool.
My recent TEDx talk, which expands on this article, is here.