The psychology of failure. What traps can cater to the beginner investor
- Investors can succumb to the behavior of the market.
- They can, without realizing it, to participate in markets distorted by the activities of other investors have succumbed to these factors.
- They may overlook the benefits that could be obtained through these distortions.
I think this is one and the same? I believe otherwise. Let’s look at these three errors in the context of one of the most harmful psychological factors — greed.
When it takes its toll rates on paper usually become too high. This perspective reduces the yield and increases the risks. Doubtful assets represent mistakes that will lead either to losses or to the income. The first of these errors — exposure to negative influences — means that you have succumbed to total greed and began to buy.
If the desire to make money forcing you to buy even at high prices in the hope that the asset will continue to rise and the current strategy to work, the loss of capital is inevitable. If you buy when the price of an asset exceeds its intrinsic value, it is necessary to hope exceptional good luck (on that asset from overrated to become even more overvalued) in order to income and not losses. Of course, inflated prices rather suggest the second than the first.
The second of the errors we might call the error of ignoring. Perhaps you are not motivated by greed; for example, in accordance with the pension plan 401(k) your retirement Fund stable and passively investing in the stock market. However, even such participation in the market, where prices are too high due to the undisciplined behavior of other investors, can have serious consequences.
Any negative impact, any “wrong” the market gives you the opportunity to earn income and not to incur losses. Thus, the third type of error is not that you’re making a mistake, and that you are doing what is necessary. Ordinary investors enough to avoid traps, while the outstanding investors should seek to benefit from the mistakes of others. When because of the greed of market participants, the asset price is inflated, most investors will not buy it or even try to sell.
But the outstanding investors may even begin to sell without covering, waiting for a income when the price drops. Unwillingness to open short positions on overvalued stocks — the third type of error, error, loss of profits, but probably most investors are quite willing to go through it.
The first and most important skill necessary to avoid the pitfalls, to be wary of. The combination of greed and optimism continually forces people to implement strategies that, from their point of view, should bring high returns without much risk; to pay for shares on the crest of success; keep the assets after they have become too expensive, in the hope that they will further rise in price.
Later it becomes clear what went wrong: expectations were unrealistic, completely ignored the risk. But the ability to detect traps, getting into them will not help protect capital. It is important to try to prevent them. To illustrate this idea I’ll go back to the last credit crisis.
Markets can teach a lesson at any time. The key to success in investing is to observe and learn. In December 2007, when the problem of subprime mortgages was already obvious, as the possibility of moving this problem to other markets, I decided to list the lessons that, in my opinion, can be learned. When I finished their structure, it turned out that it’s not just the lessons of the recent crisis, but in General the most important universal lessons.
What are the lessons we have learned from the crisis (or should make)?
1. Due to the excessive availability of capital money can go where it is needed. When capital is limited and in demand, investors are faced with a choice, reflect on the best use and make decisions thoughtfully and carefully. But when the capital is too easily available, and very few are made such investments, which should not be done ever.
2. Rash investments may lead to very bad results. When a difficult situation on the financial market rejected the claim deserves attention of borrowers. But, when money is everywhere, totally unprepared borrowers will get capital on a silver platter. This inevitably leads to non-payment, losses and bankruptcies.
3. When an excess of capital investors fighting for deals, agreeing to low profitability and a small margin for error. When people want to buy something, their competition takes the form of the auction, which they are constantly upping the ante. We can assume that the increase in rates is the agreement that you for the money you will get less. Therefore, the rates for investment can be seen as an indicator of how low the yield required by the investor and how much risk they are willing to accept.
4. Widespread disregard for risk creates a strong risk. “Can all go wrong.” “Can’t be too high prices”. “Someone surely will pay me more.” “If I don’t hurry up, buy someone else”. All such statements reflect a lack of attention to risk. At this stage of the cycle, people start to think that because they buy the shares of the top companies and their financing on favorable terms, you can use leverage more actively. This leads to ignoring the risk of adverse development Affairs and the danger which necessarily common to all portfolios formed with the use of borrowed funds.
5. Insufficiently thorough analysis leads to losses. The best defense against them — a careful, thoughtful analysis and the use of what Warren Buffett calls “margin for error”. But in overheated markets usually do not think about how not to lose money and how not to miss an opportunity, so long skeptical analysis becomes a lot of conservatives.
6. In difficult times capital is allocated to innovative investments, many of which do not pass the test of time. The bulls focus on what might work, and not on what can go wrong. It deprives people of reason, making them willing to Fund new investment products in which they do not understand. And then they can’t understand how you could be so wrong.
7. Hidden flaws portfolios can make the prices of seemingly unrelated to each other assets in parallel to change. Easier to assess the possible returns and risks of individual asset, than to understand how it will behave relative to the others. Correlation is often underestimated, especially the magnitude that it takes in a crisis. Sometimes it seems that the portfolio is diversified across asset classes, industry sectors and geography, but in tough times such non-fundamental factors such as margin calls, sinking markets and the overall trend of risk may dominate and render all your assets the same influence.
8. Psychological and technical factors can overshadow the fundamental. In the long term, the creation and destruction of value associated with such fundamental factors as economic trends, corporate profits, talent management and the demand for goods. But in the short term markets are very sensitive to investor psychology and technical factors that affect the demand and supply of assets. Overall, I believe that in the short term, the most important of all confidence. Anything could happen, and the results are sometimes unpredictable and irrational.
9. Markets are changing and the old model obsolete. Opponents of the “computing” funds indicate possible errors in the computer simulation and the underlying forecasts. The computers that manage portfolios primarily looking for profit where you could get used to. They can’t predict changes in these patterns, are unable to anticipate periods of deviations and generally overestimate the reliability of historical data.
10. Leverage increases the scale of the result, but do not create value. It is reasonable to use leverage to increase investment in the assets that are available at good prices and offering a high yield or high risk premium. However, it is dangerous by using borrowed funds to buy more assets with low yields or spreads over risk — in other words, the assets for a full or excessive cost. It is pointless to use borrowed money to turn an inadequate yield adequate.
11. Excesses make adjustments. When investors see everything in a rosy light and markets “is evaluated” on the basis of the assumption that everything will always be okay, expect trouble. It can break out, because the assumptions of the investors are too optimistic, as negative events happen or just too high prices can not withstand its own weight.
Most of these eleven lessons can be reduced to one thing: be attentive to what is happening around you: the balance between demand and supply of investment capital and the willingness to spend it. We know how difficult it is when the capital available is very limited and reluctant to part with him: there is no demand for standing assets, and the economy slows down. This is called a credit contraction. But the reverse process deserves no less attention. The official term for it though, perhaps it should be described as “too much money, too few ideas.”
But, no matter how he called surplus capital, and a concomitant lack of prudence (what we saw in 2004-2007) and their harmful consequences can be harmful to your investment, they need to quickly identify and deal with them.