Please, Don't Do That!

Rich Duprey of the Motley Fool is concerned that you might lose all your money in the stock market. That is possible, but unlikely unless you make a series of really bad mistakes. I thought it might be worthwhile to reflect upon and expand on the scope of his article.

He starts with day trading, a really bad idea. Anything that provides its victim with a random periodic reward is a surefire setup to waste time and/or money until it is all gone. Casino slot machines are programmed using data from psychological experiments to keep you sitting there for hours until you are broke. You give me a dollar. I give you 90 cents; repeat process until all your dollars are gone. Facebook wastes your time using the same principle. You post something, then you check back 100 times over the next seven or eight hours hoping that someone likes or even loves your post. Facebook has only one product, you. Their goal is to keep your eyes on the page long enough that you will be tempted to click on an advertisement or a page from one of their real customers who are paying them money to study you and then to trap you.

There is a way to become a trader. It isn’t for me, but there are people who do a very good job making a living using the statistical science called technical analysis. If you have ice water flowing through your veins, the mind of a computer, and a heart of stone, this might be your game. Think about poker. It is a game of skill. Even a master can’t win without the cards, but I’m sure you have noticed the same faces have a habit of reappearing around the final table come championship time. One of my young former coworkers is a very skilled poker player. He understands statistics and probability. He has studied the game and maintained a journal detailing every game he plays. He records what he did, why he did it, and the results. Trading stocks or betting on cards based on your intuition or emotions of the moment is a very bad idea.

Next Duprey mentions penny stocks, one of those schemes that are so idiotic I forget that they even exist. Penny stocks are shares in worthless little companies. Think about it. If the market values shares in a company’s stock at 5 cents, more than likely there is a reason. These shares go up and down very quickly. After all, a 5 cent move could double your money—or leave you broke. Most of these wild little stories return to their true value—zero. Even established stocks with a wild story, like a Canadian gold mining stock I purchased before the price of gold went on a rampage, have a habit of falling back to earth with a thud. After a wild ride, I lost money, but it was a real company so I didn’t lose all that much money.

While I don’t believe in the efficient market hypothesis as proposed by Modern Portfolio Theory is correct at any and every moment in time, it is certainly true over time. Consider, the market had a pretty high opinion of Enron, until the facts came out. Then the market changed its mind. However, once the market gets the facts, it will become pretty efficient, pretty quickly, pricing those facts into the selling price of the stock. Do you think you are in possession of some secret insider information that people like Carl Icon or Warren Buffett can’t ferret out using an army of research assistants with Harvard MBA degrees? Good luck with that.

Finally, the author denounces margin. Yes, borrowing money to bet on the stock market can make a lot of money in a short time, but if the trade goes wrong, the margin call can clean out your account, leaving you with nothing. At least using margin is better than gambling with Tony Soprano’s money. You won’t need to worry about his leg breakers visiting you in the night.

Here are some more thoughts on ways to lose a substantial amount of money in the market that I believe are more common occurrences than the three horribles reviewed by Rich Duprey.

In my experience, everyone is hoping that they can find that one hot tip that will buy them a beachside condo in Maui where they can live happily ever after, soaking in a hot tub in paradise whilst sipping a Mai Tai. If someone you know is privy to that kind of information, why is he living in a mortgaged home and driving a car that carries a note, just like you. If you happen to be a waitress at a high end restaurant on Wall Street, keep your ears open, but don’t expect anyone to share that kind of information with a waitress. If your unemployed bother in law is convinced he has the inside track on the next big thing, thank him for sharing the opportunity, but don’t give any of your money.

A story that I hear way too often concerns the enthusiastic employee who loves his company. Often rapidly growing young companies contribute shares in the company rather than dollars to their employee 401(k) accounts. Over time, these shares can grow until they constitute a very large percentage of the employee’s total net worth. If the unthinkable happens, one bad day can wipe out 15 years of savings. When this happens, layoffs are sure to follow. An employee can lose most of their money and their job in a matter of months. Diversify. Even 10% of your net worth in a single company can prove dangerous.

I love the energy sector and I have made money investing in that kind of company. I have also lost money in that sector when I had too much in gas, oil, coal, regulated utilities and pipelines when the market for commodities went south. Overall I have done well even in bad times, but I need to pay attention to my portfolio. When the price of oil drops, so did the value of shares I hold in an oil exploration company, one of my unhappy stories. The entire nation if not the entire world suffered from an overexposure to technology stocks during the dotcom crash of 2000-2002. I remember one of my coworkers, a successful investor, who helped me when I was first learning about the market, telling me, “This time it is different.” He had way too much invested in NASDAQ companies. If he had 10% or even 20% of his net worth in dotcom companies, he would have been hurt, but his life wouldn’t have been affected all that much. Instead he took a bad beat down. I don’t know if he ever recovered. Don’t put too much money in one sector. Buying shares in Exxon, Chevron, and Royal Dutch Shell does not constitute a diversified portfolio.

P.S. Later I learned that, “This time it is different,” are the five most dangerous words an investor can hear. The next time, and there will be a next time, someone speaks those words, run away.

I don’t personally know anyone who got in trouble putting too much money into the market at one time, but systemic risk is real. If you happen to get an inheritance or win the lottery someday, don’t invest it all at one time. It might be October 1929. Most normal people are de facto dollar cost averaging investors, putting a fixed amount or percentage of their income into their 401(k) every month or small regular investments into their taxable accounts over decades. This is safer. It is hard to predict when the business cycle will turn, but be assured bust will follow boom as surely as boom will follow bust.

The most serious and frequent mistake I have seen, is getting out at the bottom. In 2008 I saw way too many highly intelligent successful men sell out at the bottom, locking in their losses—forever. If they had a balanced portfolio containing stocks, bonds, and cash, they could have bought more shares at the bottom in early 2009, a time when a blind monkey with a handful of darts could make money by throwing them at names of companies listed on a dartboard. There is a flipside to this mistake, getting in at the top. That happened in 1999 when the dotcoms and the technology stocks went wild.

I believe that all these mistakes have something in common. They all involve some combination of greed, fear, and delusion. Any time you find yourself riding one of those horses, stop before making a decision. Take a deep breath. Clear your mind. Try to become a dispassionate objective observer of your own life. If you were watching a movie or a TV show how would a wise man or woman proceed?

Keep It Simple Stupid (KISS) is frequently good advice. If you are a doctor earning $315,000 a year, you are in the 1%. Congratulations, you are most likely the smartest woman in the room, but that doesn’t mean you know anything about investments. If you believe you can find a magic shortcut to riches that has never occurred to the rest of the market, you are delusional. Start with target date funds, an age appropriate mix of low cost index funds. If you have spent some time studying the classics and some trustworthy web sites, don’t be afraid to buy small amounts of reasonably safe stocks that have a long track record of paying dividends. From time to time, when the price is right, Warren Buffett buys shares in Coca Cola. He never sells Coke.

KISS is also good advice for the rich and the famous who believe they are bulletproof. Tony Dorsett, Heisman Trophy winner, rookie of the year, frequent all pro and, a hall of fame running back, decided he could play the game of oil futures with the likes of J.R. Ewing. This nefarious TV wheeler dealer was actually a composite of real Texas oilmen. Tony almost went bankrupt.

Greed and fear are sneaky emotions. I have discovered that the poor can become greedier than the rich and that the rich man can become more fearful than the poor man. Don’t believe for a minute that your judgment can’t be clouded by these emotions. They are always there, inside all of us, waiting. I have seen fear cause the rich to live as though they were poor, becoming servants to their money rather than the master of their money. Too often greed fueled by envy lead the poor into actions that will end in prison or death. Look at the list of mistakes enumerated in this article. How many of them involve either fear or greed?

Hear some all purpose advice from King Solomon, the wisest man in the Scriptures.

Proverbs 28:20-22
A faithful man shall abound with blessings: but he that maketh haste to be rich shall not be innocent.

Proverbs 14:31
Whoever oppresses the poor shows contempt for their Maker, but whoever is kind to the needy honors God.

Proverbs 6:6-8
Go to the ant, you sluggard; consider its ways and be wise! It has no commander, no overseer or ruler,yet it stores its provisions in summer and gathers its food at harvest.

Proverbs 30:8-9
Remove far from me falsehood and lying; give me neither poverty nor riches; feed me with the food that is needful for me, lest I be full and deny you and say, “Who is the LORD?” or lest I be poor and steal and profane the name of my God.

Proverbs 23:4-5
Do not wear yourself out to get rich; do not trust your own cleverness. Cast but a glance at riches, and they are gone, for they will surely sprout wings and fly off to the sky like an eagle.