Showing Discipline When Investing

https://blog.shareinvestor.com/showing-discipline-when-investing/

Foreword from ShareInvestor
This article “Showing Discipline When Investing” by Cai HaoXiang was first published in The Straits Times on 25 May 2015 and is reproduced in this blog in its entirety.

Gambling-related psychological tendencies can cause investors to take excessive risk

Many months ago, I talked to a young man who was sharing his experiences trading foreign exchange.

It was quite the cautionary tale.

He was 19 years old then and serving National Service. Influenced by friends who were into investing and trading, he signed up for an online account that allowed him to trade foreign exchange with 400 times leverage. His initial capital was S$2,000 of his own savings.In the forex arkets, the tiniest movement in exchange rates can be magnified. The very first night he traded, he took positions with a S$150 margin such that each pip (0.0001) that moved would gain him or lose him S$3.

In other words, if he took a favourable view of the euro when it was equivalent to 1.1325 US dollars and he closed his position when one euro bought 1.1326 dollars, he would make S$3.

In his case, he bet the euro would appreciate against the dollar given that US employment data released was below expectations. As it happened, the euro appreciated by a massive 200 pips that night.

He was instantly S$600 richer.

His monthly allowance from the Army was S$400. Imagine making one and a half times your monthly salary overnight.

“I am not exaggerating . . . but I felt like a god, invincible, like I struck Toto. I was so excited, I couldn’t sleep, I was taking screenshots to send to my friend,” he told me.

“I felt over the moon the whole day. Whatever the boss wanted me to do, I’d do.”

On the way back to camp the next day, he took another position on the Australian dollar versus the US dollar. He made another couple hundred dollars.

“I thought, I could do this for life, I don’t need to work anymore,” he said.

After the third trade, he had almost doubled his initial capital to S$4,000 after catching a rebound on the US dollar. He told himself he was “on form”.

But things soon went downhill.

His fourth trade was to bet that the British pound sterling would appreciate against the US dollar. This time, he took a bigger position such that each pip would make or lose him S$6.

The market was on his side for a few minutes but “there was a sell-off by banks”, he said. Within 20 minutes, he was down around 80 pips, or S$500, when he closed his position. “It was near a support point, and I was tempted to go in again. Comments made on forums said it was a good entry price and the markets overreacted,” he said.

So he went “long” on the pound sterling again, betting it will still go up despite the falling market. He took positions of a similar size as before.

The market continued to go down. “I gritted my teeth, told myself not to give up. But I was soon left with only my S$300 margin (down from about S$4,000 of capital).”

He had essentially lost S$3,700 in one night, or around 90 per cent of his money.

“My focus wasn’t on my account balance, I didn’t actually know how much I had left. All I wanted to see was the graph going back up. I was overwhelmed by emotions. It didn’t occur to me that stop losses were important,” he said. “I couldn’t believe what I saw. I was trying to comfort myself: Don’t worry, at least I still got savings.”

Things got worse.

It was the weekend, and within 12 hours, he told himself to just buy one lot and hold his position for the day.

He put in another S$2,000 from his own savings and started again.

This time, he was reluctant to close out his positions.

When he was in the red, he did not cut his losses. When he was in the green, he did not take profit. He even tried, irrationally, to hedge his positions when he was in the green, such as being three lots long and going six lots short at the same time.

He kept losing money. In less than two weeks, the second tranche of S$2,000 was gone.

“My motivation was to earn myself an overseas trip with the money I earned in forex, and upgrade my computer. I wanted more screens, like a trader. I like to eat good food,” he said.

“I was quite surprised. By nature, I am quite disciplined, I have a daily routine for what I want to do and achieve. My upbringing was quite strict. So I couldn’t understand why, I didn’t imagine my trading would be so undisciplined,” he said.

Perils Of Gambling

One and a half months ago, we delved into the topic of behavioural finance. This is the examination of one’s thought processes and emotions so that one can become a better investor or trader.

An underlying assumption is that investors are not rational. That is, they do not necessarily make the same value-maximising decision each time they are faced with it.

Various biases, be they cognitive or emotional, cause people to make trades that are against their long-term interests. They hold on irrationally to an investment when they should have cut losses given existing information. On the flip side, they sell in a panic when they overreact to new information.

In our previous article, we discussed, among others, how the loss-aversion bias causes people to avoid realising a loss because they feel more pain at losing money. This was likely seen when our young forex trader did not cut his losses.

Today, we delve into other damaging psychological biases linked to gambling. These are known as the overconfidence bias, the house money effect, the illusion of control bias, the gambler’s fallacy and the self-control bias.

They stem from the same erroneous idea that one can control the markets and predict what will happen. This is akin to how the young man felt – “like a god” and “on form”.

As a newbie, he was lucky with his first few trades. Then, overconfidence in his own abilities led him to make more and more trades until his luck ran out.

If you find yourself taking personal credit for doing well in the markets, you need to watch out. This is most pithily captured in the adage: “Never confuse genius with a bull market.”

One is overconfident when one does not give due credit to uncertainty in the markets, or when one overestimates the probability that one will be right. This leads to risk being underestimated, return being overestimated, a tendency to “go all in” to use a gambling term, and to keep trading.

Boosted by the success of his first three trades, the young man went all in on his fateful fourth trade.

The house money effect was in full bloom here, as he was taking far more risk with his profits than he might otherwise have done with his savings.

Investors should avoid a similar fate. If your painstakingly picked stocks have doubled in value, great, but don’t then go punt on a penny stock just because you think you can double your money again.

Our young man also thought that by being brave, by not giving up, he could succeed when the knives were falling. This is a false belief that he was in control and could turn his fortune around simply by staying around until the bitter end. He suffered from the illusion of control bias.

There was a bit of “tunnel vision” involved here, when the young man was so fixated on making money from his long position that he did not consider the alternative trade: to go with the momentum and go short.

You can say he was anchored to his original idea – a bias we discussed in our previous article.

Finally, the gambler’s fallacy was in play when he decided to commit another S$2,000 within 12 hours. The gambler’s fallacy is when you think if something happens less frequently than usual, it will happen more frequently in your next toss of the dice.

For example, if coin tosses showed tails for the last 10 tosses, you imagine that there will be a more than 50 per cent chance that the 11th toss will show heads. In fact, each coin toss remains an independent event with a 50 per cent chance of either heads or tails.

Similarly, gamblers who have made losses keep on trying in the hope that they will make good and that “it is time” for Lady Luck to smile on them.

Compulsive Behavior

The result is compulsive behaviour where one keeps doing the same thing. A lack of self-control in this situation to stop whatever you’re doing makes things worse.

In the end, excessive risk is taken.

This can be damaging. For example, most investors might already have bailed out of that penny stock you invested in.

You keep pumping in money as prices go even lower, accumulating a larger and larger position, firm in your belief, for example, that management’s words are right and the market will soon recover.

You do not give due consideration to how you might be wrong and how the business is in a far more risky position than you originally thought. In the end, management were overconfident in their predictions, the business runs out of cash, and it is forced to file for bankruptcy.You might have achieved vast success in a professional field, and you might have made numerous astute investment decisions in the past. It is difficult to admit that you were wrong with that investment.

This is why people tend to hold on to stocks many years after they have been relegated to penny status. They imagine that one day, the stock will somehow recover.

The antidote to the overconfidence and illusion of control biases is simple. It is to recognise that financial markets are hugely complex, unpredictable systems where nobody is entirely sure what is going on.

Timing

Timing is one thing that people often get wrong. People buy stocks expecting them to go up by the next day or month, thus allowing them to sell. If those stocks are still below their initial purchase price one, two years later, they lose interest.

However, they should have been constantly evaluating every quarter or half-year whether the company is heading in the right direction, and if so, whether its valuation is still attractive for them to buy more.

Value stocks are allegedly good value because they look cheap based on metrics such as price-to-earnings and price-to-book ratios. However, what is cheap can become cheaper. It can take many years before the value that an investor spotted is recognised by the market.

Because people tend to get their purchase timings wrong, a better approach to investing after one has evaluated a stock to be suitable is two-pronged: invest over a period of time, and have a longer time horizon. Having a long time horizon, nevertheless, is no use if an error of judgement has been made.

The quicker one discovers this, the better. An exit plan can then be formulated. Do you sell everything immediately? Do you think things will improve temporarily and allow you to exit at a higher price? If they don’t, when must you sell everything by?

In the case of the forex markets, traders not just have to understand the technicals, but also grapple with a vast array of factors. These include interest rates, economic growth data, central bank actions, what other traders are doing based on their perceptions or technical indicators, correlations with other currency pairs, trade and government debt data, inflation differentials, and political stability concerns.

Our beginner trader had no chance.

However, the story had a happy ending. The young man confessed what he did to his mother, who was angry because the money could have been put to better use.

Here comes the twist: his mother told him she was going to give him S$2,000 so he can recover the money he lost. “I took the money,” he told me. “I didn’t put the money in directly. I did research to understand what moves the market. Two months later, I started again.

“It took eight months for me to recoup my losses. I would trade on a three-to-four day position. I used stop losses, and took profits,” he said.

He subsequently realised he was not cut out for trading, and began reading up about other investments, such as real estate investment trusts (Reits). And he decided that banking and finance is a subject he can study.

After he completed his National Service, he began looking at bluechip stocks. He signed up for a mock investment account. He joined a university investment club. He said that his mother then gave him more money to invest. He subsequently put the money in Reits such as Ascendas Reit, Suntec Reit and CapitaCommercial Trust, as well as stocks such as Singtel.

These stocks didn’t do badly at all through the years.

Investing Versus Trading

Unfortunately, not many Singapore investors can say the same for their portfolios.

According to statistics cited in a 2014 article by Singapore Management University (SMU) finance professor Benedict Koh, 47 per cent of Central Provident Fund (CPF) investors investing their Ordinary Account (OA) monies incurred losses on their investments between 2004 and 2013. Some 35 per cent made net profits equal to or less than the default OA rate of 2.5 per cent. Only 18 per cent made net profits above the OA interest rate.

Some Singaporeans have a trading mentality when it comes to stocks.

They use the contra feature of markets here to buy and sell stocks within the three-day settlement period such that they don’t need to pay for their purchases.

Some use technical analysis tools to help them to predict where the market is likely to go. At the end of the period, they book a gain or loss depending on price movements. Essentially, they are using a margin account extended to them by brokers.

Buying stocks on a three-day time horizon is more akin to trading. If you get into a trading mentality, you are more susceptible to gambling-related behaviour such as the overconfidence and the illusion of control biases we discussed earlier.

If you start to make losses, you have to be disciplined and avoid losing control and falling prey to the gambler’s fallacy.

The moral of the story here is to understand yourself before you decide what asset class to invest in. Also, markets are unpredictable and nobody – your broker, your financial consultant, your banker, your fund manager or your correspondent here – necessarily knows what is going on.

And perhaps another moral is to give your children a chance to prove themselves. You never know where that will take them.