Investors Behaving Badly: How Investors Set Themselves Up For Failure

Over the years, I have had the chance to speak with thousands of investors. After a quarter of a century doing education in the world of derivatives on the retail and institutional level, as well as at local colleges and universities, I have seen upfront and close, the mistakes that investors make. Some are minor and can be recovered from. Others are near catastrophic and have caused serious and permanent loss of capital.

The reasons for failure in the investing world are identical to the reasons why many businesses fail, and they can usually be traced to the following three issues:

  • Lack of knowledge (or lack of doing your homework & due diligence)
  • Lack of adequate capital
  • Lack of risk management

If you possess knowledge and capital, and manage risk, you certainly aren’t guaranteed success; but the odds will be in your favor. If you lack all three, you aren’t doomed to fail; but I would love to fade you (take the other side of the trade as it’s likely to be painful). So let’s take a look at each of these. And by the way, they pertain to investing in all asset classes—not just the stock market. If you invest in bonds, metals, futures, real estate or any asset class, you want these tailwinds at your back.

Knowledge. One of the biggies. A few years ago, a young woman came up to me after a seminar in NYC. She received part of her inheritance. The first installment was about $200,000. She was very upset that she lost half the installment in only a few months. I asked her what she invested in. Her response floored me—she was dealing in options. In fact, she was selling options. Her first trade was selling puts on Apple computer. I asked her a few questions to see where she was at on her learning curve. She couldn’t answer the most rudimentary of questions on volatility, time decay and the risk reward profiles of short options. Yet somehow, someway, found herself dealing in one of the most sophisticated areas of finance—selling put and call options naked. Not only was her knowledge sorely lacking, her timing was bad too, as was her risk management. She sold puts on Apple (selling puts is a bullish bet and if the stock were to decline, she could suffer massive losses. Unfortunately, she sold puts on Apple right as it began its sickening 35 percent correction a few years ago. Drilling down further, she sold puts on a very expensive stock (this was pre-split) that had high volatility. Selling options when you don’t know what you are doing can be a painful lesson, and she learned the hard way. Remember—a fool and his money are soon parted (and as Gordon Gekko said in the movie Wall Street, “A fool and his money are lucky enough to get together in the first place”). How could the young lady have avoided her losses? She could have done a lot more homework. She could have taken classes on investing/trading. She could have talked to an expert in the field. She could have spoken with the people at the options exchanges or the Options Industry Council FOR FREE. They have plenty of educational material available online and would be willing to help. Many of the educational materials available from exchanges are of high quality. Moreover, with options, I’d always refer to one place: Options as a Strategic Investment by Larry McMillan. His book has educated thousands of people on options trading. I tell everyone interested in options to read the book cover to cover twice. I did, and it made a huge difference. Get educated, or get fleeced!

Adequate Capital. I received a call from another individual many years ago. This person was down to their last $2000 and needed money badly. The person even sounded desperate over the phone. She wanted to know how she could speculate in stock index futures and turn the sum into a small fortune. I begged her to consider something else. She barely had enough funds for a simple mutual fund and could hardly afford a loss. Stock index futures could have turned her $2000 into zero in a few hours if she made even a small misstep in timing. True we hear dozens of stories about people turning small sums into giant fortunes: Michael Dell’s PC company started out of college dorm room with a few thousand in PC parts; and Richard Dennis, the famed commodity trader, turned a stake of a few thousand into several hundred million dollars. But, in general, if you lack adequate capital, you will not have an adequate cushion to hold you through a bad investment in the market. You will be trading “scared” capital, and you will be forced out at the bottom should a decline ensue. You need to be able to withstand severe weather in the markets. I often tell people you should be able to handle several bad trades/investments in a row… because one day you will have a really bad streak. Everyone does.

Risk Management. An acquaintance of mine bought a stock at the height of the tech bubble in 2000. The stock was Cisco Corp, the manufacturer of routers and internet equipment. The stock had made a fortune for its investors. Problem was, the acquaintance bought Cisco at $81 a share. Risk management is EVERYTHING. And lack of risk management has killed many a portfolio – even those skillfully assembled with adequate capital and knowledge. I pleaded with him, “please put a stop loss order in, so if the stock loses 20% of its value, you get out.” He laughed and cursed and said the internet is changing everything and he would double his money in 6 months. My reply, “You might. But you have a better chance of losing half your money in the next 6 months.” A couple of weeks passed and Cisco hit $84 a share, and for a mere 3 hours, its market cap exceeded General Electric as the most valuable company in the world. He called me up, accused me of being an idiot, and suggested that I should dive in and buy Cisco. I said, “No thanks. Please put in a stop loss order NOW.” He hung up. Cisco topped out a few weeks later, just a few points shy of $90 a share… and then began a swan dive into near oblivion. When the bubble burst, Cisco was slaughtered. Before it was over, Cisco was down 85% (most internet stocks were down 95 to 99 percent). Sixteen years later, Cisco is nowhere near its all-time high. In fact, it needs to more than double from its current $31 a share, just to return to its 2000 all-time high of about $85. I saw this individual a few years later. He confessed he dumped his Cisco at under $20 a share. He never exercised any risk management and never put in a stop loss order to limit his losses to a predetermined level. So much for doubling his money in six months!

A fool and his money are soon parted.

Seek wisdom.

Dave and Jodie


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