In the book Where Are the Customers' Yachts, Fred Schwed Jr. uses great writing, humor, and his experience to discuss the craziness of the markets.
Warren Buffett, Michael Lewis, and Michael Bloomberg have all recommended this book.
I discuss parts from this book that relate to some of the important emotions and traits we need to be aware of when investing in markets.
The emotions or traits that I discuss are: Greed, risk aversion, fear, patience, overconfidence, being overwhelmed, and denial.
Fred Schwed Jr. demonstrates in his book Where Are the Customers' Yachts a very humorous style of writing about the craziness of the markets and its participants. Some of the most salient emotions that we all experience while investing in the market are mentioned in this book mostly through humorous and witty examples that Fred gives. He draws upon his experiences as an investor in the stock market boom of the 1920s and during the Great Depression when he lost a lot of his fortune.
This book is on Warren Buffett's list of book recommendations and received the following praise from Michael Bloomberg:
"How great to have a reissue of a hilarious classic that proves the more things change the more they stay the same. Only the names have been changed to protect the innocent."
I only mention seven of the numerous emotions or traits that investors experience while investing in the stock market here, but I've attempted to encapsulate the more common ones.
GREED can be one of the most dangerous emotions while investing in the markets because it prevents us from thinking of the downside and evaluating what can go wrong. All we end up thinking about is what can go right, and we constantly want more gains, or in other words, more profits.
We keep speculating and that emotion drives us to stay overinvested in the wrong assets for too long. I say wrong asset because there is usually an asset at the end of a market boom that has accumulated an incredibly high percentage of gains but isn't based on any fundamentals. It is based purely on speculation and the idea that someone else will buy that overpriced asset from you with no reasoning whatsoever except that they can turn around and sell it to someone else at a higher price. The speculative asset of the markets today that comes to mind are cryptocurrencies.
Source: GMO Viewpoints - Bracing Yourself for a Possible Near-Term Melt-Up
And what do people do when they are greedy but the amount of money that they have available to invest isn't enough to make them the profits they desire? They borrow money and invest it in the hopes that they can have more with less, but what people seldomly tell you is that it works the other way too. If things go wrong, you can have less with more. I'm talking about less capital but more debt.
Here is Fred from his book on leverage and greed:
"Americans find margin trading a particularly attractive little invention. It parallels the American principle that the first thing a man should do with his home, even before moving in, is to put it in hock. The idea is that he only has to pay 6% or so on the mortgage and if you can't wangle something better than a measly 6% out of a round lot of money, he ought not to be in business. This is another argument I am unable and unwilling to discuss further. The idea is easily extended to margin trading. We assume that it is a wise and profitable venture to buy 100 shares of United Fido at 10, paying $1,000 for it. Ergo, wouldn't it be even better to buy 200 shares paying the same $1,000? And even better to make it three or four hundred if we can find a sufficiently kindly broker to do us this favor? The answer is no. But I only know one way of proving it to you conclusively. Go try it."
RISK AVERSION - The impact of a loss has a lot more of an effect on us than our desire for a gain. This was ingrained in our minds from our ancestors when we were much more worried about our downside than our upside because back then our downside could have meant being eaten in the jungle or some other form of death. We just weren't nearly as safe as we are today than we were back then.
We haven't been able to get rid of this feeling even when our safety has increased tremendously and the world we live in is much different than the one our ancestors lived in. The probability of dying when you walk around outside today is a whole lot less than it was back then.
Fred gives the following example from his book about investors fearing the losses twice as much as the gains:
"When he buys a stock, borrowing money casually from the broker to do it, and the stock goes down five points he is comparatively calm. But when he sells it short and it goes up 3/4, he is immediately desperate. He thinks it might go to 1,000, although precious few stocks ever have. When he buys he never considers that it might go to zero, though that is the precise figure where a great many stocks eventually wind up."
FEAR along with greed are two of the most important emotions because they are the two that cause most of the movements in the markets. Markets very rarely stay at equilibrium and mostly swing from one side to the other while spending the majority of their time on the greed side or the fear side.
Everyone knows that you must buy low, and the great majority know that in order to do this successfully, you have to have the courage to buy when there is the most fear in the markets because that is when everyone is selling and that is when asset prices are on sale. What everybody doesn't know though is how to do this successfully. This is true today and this was also true in the early 1900s.
"Buy them when they are up, and sell them when the margin clerk insists on it. It is obviously impossible for the thinking Wall Streeter to avoid acting on that principle. He certainly can't buy them when they are down, because when they are down 'conditions' are terrible. You can't ask an experienced Wall Street man to buy stocks when carloadings having just hit a new low and unemployment is at a peak and steel capacity is less than half of normal and a very big man ('of course I can't tell you his name') has just informed him in confidence that one of the bank underwriting houses in the Middle West is in really serious trouble."
PATIENCE is one of the most important traits to have as an investor. I don't know of anyone who got rich by trying to time the market accurately or in other words: buying at the bottom, selling at the top, and then rebuying at the bottom again. Investors mostly get rich by buying and holding for long periods of time as the underlying asset appreciates in value over that long period. Although patience is one of the most important traits to have, it is surprisingly one of the most difficult to develop.
Here is the author on his difficulties with it:
"I happened to be the beneficial holder of shares in a good investment trust. These shares, being a 'closed-end' company, had not been sold to me by a salesman. I had purchased them, on my own judgement or whim, on the New York Stock Exchange. A few years later, observing that they had all but doubled in value, I judged that this was ridiculous, and sold them, via the New York Stock Exchange, to some faceless stranger, who was a fool for luck. I also did this on my own judgement. My crafty plan was to repurchase them after they had gone down to some more sensible level. As it happened I never repurchased them because they never went down. Where they have gone up to I don't feel in the mood to discuss just now."
OVERCONFIDENCE is another one of the great pitfalls of being a good investor. Ray Dalio in his new book Principles talks a lot about this pitfall and how being overconfident led to the failure of his fund in the early 1980s.
Overconfidence has a lot to do with just assuming you're right and not asking yourself why you may be wrong. A lot of times investors may think they are investing, but what they are really doing is speculating. They may also think that they are very talented investors even though they have only experienced a bull market, but never a bear market.
The first quote below reminds me of a new investor right out of college who hasn't had enough experience yet to understand that he can't predict the future of the financial markets.
"It seems that the immature mind has a regrettable tendency to believe, as actually true, that which it only hopes to be true. In this case, the notion that the financial future is not predictable is just too unpleasant to be given any room at all in the Wall Streeter's consciousness. But we expect a child to grow up in time and learn what is reality, as opposed to what are only his hopes."
The next quote reminds me of an investor who is taking the much better and the opposite approach of overconfidence which is to be humble and to keep your ego in check. He is evaluating his skill as an investor and determining whether it is due to luck or skill.
"Admittedly, it is preposterous to suggest that stock speculation is like coin flipping. I know that there is more skill to stock speculation. What I have never been able to determine is how much more?"
The last one reminds me of a time I stupidly thought that one of my stock picks was so correct that it couldn't go wrong that I should sell cash covered puts which would have given me an obligation to buy a large portion of the equity at an already determined price, also known as the strike price. Luckily for me, my broker required documents from me to buy and sell options, and in the end, didn't deem me experienced enough for options at the time after reviewing those documents. They were correct as I avoided a large loss on this one.
"Options are infinitely attractive to dream about. We all know many stocks which have moved much more than 10 points in a month, and more than 50 points in 3 months. But when a man stops dreaming these transactions and tries doing them, something different always seems to happen."
Being OVERWHELMED by too much information isn't something I would have thought of coming from this book since it was written so long ago. The information overload back then doesn't pale in comparison to the information overload you see today. There are articles written daily on stocks today, news coming out daily, and so much information that is out there on the web that it is essentially impossible to keep up.
I imagine this next part came about because of all of the fraud leading up to the Great Depression that it led the SEC to instigate new rules and regulations that required companies to produce more paperwork and public information to investors. Since investors weren't used to having so much information at their disposal then because of the lack of public disclosure and rampant insider trading before the Great Depression, it must have felt overwhelming even though it was highly necessary.
"In the days before the S.E.C, the description of a new issue commonly consisted of a couple of pages containing an inadequate balance sheet, a skimpy indication of recent earnings, and perhaps a little pep talk. This leaflet didn't begin to contain the things that an investor should know. But it did have one tremendous advantage: an investor could be persuaded to read it. Nowadays a properly registered prospectus contains everything; it is as long as this book, and duller. Just looking at it causes the intellect to shrink up into a ball of protest."
DENIAL can be a huge psychological defense mechanism for investors as they face the reality of losing a large sum of their savings or even watch a big paper gain evaporate in less than a month. They don't want to admit the truth of what really happened or they are in too much shock to believe it, so they just deny it ever happened.
"Some of [those customers] still believe in their hearts that the money they lost in 1929 became the property of their brokers. They secretly continue to believe this after lengthy explanations. The notion that all those greenbacks just evaporated seems to them fanciful."
And with all of this being written, I will leave you with my favorite part from the book when I read it two and a half years ago. It isn't a coincidence in why it's my favorite part. After all, we tend to like the people the most that we share the most in common with, so it shouldn't be a surprise to you that my favorite part in the book was the part that advises a very similar strategy that I've been following for the past 3-4 years.
Source: Google Finance
Just substitute bonds for money market funds and you got a very similar strategy except for my 401(k) and some small investments here and there in certain equities as I find a good opportunity which has been difficult and rare for me lately. As shown from the chart of the S&P 500 (NYSEARCA:SPY) above, this strategy hasn't fared so well, so once I publish this article, I can always reread that part about trying to time the market.
"For no fee at all I am prepared to offer any wealthy person an investment program which will last a lifetime and will not only preserve the estate but greatly increase it. Like all the great ideas, this one is simple: When there is a stock market boom, and everyone is scrambling for common stocks, take all your common stocks and sell them. Take the proceeds and buy conservative bonds. No doubt the stocks you sold will go higher. Pay no attention to this - just wait for the depression which will come sooner or later. When this depression - or panic - becomes a national catastrophe, sell out the bonds (perhaps at a loss) and buy back the stocks. No doubt the stocks will still go lower. Again pay no attention. Wait for the next boom. Continue to repeat this operation as long as you live, and you'll have the pleasure of dying rich."
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.