The market - investing - is the greatest game of all.
These are the words of Adam Smith (aka George Goodman) in The Money Game. He explains:
All the participants play the game differently. They make up their own set of rules and have a different definition of winning. And they often change the rules and the definition multiple times depending on how well they’re playing.
The stock market can be an intimidating place. It's filled with investors who have different agendas. Some see bubbles everywhere while others tout the next millionaire-maker micro-cap. As a result, it can be hard to know where you fit in this complex machine.
You can't win at a game that has no rules and no definition of winning. You would end up aimlessly wandering, always seeking "more." Defining what game you are playing is the most crucial step you'll go through in your investing journey. For some, it might take years of trial and error to find their footing. Others may never know the answer.
If you try to pursue every game in town, you might fly high for some time. However, unless you define rules for yourself, there is a good chance that, like Icarus, your wings eventually disintegrate.
What are you trying to achieve? What does success or failure look like? Is there a goal post? What can you do to make sure you can stay in the game at all costs? Answering these questions can be increasingly difficult in a world flush with information and success stories that may lead to the wrong conclusions.
Many biases can lead to painful and costly lessons: Herd mentality, contrarianism, survivorship, overconfidence, self-attribution, or confirmation bias, to name a few.
In this context, let's review how to define the game and identify the participants who can mess up a well-thought-out plan.
You don't need to read many classic investing books to start seeing many commonalities between them. Those who have a proven track record over decades in the market tend to have the same views on what to embrace and avoid. I discussed previously the five books that changed my life as an investor, from Peter Lynch to Philip Fisher.
At their core, they tend to preach the same concepts:
These principles are simple. Unfortunately, they are ignored by too many.
The study below by JPMorgan found that the average investor earned just 1.9% annual returns from 1999 to 2018, illustrating that many retail investors blow up their accounts one way or another.
People find excuses to ignore common sense. They tell themselves that they have an informational edge or some unique skill. I touched recently on why this can lead to a fragile portfolio.
Whether you are an investor or a trader, your strategy must be governed by a set of rules to survive under all circumstances. Learning how to stay in the game should be the very first principle you live by. However, it can be excruciatingly difficult to put in practice when we are surrounded by people who made a fortune, specifically by going "all in." As a result, there is a great deal of survivorship bias.
In the world of investing, being right once on a big bet is enough to give you a lifetime of fame. Michael Burry (The Big Short) is exhibit A. But, unfortunately, his success has led to a generation of investors looking for the next big short and predicting the next market crash. The most recent example of a negative outcome is Bill Hwang, who lost $20 billion in two days.
We are all subject to greed and fear. You have to accept it and learn to live with these emotions.
Because of greed, new investors end up with half of their portfolio allocated to two or three companies that IPOed in the past three months, buying at the peak of the hype. Then, because of fear, they end up selling their winning investment too early.
Our worst investing decisions are emotional. They happen in reaction to a stimulus. So whether you are panic-buying or panic-selling, you are succumbing to an impulse that is dictating your strategy.
In his book The Psychology Of Money, Morgan Housel borrows from Napoleon and his definition of a military genius:
A good definition of an investing genius is the man or woman who can do the average thing when all those around them are going crazy.
Doing the average thing should not lead to average returns. Instead, the average thing means operating within your safeguards.
I have shared on Seeking Alpha the 4 Simple Rules I use to protect my portfolio:
These rules may appear simplistic at first, but they serve as essential safeguards. By working within these rules, I know I can't blow up my brokerage account. These rules induce discipline and delayed gratification in my investing strategy, covering two of the Four Ds of investing.
These rules are not for everyone. My point is merely to emphasize that you want to define the rules before starting the game. These rules may change over time as you gain experience and refine your craft. New goals may lead to a new approach over time.
Defining your safeguards when you are calm and collected will better serve you. So that when your buttons are pressed, you'll know what you're supposed to do.
Some kids try to emulate Steph Curry when they play basketball in school. They try to shoot from mid-court without looking for a teammate on the wing or a better option to get closer to the rim. They may be playing the same sport, but that doesn't mean they should play like him. They end up wasting plenty of opportunities by trying to emulate someone who plays in a different league and under a different set of rules.
The suboptimal aspect of this approach is obvious. But what about investors who try to take cues from multi-billionaires calling market tops?
In The Money Game, Adam Smith adds:
The end-of-the-worlders, doomsayers, and gold-bugs have existed in markets forever and their calls will never cease.
Billionaires are particularly notorious for calling market tops ad-nauseam. Who can blame them? They are in the business of preserving their wealth and reputation, not building it. For example, in May 2020, Stanley Druckenmiller said that "the risk-reward of investing in stock has never been worse." Since then, the S&P 500 (SPY) has been up 56% while the Nasdaq (QQQ) is up 66% in just over 17 months.
More recently, Robert Kiyosaki, author of Rich Dad, Poor Dad, predicted a "giant stock market crash" happening this month.
While Kiyosaki wrote a popular book about personal finance more than 20 years ago, that doesn't qualify him as a modern Nostradamus. Below is a chart summarizing the many times Kiyosaki called for an upcoming crash in the past ten years.
Eventually, he will be right. Even a broken clock is right twice a day, as pointed out by Nick Maggiulli. But imagine taking cues from him in the past decade, watching the S&P 500 more than triple from the sideline.
The doomsayers have to stick to their guns until an actual crash happens because it would be foolish to capitulate only to be wrong on the flip side if a market crash does occur.
It's essential to focus on the knowable and ignore the rest. But, unfortunately, most financial news is focused on unknowable forecasting.
These are all examples of useless information focusing on the unknowable.
Your time and headspace should be primarily focused on information and sources anchored in what is knowable: past performance, company statistics, trend analysis, business analysis, market research, or best practices.
Successful investing should be about business analysis and risk management, not about market predictions.
All investors should seek negative views about their holdings. It can help you understand what could go wrong and nuance a high conviction. And there is nothing more sobering than a well-articulated bear case to look at a holding with a fresh pair of eyes.
Nevertheless, it's essential to appreciate if the opinion you are reading comes from someone playing a different game. Most opinions online, bullish or bearish, are not a call to action. And one investor's reason to sell is another investor's reason to buy.
I have my fair share of biases. I generally write about companies for which I have skin in the game. I invest my money in my bull cases alongside members of the App Economy Portfolio. However, I like to build my positions in small increments over several years, so I have little interest in where a stock might be trading in the short term.
But how about those who use options aggressively and would greatly benefit from short-term stock price movements? You can usually recognize them by their aggressive style and their level of confidence. Swing traders come to CNBC to tout the prowess of a company they know nothing about, just because they hope to make a quick profit.
To illustrate, below is a CNBC interview that went viral last week. The last 30 seconds of the video are fascinating. It shows a trader touting his investment in Upstart (UPST), saying that it is "probably a little overextended right now, but longer-term, that's a good looking name, very powerful, very strong earnings."
Yet, when asked by the CNBC host, "what does the company do?" he's unable to answer and pretends that there is an audio problem.
If you are an investor, you are probably better off ignoring any commentary coming from swing traders. Why? Because they work under a completely different set of rules. For example, a swing trader might be bullish or bearish solely based on recent price action, which is nothing but noise for someone with a multi-year time horizon.
Yet, many people get emotional, particularly when their holdings suffer from negative sentiment and are sold by swing traders who bank their gains. In reality, none of this should matter. The buying and selling of someone playing a different game should be only noise.
You'll also come across perma-bears who have something negative to say about a company every other month.
Amazon (AMZN) has been almost a 10-bagger since spring 2015. And below is a list of bearish articles about the company published on Seeking Alpha in 2015.
Source: Seeking Alpha
It's an excellent exercise to review what the bear cases were all about back then to put things in perspective. For example, the authors were concerned about short-term profitability, higher shipping costs, or the potential failure of the dash button.
How about the endless list of articles suggesting you "lock-in gains" in your Apple (AAPL) shares? AAPL has been a five-bagger in the past five years, beating the market by more than 3X. Bear cases five years ago were warning readers of the "boring" iPhone 7, low demand for its products, the threat of Android, or the strange appearance of the AirPods (they will later on become Apple's most popular accessory products, taking over about half of the market for wireless earbuds).
In retrospect, with years of hindsight, these negative views appear incredibly narrow. However, in the moment, they may have compelled investors to sell their shares. A narrow analysis can be pernicious because it focuses on a particular aspect of a business. It can lead to missing the forest for the trees.
Similarly, those who build very concentrated positions quickly tend to become impatient. Some investors have the fiduciary duty to de-risk their portfolios if their exposure to a single company has become too large. If they decide to lock in their gains, they may turn bearish on a company they previously liked.
Nobody is more bearish than a former bull who just sold their shares. It comes from the simple premise that nobody likes to be wrong and see a stock they just sold turn out to be a big winner. As a result, they may find reasons to sell even though these reasons already existed when they bought their shares in the first place.
That's why investors need to write down their bull case and know why they are invested, to begin with. So, for example, if you invested in Amazon while recognizing that profitability might be elusive for years, none of the bear cases in 2015 would hold up.
Skepticism is essential, particularly before starting a position. But it should not trump optimism. Every single one of your holdings will face turbulence if you hold them long enough. And just like turbulence on a plane, the best course of action is often to do nothing.
In his book The Most Important Thing, Howard Marks explains the concept of second-level thinking:
First-level thinking is simplistic and superficial, and just about everyone can do it (a bad sign for anything involving an attempt at superiority). All the first-level thinker needs is an opinion about the future, as in “The outlook for the company is favorable, meaning the stock will go up.” Second-level thinking is deep, complex and convoluted.
First-level thinking is fast and easy.
It's usually something easy that only solves the immediate problem without considering the consequences. Reasoning such as:
Second-level thinking is more deliberate.
You have to think in terms of interactions and time, understanding that your decisions can lead to a worse outcome despite your best intentions.
Second-level thinkers think about the consequences of repeatedly eating ice cream and are more likely to eat something healthy. They see that a company is expected to beat on revenue for the quarter, but that guidance will be lower for the full year due to a canceled future project.
The easiest way to achieve second-level thinking is always to ask yourself, "and then what?"
Think through time and the consequences of your decision in ten minutes, ten months, or ten years. To do so, describe what needs to go well in your bullish thesis over the short, medium, and long term. Then, calibrate your thinking with the very long term in mind. For example, if full year guidance was just lowered, or the CFO is leaving the company, you have to ask yourself:
Often, you'll realize that it has little to no impact. That's why you want to understand both the immediate and second-level consequences before you make a decision.
Watching an investment too closely can lead to analysis paralysis. It's imperative to be critical of any company-related news and focus on the greater context.
To use another quote from The Money Game.
If you don’t know who you are, this [the stock market] is an expensive place to find out.
Knowing yourself should help you define the game you are playing.
Sahil Bloom recently touched on the importance of operating within your "Zone of Genius."
You have probably heard of the idea of sticking to your "circle of competence," a mental model developed by Warren Buffett and Charlie Munger. I would add that your circle of competence is not finite and should expand over time if you approach life as a constant learner.
Sahil's idea goes deeper. Your "Zone of Genius" in investing might be about your specific investing style. You have your own set of personal circumstances, and only you can define the right amount of risk, concentration, and time horizon that is right for you.
For example, I own a diversified portfolio of more than 70 stocks, with my top eight representing about half of my portfolio allocation through their performance over the years. As a result, no single stock keeps me awake at night. I don't identify with any particular investment, even my biggest winners. I try to maximize the odds in my favor when I select a new investment. I let my winners run and let the story play out over many years.
As explained in my article about How Many Stocks You Should Own, the right level of diversification and concentration will be different for everyone. So find what makes you unique and embrace it.
Philip Fisher, Warren Buffett's mentor and creator of the scuttlebutt approach, looked back at his past investing successes to find that only a tiny portion of them was discovered through his comprehensive checklist. Instead, most of his best ideas came from a network of intelligent people he knew and trusted.
Multiplying your sources and cross-referencing your research are essential steps in the arsenal of the investor.
When you come across a new paper, always remember that nobody has a 100% hit ratio. For example, I tend to be wrong three or four times out of 10 if I look at my past investments. That's an excellent batting average when you consider that only about a third of stocks outperform the market over time. More importantly, what matters more to me is my slugging average. How right am I when I'm right? How much alpha can my biggest winners create for my portfolio?
What is the track record of the author you are reading? Are they consistent in their approach? How repeatable is their process?
Build a comprehensive list of people who play the same game and can help you with reliable, curated content. For example, Ram Bhupatiraju, an investor sharing valuable insights on Twitter, recently shared a list of close to a hundred sources he likes to rely on to gain a broader perspective.
Realize that you are far from being alone on your investing journey. The best ideas don't have to be "yours." Enriching your life with the research and insights of other like-minded investors goes a long way.
The investing game is a path to being rich. But how to define rich? Where is the tipping point? Money, after all, is merely a means to an end.
We all take pride in winning. However, knowing what game you are playing also involves knowing when you've won. Our obsession with winning should not overshadow the fact that we all have a limited time on this planet. As you chase the next best move for your portfolio, remember that your financial freedom and enjoyment of life should be your priority.
What about you?
Let me know in the comments!
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Discipline and consistency win the game over time. Unfortunately, many investors violate their own model or strategy when their portfolio performance is temporarily disappointing. I would rather sell too late than too early, so I tend to never sell. I let my winners compound to a significant portion of my portfolio and let my losers become insignificant over time.
All App Economy Insights contributions to Seeking Alpha, or elsewhere on the web, are personal opinions only and do not constitute investment advice. All articles, blog posts, comments, emails, and chatroom contributions by App Economy Insights - even those including the word "recommendation" - should never be construed as official business recommendations or advice. In an effort to maintain full transparency, related positions will be disclosed at the end of each article to the maximum extent practicable. The premium service App Economy Portfolio is a research and opinion subscription. I am not registered as an investment adviser. The majority of trades are reported live, but this cannot be guaranteed due to technical constraints. Investors should always do their own due diligence and fact-check all research prior to making any investment decisions. Liability of all investment decisions reside with the individual investor.
Disclosure: I/we have a beneficial long position in the shares of AAPL, AMZN either through stock ownership, options, or other derivatives. 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.