My writeup on the inconsistent and faulty feedback loops provided by the markets in addition to certain lessons learned over the last few years
I recently bought a Casio. One of the reasons I bought it is so that I could play the old classical hits of Beethoven, Vivaldi, and Mozart by my hand. I do hope to play some of their pieces someday. But it is hard. Extremely hard. The chances of me (or anyone) playing a Fur Elise, Ode to Joy or a William Tell overture with both hands and without any errors is close to nil in absence of any prior practice. Actually, It is a big fat zero. Getting one of those pieces right is a monumental effort. Easy by the looks of it but takes weeks, if not months for any new pupil to master. And certainly, my efforts right now are making Beethoven cry in his grave.
Similarly, it is extremely hard for someone who hasn’t held a cricket bat before to survive ( not even play but survive) a mere six balls from a professional cricket bowler (say Brett Lee or Jofra Archer) while hopefully also avoiding taking a trip to the nearest hospital.
I cannot claim expertise in performing heart surgeries just because I read a couple of books on it. If someone wants to give their heart to be operated upon by me despite that, please do contact me. But please don’t sue me if something goes wrong because I hate communicating with lawyers.
Anyone playing the keyboard the first time cannot get even some of the Fur Elise right the first time he tries his hands. Neither can a first-timer with no prior experience be able to perform open-heart surgery. But in Investing, a rebellious teenager with no experience can beat a 90-year-old Warren Buffett and claim millennial supremacy(for a while). No other place in the world offers that dichotomy. That is the reason I see the investing world from a different perspective than I would see any other field. It gives so many false signals to fool you into thinking that you are a genius. It is the only place in the world where one can be wrong yet make a ton of money for a while. Part of the problem is that the securities market is one of the few places which offers ‘temporary success’ i.e. the ability to be perceived right temporarily. And it is also the only place in the world where clueless millennials who follow even more clueless Youtubers can beat experienced investors with decades of experience. No other profession allows that. That is part of the reason why stock markets often enjoy universal and unabated craze in mad bull runs as you don’t need to be smart sometimes to make money here.
The point is that it’s easy to differentiate skill and luck in most professions. But not all the professions. And certainly not in investing. Most of the other places offer good signals to separate the highly skilled from charlatans/idiots. Or in a more brutal tone, the sophisticated from the bullshitters. Not in finance. This is a place infested by idiots, charlatans, and worse a combination of both.
There are a few takes that I have on this conundrum of being rewarded for bad decisions.
My Five Learnings
- Smart investing is not learning how to make money. It’s being aware of how you could lose it
There is no one correct method of Investing. Every great investor or trader has been successful by their unique method which suited their psychology and behavior. Finding your investing style is a process of discovery that can take decades if not years. Most of the great investors have had investing styles that were contradictory to each other. The fact that something worked for someone else doesn’t indicate that it is going to work well for you. They all had their own unique approach to markets.
“All I want to know is where I’ll die, so I’ll never go there” – Charlie Munger
But all great investors have one thing in common. They are all brilliant risk managers. They were wrong often but didn’t lose much when they were wrong. The fact is that there are only a few ways to lose money permanently. And it is partly caused by poor risk management and a weak understanding of psychology in addition to some other things. It’s extremely important to be aware of the magnitude of risks one exposes themselves to.
Trader Jim Paul expands on this brilliantly in his wonderfully written honest memoir ‘What I learned losing a million dollars’. He stated
“Why was I trying to learn the secret to making money when it could be done in so many different ways? I knew something about how to make money; I had made a million dollars in the market. But I didn’t know anything about how not to lose. The pros could all make money in contradictory ways because they all knew how to control their losses. While one person’s method was making money, another person with an opposite approach would be losing –if the second person was in the market. And that’s just it; the second person wouldn’t be in the market. He’d be on the sidelines with a nominal loss. The pros consider it their primary responsibility not to lose money. The moral, of course, is that just as there is more than one way to deal blackjack, there is more than one way to make money in the markets. Obviously, there is no secret way to make money because the pros have done it using very different, and often contradictory, approaches. Learning how not to lose money is more important than learning how to make money. Unfortunately, the pros didn’t explain how to go about acquiring this skill. So I decided to study loss in general, and my losses in particular, to see if I could determine the root causes of losing money in the markets.”
Jim Paul was caught with his pants down in a trade he thought would be a trade of the lifetime. He was betting it all on one big idea. Everything made sense but the markets just didn’t agree. Within a few months, he had lost all his money as his margin calls got triggered. Ironically, after he lost all his life savings when his position turned. It turned out, he was right but early. And in markets, many times being early is the same thing as being wrong.
It is often the case in investing and business that a bad decision can have a good outcome. And sometimes a good decision can also result in an extremely bad outcome. And bad decisions could work well for many years and the fallacies of the method would escape your mind as you would be blinded by your success and ego inflation as a result of it. But it is always important to be mindful of the great rewards one can get as a result of bad behavior. Repeating bad behavior might be rewarding in the short term but it will likely take away more than what it gives you as in the long term, things often even out.
- Paradoxically, You can lose money on a right trade for a while
I was fortunate enough that I had gotten into investing in a brutal bear market. The two-year period starting from 2018 was one of the most brutal markets for Small cap companies where I had a majority of my portfolio. There was a perception in the market that small caps are the domain of the crooks with weak business models. I didn’t agree with that at all. But the market had other plans.
Every week, a new fraud or an accounting scam surfaced in some small-cap company. These developments made most equity funds and investors wary of small caps. There was a mass selloff for two years. The valuations tumbled badly. Some of my portfolio was in NBFC companies. And worse, a liquidity crisis ensued which took out many lending businesses all over India. I bought into some stocks that were falling sharply thinking of them to be value stocks. I tried to catch a falling knife and the knife turned on me.
It was painful to see my portfolio in red every day. Some stocks deserved to fall. I hadn’t known the risks but was about to. The whole fiasco taught me that to make money, it is first extremely important to know how not to lose money. Margin of safety became my ultimate priority and compromising on it suddenly seemed like blasphemy to me.
I had bought into the businesses for the long term and despite that, it was difficult to subside emotions. At the end of the day, you are a human. It is hard to set emotions apart.
If you have not bought the stock at the absolute bottom, it is a hard-hitting reality that at some point in time you will be on a loss (paper) in your position. And since buying at the bottom consistently is almost impossible (only charlatans or idiots claim to buy at the absolute bottom), avoiding paper loss in investment at every point of time is a pipe dream.
A couple of the companies I bought into have gone bankrupt. Some others have become a fraction of the size of what they were. But despite my dumb mistakes, some of the companies I bought gave me multiple-sized returns from my first buying price. Most more than doubled in price. Some went up more than 5 times. And they all fell more than 30% at least once.
Every fall in the stock price does not indicate a problem. But some falls surely do. The graveyard of failed companies is much larger than multi-baggers shared on neuron-damaging WhatsApp investing groups. And I will be honest here. It’s hard to distinguish whether the fall is driven by fundamentals or sentiment. And it’s much harder to have a clearer picture if you are invested in that company and are at a loss in your position. Investors always want to recover the losses on their investing positions. I have been in a similar position multiple times. Once, I started to throw good money after bad in a clear case of the Sunk-cost fallacy.
But over the years, I realized the problem with being invested for the longer term is that you have to be willing to be wrong a few times. Future is hard to predict accurately and you are bound to get wrong sometimes.
My only advice here when found yourself invested in the wrong investment is to take your lovely little ego and hope out of the picture and cut your losses quickly. Kill the monster when it’s young.
One must be honest with himself/herself here. Assess the facts, read more, think objectively, and leave emotions out of the table as much as possible. Become aware of your emotions but don’t act on them. Maybe diversify a little more if that helps neutralize some of your dumb mistakes and helps you sleep better at night.
There is always some chance where one might be wrong. It’s impossible to hit every ball to the boundary no matter how bad the bowler is or how good of a batsman you are. And Losses and making mistakes are a part of the game. Blowing up and risking ruin is not. Losses must be kept as minimum as possible. That ensures survival. That is part of the reason I never short the market (https://curioushound.wordpress.com/2021/01/28/the-reason-i-dont-short/) or don’t take leverage. My losses can be infinite and I like to have a sound sleep.
- Being right and being at a profit are two different things. Similarly, being wrong and being at a loss are not the same. Don’t confuse them
All the speculative bubbles in history have burst at a peak. It indicates that at a point in time everyone was at a profit. Yet when the dot-com bubble burst, millions lost their wealth. Everyone would have conceived themselves as being right at some point in time. And they did seem right – for some time though. Till they were proven otherwise. Almost every participant in a speculative bubble throughout history had been in a profit. This fact makes the markets an extremely tricky place. The linear thought approach proves to be harmful. Thinking of being in profit is equivalent to being right is not only misleading but dangerous.
Take for example, the crazy dot-com boom of 1990’s. Most of the tech investors during the dot-com bull run of late 1990’s experienced outsized gains for a while. And then they didn’t. The portfolio of Warren Buffett at that time, which was largely composed of boring companies in traditional industries took a big beating during a dot-com bull run. He was criticized and mocked for sitting out a rally of a lifetime. New investors (the equivalent of Tik-Tok crowd these days) had declared value investing dead and considered his methods outdated. Yet, some years later, the cards had reversed. Not doing anything stupid when the world around you is going bananas is extremely hard. Sometimes one has to be willing to be looked at like an idiot for a while.
It can be the case that you are not right, it’s just a bull market or a strong narrative pulling your portfolio forward. And is extremely hard to distinguish whether the increase is fundamental or influenced by narratives. The financial world doesn’t work like physics in which laws can be clearly defined. It works on probabilities instead of black and white outcomes. There are no proper quick feedback loops to differentiate right and wrong. It’s still hard to get the lessons right after being caught off guard in some situations. These are one of the few things that make investing extremely hard.
- Try to develop a sustainable investment strategy that ensures margin of safety
I have a friend who loved going to the casino while I was in Europe. He used to bet big money on the roulette wheel. He sometimes won big only to lose it bigger the following day. One day, he claimed to have developed a strategy that would ensure a decent return. Out of 36 spots, he would bet on around 33 or 34 of them. Since the probability of getting 2 or 3 numbers out of 36 is in single digits, it was hard for him to lose. But he missed out on one thing and as you would predict, he lost money. More than he had expected.
Any strategy that entails repeated exposure to a small risk of ruin is bogus and dangerous. Playing a game of low risk of ruin could work if played once or twice. But, do that regularly and it leads to ruin with a probability of 100%. A low probability event will occur with a 100% probability if played infinitely. Nassim Taleb has talked extensively about this problem in his brilliant “Incerto” book series and termed it non-ergodicity.
The tragic number on the roulette wheel came rarely, but it wiped out all of the profits he had earned over the last 20 or 30 rolls of the wheel. So much for all the time and money.
History books are filled with traders making multiple millions over many years and losing it all in a matter of weeks if not days. Using leverage can be a double-edged sword over which you have little control. It’s all fine till the sword changes directions. The bad part about this is that game stops on one bad trade. There are no survivors in non-ergodic games. It’s all bottoms up all over again.
- Remember : You are the easiest person to fool for yourself
In late 2018, a mutual fund sold some bonds of ILFS and certain housing finance companies at a steep discount. This triggered a chain reaction that lasted more than a year and took down many NBFC’s in India.
I had bought certain housing finance companies buying into the bull narrative of urban housing in India. It just made so much sense and it felt stupid to miss out. I understood the business model of banks and NBFC’s. But only the good part of their business model. The bad part was yet to come. The liquidity crisis that ensued was the talking part of the financial town for months. They were all collapsing like dominoes. I had seen a trailer of what had happened in 2008 and it was scarier than the best horror movies I had ever watched.
“Every plane crash makes the next one less likely. Every bank crash makes the next one more likely” – Antifragile (2012)
Many NBFC’s were opening on the lower circuit for weeks. I was invested in a couple of them. My Bank stocks were hit badly as banks had exposure in their loan books to NBFC’s. It was painful to see the stock opening at the lower circuit every day. I could have sold earlier. I should have sold earlier. But the fact that I was invested made me desperate to cover the losses. It made me focus on the reasons I wanted to hear rather than the true reasons. Thinking that things will turn around gave me comfort for a while but deep down I knew that I was lying to myself.
The whole fiasco made me realize how easy was it to fool myself into believing what I wanted to hear. I came up with bullshit reasons to explain to me that things will bounce back. They didn’t. That was not a pleasant experience. I decided to make sure that every time I take a position, I had to be aware of the magnitude of risks that I am susceptible to.
One of the things that I learned was that it was extremely pivotal to be incredibly honest with myself regarding everything. I read up on a lot of psychological literature like Thinking, Fast and Slow and learned about biases and the ways to fool myself. I stopped taking myself too seriously and found it made more sense to kill your best-loved ideas in the face of contradictory evidence. I was wrong and I will be wrong many times in the future again. It’s just the nature of the game that one gets wrong often. But the difference is that I don’t want to lose much now for my mistakes. It’s better to realize the mistakes sooner than later and act on it quickly than hope for a turnaround.
Sheep of Bull Markets
Bubbles are often a case of mass delusion. That is why they are called bubbles. Everyone is confirming everyone else’s views. They are Cautious people sitting out of the rally are ridiculed and made fun of.
Santosh Nair in his brilliantly entertaining book “Bulls, Bears and other Beasts” wrote about the public optimism around 2007. It is frighteningly similar to what is happening today.
“Even as the bull market was gaining in strength with each passing day, it was hard to ignore the signs of trouble surfacing in the global markets intermittently. But the tide of liquidity washing up the shores of the Indian market was so strong that it had managed to temporarily suspend the law of gravity in share prices. Analysts were devising newer ways to justify the bizarre share valuations, which were now factoring earnings three to four years ahead. The engines of the economy were running at full power; tax collections were at a record high; and the profit and loss statements of companies were not in good health. Going short turned out to be suicidal for the handful of traders who were convinced that fundamentals did not justify the high valuations and that stock prices had to correct. They were right in their assessment of valuations, but lost money trying to stand up to a crowd that was willing to pump in funds without any thought to fundamentals. Also, promoters of most of the mid-cap companies were dabbling in their own stocks, using money borrowed by pledging their own shares.
Over the years, I had developed my own set of indicators to warn me of impending danger in the market. One such indicator was the ease of making money. The easier it becomes to make money off shares, the closer you are to the day of reckoning. By now the point had come when all you had to do to make money was to show up in front of a trading terminal. Pick any stock at random and you would still be able to sell it 10 per cent higher the following day. To me, this was a sure sign that the bubble could burst any time. But getting the timing right is the most difficult feat for any trader, no matter how experienced he is.
Traders who tried to call the top in realty and infrastructure firms in recent months had taken a nasty licking. Many of them had even become converts, turning buyers in those very stocks they had shorted, in the hope of recouping their losses. This was similar to the trend seen in technology stocks during the dotcom boom of 2000. I was reminded of a stock market adage: a bull market does not start till the last bull has given up hope and a bear market does not start till the last bear has given up hope”
Bull markets often give old wise lessons to new investors. It’s really hard to see how things can go wrong when everything is Hakuna-Matata. History is filled with unexpected events which changed everything yet were not predictable. So always take your predictions with a pinch of salt and keep them open to scrutiny.
Remember that all the famed historical bubbles burst at the peak of public optimism and euphoria. Avoiding the madness of bull markets requires a contrarian approach and mindset. You have to be willing to go against the majority crowd for a while. I am often reminded of these wonderful quotes by the Oracle of Omaha.
- First the innovator, then the imitator, then the idiot
- What the wise do in the beginning, fools do in the end.
Don’t let confirmation bias suspend the sanity inside you.
The only useful skill
The reason I respect old investors from the new ones a lot more is that they have shown the only evidence of skill that is required from them: Survival.
Over the years I have learned that only real skill in markets is surviving, making money is partly driven by luck and skill. And delivering a huge outsized performance signifies some extreme luck. But being able to play the game after many decades of bull and bear markets is an indicator of a good investing strategy coupled with an equally good temperament.