It is not uncommon for intelligent, competent people who have been successful in business or an academic environment to try their hands at trading on the markets. In essence, because they have managed to outpace the competition in the business or university sector, they think they can do the same with investments. However, while this logic may be appealing, it does not always pay off and many of these individuals lose money for a variety of reasons.
A Common Beginning and a Good Start
The German expert Jochen Steffens explains how this can happen (Investor's Daily, November 2004). In an example, Steffens describes a new "intelligent" investor named John. John is advised by a friend to put some of his money into the stock market. He does so and buys a very promising stock. In one month, he turns $30,000 into $35,000. All he had to do was phone in and place an order. John now believes he is on to a good thing. There are few other areas where you can make such good money with so little effort.
The problem is that John now thinks he can carry on doing this. His reasoning: "I am more intelligent than most people. I have proved that throughout my life. I can now use my knowledge and intelligence in the stock market to gain an advantage over all those other idiots out there who think they know what they are doing, but don't." This, says Steffens, is a fatal mistake.
Intelligence and education often guarantee success in academic professions and sometimes in business, but the world of investment is driven very differently. (To learn how to start investing for yourself, see our Investing 101, Stock Basics and Basic Financial Concepts tutorials.)
Things Start to Sour
John then buys another stock, but this time it does not go up, but down. John is very surprised. He researched extremely carefully on the internet and found all sorts of evidence to suggest that this particular share could only go up. But it didn't. John now makes the next fatal error. He believes that "all those idiots who are selling this stock just don't realize how much it's going to be worth over time! It's really a great buy, but only truly intelligent people can see this."
Unfortunately, all those "idiots" continue to sell and sell. The stock is now worth 60% of what John paid and he is faced with a nasty dilemma. He could accept that he is one of the idiots after all and sell. But this is difficult - John is keen to preserve his own self image as an astute judge of the market, companies and other investors.
Human (market) psychology being what it is, John looks for another reason why things went wrong. It could be Ben Bernanke, events in China, the weather or even the phase of the moon. Anything but the fact that John simply made a mistake, or a series of them. (To learn more, read How Investors Often Cause The Market's Problems.)
From Bad to Worse
Something else is very clear to John: the share has dropped so much, that it can't fall any farther. Therefore, John reasons that it's best to wait until his shares climb back to his purchasing price of $30,000. This is the next in this not-so-funny comedy of errors, because the stock continues to fall, eventually grinding to a halt at $15,000.
John now waits for that inevitable meteoric rise that will salvage not only his savings, but also his sense of self-esteem. However, the rise never comes, and the stock languishes between $15,000 and $17,000 for a year. Finally, our intrepid investor realizes it's game over and sells.
The Cycle Begins Again
Then, the truly inevitable happens. The company is taken over, restructured and streamlined with great skill and precision, the products remarketed and the stock starts to rise and rise. Our hero goes though stress and misery once again.
Now he realizes there is only one thing that he can rely on - cash is king. At least until our hero starts to get very frustrated when his friends, who are definitely not as intelligent as he is, tell him how much their portfolios are making.
The Market Takes from Everyone
Steffens' story of "Intelligent John" is largely a psychological one. John was subject to a series of emotions and their consequences, all of which are very common in the investment sector. John's "sure thing" plunged downward and he felt humiliated. In order to maintain his self image, he kept the stock way too long, hoping that all would be well in the end. Even worse, says Steffens, "he wanted to show the stock market who was boss.
However, the stock market does not care who it takes money from. Whether it be a construction worker, professor, doctor, politician, economist - or our poor intelligent John - is irrelevant. The illusion of control, self-overestimation and the classics of greed and fear are poison in the markets. The most intelligent and educated people are anything but immune to such "psychotraps". (To learn more about the psychology of investing, see Master Your Trading Mindtraps, When Fear And Greed Take Over and Mad Money ... Mad Market?)
As German behavioral finance expert Joachim Goldberg points out, "If people win a few times on the market, often with small amounts, they think: 'Now I know how it works,'" ("Strong Emotions Hamper Trading", Handelsblatt, October 2005). As a result, they start putting more and more into the market until things go horribly wrong.
When things take a turn for the worse, investors tend to make a classic series of mistakes: hanging onto stocks that are losers, selling far too late, then moving too much into cash. As Goldberg confirms, "the most common errors are to act too suddenly on important trades, not to realize losses in time or to take profits too early."
Heinz Werner Rapp of Feri Wealth management in Germany adds that in 2000, as in other euphoric booms, the most obvious behavioral problem is that "people blind themselves to anything they don't want to hear" (Handelsblatt, October 2005). They refuse to believe or act on the simple truth proclaimed by independent experts. As such, as smart as they may be, they are destined for failure.
In 2000, the fundamentals of the new economy shares were hideously out of line with their stock market evaluations. Investors watched their stocks climb to dizzying heights and deluded themselves that the world had changed and that the party would go on forever. But the new economy was not so new after all - the cold realities of the old economy prevailed in the end, and they always do - even for the smartest investors.