Knowing how irrational markets are can get you out of tough situations
We’ve all done it: becoming way too attached to an investment or trade that just isn’t working. No matter what we do, we can’t bring ourselves to press sell in our brokerage accounts.
Instead, we average down until finally realizing we were wrong, but by then, it’s too late. The stock’s down 40% since last fall, and the company’s outlook doesn’t seem as bright as the analysts on television predicted.
But this behavior is quite normal. We are human. And the reason why we allow losses to run is our emotions. Whether it’s because we’ve done hours of research, can’t bear to lose money or just like gambling, humans are programmed to take small profits and heavy losses.
Though your mind is telling you a lot will go right, it blinds you from the harsh truth about markets: a lot can, and will, go wrong.
The late polymath and mathematician Benoit Mandelbrot exposed this in his book, The Misbehavior of Markets, highlighting the challenge you face when trying to make a profit in financial markets: “In theory, people have the same investment goals and the same time-horizon, so given the same information, they would make the same decisions.” He adds, “but patently people are not alike — even if differences in wealth are disregarded.”
In reality, the market and its participants are incredibly diverse in almost every regard. Some investors are compassionate while others are competitive, and some are complacent while others have strong convictions.
“Some investors buy and hold stocks for twenty years for a pension fund; others flip stocks daily speculating on the Internet. Some are “value” investors who look for stocks in good companies temporarily out of fashion and others are “growth” investors who try to catch a ride on rising rockets.”
— Benoit Mandlebrot
Knowing this, being able to ditch bad investments requires you to acknowledge two popular, false assumptions: people are rational, and they think and want the same thing as you.
If you add the sheer complexity of human psychology to the number of participants trading an asset, it’s clear that being right, even 50% of the time, is a tall order. For example, the most traded stock on the Nasdaq Exchange is Advanced Micro Devices, ticker $AMD, with an average daily share volume of 57.95 million. That’s 57.95 million potential reasons why you may end up losing money.
If that doesn’t convince you that things can go wrong more than right, it helps to think about the unsuccessful investments you’ve made over your lifetime.
Here are some common cases:
- Research leads you to believe Microsoft’s stock will gain 25% or higher over the summer, but at the same time, the rest of the market decides — for any reason — to sell and the stock falls 25% over the same period.
- You might have day traded the S&P500 to profit from a positive Trump trade tweet, but then he backtracks and decides to increase tariffs on China.
- You were bullish on the stock market going into 2008. That’s a 60 percent drawdown in six months!
Clearly, these ideas didn’t go to plan. It happens to everyone, we can’t get all our trades right. It’s never been done before, and it never will. Yet admitting you were incorrect and limiting losses is a difficult skill to master.
Within the retail trading industry, statistics show non-institutional investors are way more likely to lose than make money in the current economic climate. In Brazil, for example, it was reported that 97% of day traders lost money. And if you visit any popular brokerage platform, you’ll see a regulatory message appear in the top banner: “70–90% of our customers lose money.”
Never think you’re alone in your failures. Looking back at the history of my own investing career, although remaining profitable, I’ve got about 45% of my investments right over time. When I’m wrong, I accept it and trade out before getting carried away.
Taking everything into account, succeeding in investing looks somewhat of a challenge, to say the least. But now if an investment or trade starts to go against you, you’ll be able to say, “maybe I got it wrong this time,” and cut your losses with conviction knowing there are a million or more reasons why.