Tuesday, August 26, 2008

Investment Sins Part 5 - Avarice

Avarice (another word for "greed"), our 4th discussed sin, strikes most investors during the peak of a bull market or during the middle of a raging bull market. It will be rather self-explanatory to the informed reader that greed is part of a normal investor's psychology, and therefore should be controlled as part of the fear/greed combination which occurs in such potent fashion while investing in the stock market.

However, what may not be obvious is that avarice can take different forms and may manifest itself in different ways (through various behaviours). The objective of this post is to highlight the various forms of avarice, how they are demonstrated and how to effectively curb such behaviour and prevent it from ruining our investing lives. First of all, Mr. Fertig's book points out that greedy investors tend to be unrealistic investors. To give an example, one may invest with the proper research framework and do their requisite reading and valuation tests to look for a suitable investment. However, when it comes to expectations of returns, avarice causes the investor to have wildly unrealistic expectations. He may envision a 200% rise in the stock price over a period of a year, or errorneously believe that his company is the best in the industry and immune to downturns. Such unrealistic expectations usually cause an investor to lose focus of reality and may cause recklessness and deep disappointment.

Another consequence of excessive greed is the desire to chase performance, which may result in even poorer performance than if one had just "stayed put". One example given in the book is the chasing of "hot" mutual funds (unit trusts) in the hope of maximizing returns. The greedy investor will "hop" from one year's top fund to next year's top fund, all the while switching from one to another in the (vain) hope of maximizing his wealth. However, this is usually a losing strategy as there is no guarantee that this year's top performing fund will continue to outperform. Frictional costs related to switching (some funds charge upfront sales charges) may also work to erode gains. leaving the investor worse off than if he had just invested in a low turnover, low expense ratio index fund !

A third result of greed is the failure to do proper due diligence. Greedy investors often throw caution to the wind and "invest" based on tips and rumours, with the hope of a windfall or jackpot (akin to lottery gambling). Such moves are often detrimental as investing based on such scanty and subjective information usually means the investor ends up not knowing what he is investing in, and this almost always spells trouble !

A further effect of greed is that it prevents investors from studiously monitoring their current investments for signs of any trouble. A greedy investor always assumes the best in his investments and fails to spot signs which may affect the companies which he invests in. This is a case of selective perception and the greedy investor wishes to look out for information which affirms his avarice, rather than objectively assessing information in order to make a more informed decision on whether to hold, or sell an under-performing investment.

The key to preventing greed from affecting our investment lives starts with proper self-control and being realistic. For example, it is unrealistic to expect to "beat" or even equal the performance of investing legends such as Peter Lynch, Warren Buffett and John Templeton. As retail investors, most of us are just average folk and therefore should accept a decent return on investment (in the region of 5-6% per annum is fair). Also, train yourself to assess an investment in an objective, calm and rational manner, so that greed does not cloud one's judgement and make an investment seem much better than it really is. And, probably the most difficult thing to do is to convince yourself that the market will eventually reward the patient, long-term investor and punish those who speculted without doing their due dilligence. In other words, greed does not pay and only in the long-term will this become obvious.

Warren Buffett's famous line is "You only know who's swimming naked when the tide goes out". Such a sentence is very true indeed in this current bear market, as most who purchased at very high valuations are sitting on significant paper losses now. Personally, I believe that greed will not give me a good outcome; thus I choose to "get rich slowly" instead of gunning for quick, ephemereal gains.

8 comments:

Anonymous said...

Very well writtern. However i have a question, what would buffet do? If he know he bought a good stock at a good price, but it keeps dropping and dropping further deal to no fundamental fault of the company. How then should one stay determined to keep holding on?

Anonymous said...

another issue is the risk of running out of "bullets" and your share price keep on dropping

DSEA

Alisa said...

Greed is a powerful emotion the consequences of it are many; as you mentioned. Another consequence is the debt of this nation. I was shocked to hear the staggering statistics concerning debt and our current financial situation and I think greed also played a critical part. Got to have it now... doesn't matter if I can afford it or not. I summarized some critical information about a documentary addressing this very issue. Warren Buffet was one of the panelist and, of course, he had some great insight. Check it out here: http://ourstockmarketjourney.blogspot.com
@anonymous concerning what buffet would do with a steadily decreasing stock price. I would guess that he would have put a significant amount of time and effort in researching and evaluating the underlying business first. (For him... it probably would take 1/2 hour if that much)Since he seems to really be concerned about adding value for his shareholders; I don;t think he would go into any purchase lightly. Then, if the results research on the business fits his investing criteria; I then think that he would purchase shares with a margin of safety in efforts to minimize his losses... should they be steep. But then, I think he would just sit back and wait, and wait, and wait, and (well you know...wait). All the time ignoring the noise generated by Wall Street and all the other market commentators. I think his experience, education, and previous successes would allow him to do this, rather calmly. As a matter of fact... he may just buy more of the stock at the depressed price knowing "intrinsically" what the true value of the stock is and that it is just a matter of time before the price begins to reflect this true value.

Be well.

musicwhiz said...

Hi Anonymous @ Aug 27,

If there is no fundamental problem with the company, I would think the intelligent investor would take advantage of lower prices to purchase more shares, as he will then have greater margin of safety.

Regards,
Musicwhiz

musicwhiz said...

Hi DSEA,

Yes, but there always has to be a limit as to how much one can average down, because our funds are limited and we can never time the bottom anyway. I would be happy to average down just to achieve better margin of safety. I have no expectations of "catching the bottom" as I believe it is impossible to do so.

Cheers,
Musicwhiz

musicwhiz said...

Hi Alisa,

Yes greed is a very powerful emotion and investors have to constantly keep this "demon" under control.

I think Buffett is an expert on valuing companies, we can only hope to get an approximate value after spending lots of time on research. As long as I get a decent return from my investments, I am satisfied. No need for an exceptional performance. :P

Cheers,
Musicwhiz

Miguel Barbosa said...

Great Post and Great Comments. Keep up the good work. This blog is going to make everyone a better investor.

musicwhiz said...

Hello Miguel Barbosa,

Thanks, do come and visit more often to share in the discussions as well. :)

Regards,
Musicwhiz