Thursday, January 21, 2010

Investment Sins Part 7 - Gluttony

With the dawn of the new decade, I felt it was an opportune time to continue this Investment Sins series. I last left off with Anger/Wrath and now the next in line is “Gluttony”. Gluttony is defined as greed personified, and is basically an extreme case of wanting to eat more and more, even when one ceases to be hungry. A glutton will also eat for the sake of eating, which brings me to the description of this investment sin. Note: All these investment sins are described from the book “The 7 Deadly Sins of Investing” by Maury Fertig, which can be found in all good bookstores.

Signs of an Investor Afflicted by Gluttony

The book illustrates four examples of investors who are afflicted by gluttony. Are you afflicted as well? The four signs are described below:-

1) Buying in the worst possible markets

Normally, the correct mindset for an investor to adopt is to buy in plunging markets and sell in markets which are soaring on hope and optimism. Investing gluttons, however, buy indiscriminately and without doing proper due diligence or research. So it’s akin to throwing darts on a dartboard to try to pick those few winners. These people also like to take a small piece of positive information to justify a BUY, even though it may just appear to glitter like gold on the surface and have no substance within.

2) Viewing their investing with false optimism

Gluttons are great deceivers, of themselves! They tend to perceive everything positively, and remember their winners best while conveniently forgetting their losers. These are the guys who tend to claim they make money whenever they are at a cocktail party; of course this is simply the result of selective amnesia.

3) Becoming a 24/7 investor

The gluttons become so obsessed with investing that it dominates all aspects of their lives, including their personal lives and private time. As a result, they often neglect their jobs, loved ones and get into trouble at work because they are overly focused with investments. There is no proper balance in their lives and this mental state is unhealthy in the medium-term.

4) Investing heavily in small caps and options

The author mentions here the glutton usually gravitates towards small caps because they are cheap in absolute terms and also because of their volatility and potential for profits. The problem is that most small caps are not able to generate consistent gains for their shareholders in terms of earnings growth, and most fall by the wayside and fizzle out. The glutton neglects his research and will choose to punt recklessly in the hopes of quick profits; and he does this to his detriment.

So the above are the four classic tell-tale signs of investing gluttony. The book goes on to mention why gluttons almost invariably lose money. Four factors are stated but only three are applicable in Singapore’s context as one of them mentions about capital gains taxes on short-term trading gains, versus taxes on long-term capital gains. These are stated below:-

a) Commissions

This is the classic sandpapering of your gains when you trade frequently, and magnification of your losses – all the hallmark of the fervent glutton who trades frenetically as if there were no tomorrow. Even if commissions were much lower through the use of online brokers, gluttons tend to trade so frequently that the costs eventually add up and erode their gains. Commissions are one of the most insidious aspects of high-frequency trading, and gluttons often fall prey to this without realizing it.

b) Bid-Ask Differential

This represents the difference between what a buyer is willing to buy a stock for, and what a seller is willing to sell for. For liquid stocks, the differential may not be very significant, but for other less liquid stocks there could be a significant bid-ask differential of a few bids. This also adds up to additional trading costs if one decides to enter and exit in a hurry.

c) Over-Reaction Bias

This is the effect of over-reacting to positive or negative news and jumping in and out of the market, thus unknowingly exacerbating the reaction bias associated with this behavioural finance trait. Gluttons usually believe they can get in early when they first hear about the news, and get out quickly before the bad news hits the fan. While it is true that some money can be made this way, it is hardly consistent as the market does not always react as anticipated to news, as some of it may already be reflected in the share price. Also, once the news is out, most of the movement may already be reflected in the opening price for the day, thus obliterating any chances of profiting from such news.

So how does one rid themselves of this investing addiction? The key is to go Cold Turkey, but do so gradually. Just like a smoker cannot be expected to quit in just one day, or his nicotine craving would be too great and his withdrawal symptoms would be unbearable; so should the investing glutton slowly wean himself off trading. Some of the suggested methods are:-

i) Reserve 5-10% of your portfolio for “play” or active trading

Well, as the saying goes, if you simply HAVE to get your daily trading fix, make sure you limit the amount of money you risk, and by limiting it to 5-10% of your portfolio you also restrict yourself from losing too much. Of course, mental fortitude is also needed to prevent oneself from raising this limit to say 20% and higher in order to get more funds to “play”.

ii) Refuse to invest in the stocks and funds that everyone is talking about

In other words, steadfastly refuse to follow the herd mentality! It’s easier said than done though, and once again you need to tell yourself to hold your horses and not do the popular thing. Once you start getting used to this, it’s the first step towards curing that gluttony addiction.

iii) Substitute buying “beaten-up” stocks for high performing ones

One should actually do some real research for once and purchase quality, and not quantity. In this case, “beaten-up” may be beaten up for a good reason, as fundamentals may deteriorate or the Company may be managed poorly. Cut the losers out and focus instead on companies with good management, clear earnings growth visibility, good cash flow generation and are selling at cheap valuations.

iv) Increase Benchmarking

It’s a good idea to benchmark against an index to see how you are doing objectively in terms of performance, so this is an effective way to stop deluding yourself that you are better than everyone else!

v) Reduce the number of trades gradually

As mentioned before, do the slow cold turkey instead of the instant one. This is because addictions are mental habits which are difficult to break off suddenly. Therefore, slowly reduce trading until it becomes no more than an afterthought, and after that you should do fine.

vi) Use a passive or index strategy when investing in small caps

Since the risk of small caps is much higher than blue chips, it is advisable to use a passive strategy of investing in an index fund of small caps to diversify away the risk of any single company collapsing. In this way, you mitigate the chances of losing a huge chunk of money and also slowly kill that inner demon of a glutton within.

I hope the above is helpful, and the last section of the Investing Sins series will tackle the issue of Sloth, or laziness. Watch out for it soon!

8 comments:

Kian Wei said...

Hi Musicwhiz

Thanks for the post!
Keep it coming!

Regards

Lau said...

Hi Musicwhiz,

Great post.

Would u like to exchange blog links?

Musicwhiz said...

Hi Kian Wei,

Thanks for visiting!

Cheers,
Musicwhiz

Musicwhiz said...

Hello Lau,

Sure, I am open to it. What is your blog about and what is the URL?

Thanks,
Musicwhiz

Lau said...

Hi Musicwhiz,

It's about health, financial planning and investments.

http://anifaview.blogspot.com/

^_^

Musicwhiz said...

Hello Lau,

Added!

Cheers,
Musicwhiz

header said...

Hi Musicwhiz
Learnt alot from ur post. Keep it up!

Btw, do u know where are experts like dydx from wallstraits? Miss their posting...

Musicwhiz said...

Hi header,

Thanks for the support. Wallstraits has now moved to Afralug.

Check out http://afralug.com/wsforum/

Regards,
Musicwhiz