Buy the Book: Fred C. Kelly figured out that behavior plays a bigger part in investor success than most thought. That he did so in 1930, says a lot about how little human nature changes. Kelly proposed that by acting counter — contrarian — to the general tendencies of most market participants, one avoids most typical mistakes, and succeeds at investing. Studying average investor mistakes presents a guide to future dangers.
The Notes
- Great Dedication = “To My Best Friend the Margin Clerk Who Compels Us To Sell When A Big Decline First Starts”
- How people behave says a lot about who they are. Anyone willing to study the mistakes of average investors will have a guide on future pitfalls to avoid.
- The way to look at markets is through the perspective of crowd behavior.
- “I believe the way to win is to do exactly the opposite from what nearly everybody else is doing. In other words, one must be contrary! Yet I know, simple as this formula seems, few will ever follow it. Indeed, if many followed it, then it wouldn’t work. If everybody tried to buy when prices are low, then bargains would never exist. A few find bargains only because the majority never recognize bargains. The crowd always loses because the crowd is always wrong. It is wrong because it behaves normally. Every natural human impulse seems to be a foe to success in stocks. And that is why success is so difficult. If you think it is easy to do invariably the opposite of what seems to be the sensible thing that everybody else is doing, just try it. At every step, one is tempted to do that which seems logical, but which is nevertheless unwise.”
- “I learned that men win or lose not so much because of economic conditions as because of human psychology. Certain mental traits that we nearly all have are barriers to success.”
- The cycle of behavior: The average investor is cautious and timid as they buy into the start of a rising market. They’re also cautious and timid in selling — taking small profits. But as prices rise, they get overconfident in buying and selling, hold on too long, see every decline as a chance to buy, until the media is full of bad news. Only then, do they sell out discouraged, at a loss, and near the bottom.
- Mistakes: Vanity is the enemy of investor success.
- “It is vanity that leads us to take small profits but large losses.”
- Because small losses hurt, most investors choose not to sell in the hopes of getting back to even. Taking a loss is like admitting to being wrong and nobody wants to do that. That often leads investors to sell profitable, winning stocks, while holding on to losers.
- Vanity makes investors believe stories and tips as if it gives them secret insider knowledge. The more they believe it, the more they’ll risk.
- Mistakes: Greed is the worst influence on decisions.
- “If I had only sold every stock I ever had at the price I expected to receive at the time I bought it, I should be far better off.”
- Investors buy stock to make money, but sell because they no longer see a chance for gain. Optimism tends to get in the way of this because greed affects optimism.
- “People are so optimistic by nature that they are not easily scared—not easily enough for their own good. Beautiful as is optimism, we must beware of it. Not every optimist is a sucker; but most suckers seem to be optimists. The optimist always thinks the market is going to move upward soon. He cannot imagine a long period of declining prices. However, once fear has been induced it works more quickly than does enthusiasm. Consequently, stock prices go down much faster than they go up! Bear markets never last nearly as long as bull markets.”
- “Few can sit back and wait for bargains. Greed is an enemy of patience.”
- The worst losses happen when investors buy at too high prices when everyone is optimistic and greed is rampant.
- How market bubbles are like ice cream — “I suppose the stock market is like this: Here I have a dish of ice cream that cost me ten cents. Robert, the waiter, comes in and says the ice cream is all gone and no more is to be had tonight. My ice cream suddenly seems more valuable to you and you offer me, say, twelve cents for it. Then Bill, who had intended to order ice cream, makes you an offer of thirteen cents. You, being Scotch, can’t resist taking a profit. Bill brags so much about the ice cream that I decide I was foolish to let it go in the first place and buy it back for fourteen cents. About that time I discover, to my dismay, that the ice cream has melted.”
- Mistakes: Hope, the will to believe, leads to poor decisions.
- Highly speculative stocks, lottery stocks, looking for the big win, are reliant on hopes and dreams to pay off. They’re more likely to lose than win.
- Mistakes: Being “logical” is often wrong.
- Doing the illogical thing often leads to success because it’s a form of second-level thinking. The logical thing is first level thinking. If most people act on the logical thing, doing the logical thing will get the same results. If you want to do better than everyone else, avoid the mistakes most people make, then you have to do the illogical thing. You have to invest differently — be contrarian — because what seems logical, is often a mistake.
- Example: The logical thing is to buy high because all the news is great and optimism abounds, thus stocks should go higher. The illogical thing is to sell high because the great news won’t last forever.
- Example: The logical thing is to sell low because the news is terrible and things can only get worse. The illogical thing is to buy low because, while the news is bad, it won’t stay bad forever. The illogical thing is to get excited as stock prices fall.
- Example: The logical thing is to sell stocks with gains and hold onto to losers. The illogical thing is to sell the losers and keep the winners because the winners likely gained due to a fundamental improvement in the business.
- “Anybody knows that when a thing has happened over and over again the presumption is in favor of its continuing to happen in the same way… It is this disposition to expect a stock to continue in the same direction that it has been going which leads people to buy at top prices after several days’ rise, or to sell after several days of decline… We are inclined to think it a strange coincidence that immediately after we bought, our stock ceased to go up, and, that it quit going down after we sold. But this is simply because human nature in different individuals is so much alike and can stand just so much strain. The same influence that makes one person finally yield to buying or selling pressure makes nearly everybody else do the same thing. You are likely to pay the last fraction of the top figure, for the simple reason that you are an average person. At least, it is fair to assume that you are average. So many are!”
- Kelly relays the story of the Crash of ’29: All the Sunday papers that came out after Black Tuesday proclaimed the market would be swamped by buyers picking up bargains. The logical thing to do was to get in early before prices rose. Yet, the opposite happened — prices fell. The illogical thing to do was to recognize that the average investor would try to buy bargains, so the wise investor should sell.
- “It must be evident by this time that the only safe method is to be illogical. If you are logical you merely do what everybody else is doing. You can’t make money that way any more than a group of people can get ahead in the world by washing one another’s clothes. You can make a profit in the market only by outwitting the majority of other people. But you can’t do that if you follow the same plan that they do.”
- In the 1920s and earlier — pre-SEC days — pools were used to manipulate stocks prices to profit. Stock pools would buy up the shares of a stock, then spread wonderful rumors and “news” stories to drum up demand, only to sell it to the unsuspecting buyers at a much higher price. A similar thing was done to push prices lower — spreading false rumors and horrible news to drive sales so as to buy a stock at a steep discount.
- The pools, knowingly or not, took advantage of basic crowd behavior.
- “Most of us in our zeal for bargains are poor judges of bargains. People remember a stock’s former high price long after they forget that it also had a former low price. We may think a stock is cheap simply because the price is lower than it was yesterday, disregarding the possibility that it may be still lower tomorrow. Wise men do not buy a stock until it has been through severe tests and shown an unwillingness to go any lower. But most of us are too impatient to wait for a stock to show its mettle…”
- “To succeed in the market, then, one must not do what most others are doing. Hence it is dangerous to pay the slightest heed to what you most often hear or see— vox populi, vox Dei, regardless. But since most people are fairly sure to be wrong, he who does the opposite has a good chance to be right. We may not know what the highly intelligent minority are doing, but by watching and studying the crowd, we can pick up useful clues as to what that same minority are not doing. In other words, those of us who are only moderately intelligent and might not behave wisely by independent effort always have the opportunity to join up with smart folk if we’ll just consistently pay no attention to all the signs which say: Follow the Crowd!”
- Easier said than done. Two important things must happen. You have to recognize what the crowd is doing (which is not always obvious) AND not be tempted to follow along. You must do the opposite. Safety in numbers is only partially true, except in investing it refers to a feeling, not an outcome. People take comfort in doing what others are doing, even when its wrong.
- “When all our neighbors, our favorite financial pages and all other agencies keep drumming it into us that one line of action is wisdom, such thoughts become so merged with our own, if we ever had any of our own, that the line of least resistance is to do what everybody says. Even a high degree of intelligence won’t always save you from doing wrong, unless you are mentally guyed and braced and on the alert against following the current.”
- “Another reason for behaving differently from the majority is that the human mind is inclined to go back to the last experience in the market and judge the future by that. Most people look back rather than forward… The average speculator thinks that the stocks which went up in the last bull market are the ones most likely to go up in the next one. Hence, one must steer clear of mere average judgment.”
- “To understand the market, one must think of the human element — of the great mass of unthinking speculators and investors who are going to be wrong. No two speculative moves are ever the same; no two markets are ever alike; and no two market manipulators ever operate alike. It is like a bridge game in which the same combination of cards may never occur again in your lifetime. But if you play carefully and watch each move of the other fellow, you nevertheless have a chance to come out ahead in the long run. You can’t beat the stock market, we are assured, any more than you can hold back the tides… Instead of trying to pick a fuss with the tides, why not ride with them?… The stock market moves up and down in great waves. Most people, being less smart than a few people, invariably mistake a trend of these waves and therefore buy and sell stocks at the wrong time. To get aboard the tide at the right time, it is only necessary to disagree with the opinion of most of your neighbors who are following what they consider logical reasoning processes. Be contrary! But be cautious!”
- Conveniently, doing opposite the crowd tends to follow the value dictum — buying low, selling high — of buying bargains and selling at a fair price.
- It does another important thing: it avoids losing over winning — “I shall always follow the hypothesis that it’s more important to avoid losing than to win. Losses hurt one’s morale. When thinking of buying a stock expected to rise, I shall first of all ascertain if its earnings and outlook make it reasonably loss-proof.”
- Avoiding losing means not taking an unnecessary risk using margin because using margin you have to be right twice: on the timing and the stock. If the stock is right and timing is off, a short-term move higher can trigger a margin call.
- Strong beliefs, loosely held: “The stock market is no place for a person who lets strong convictions take root in his mind and stay there… Obstinacy may have its place among the virtues, but a mind where beliefs crystallize and won’t be dislodged is not ideal for successful operations in Wall Street.”
- Charlie Munger offers a similar take as the quote above — Go out of your way to destroy previously held beliefs.
- Kelly lists the characteristics of people who should avoid stocks entirely: the highly intelligent but handicapped by temperament, the person who would spend more time shopping for a shirt than a stock, and the lazy out for easy money. The last two came with great quotes:
- “The type of person who is bored with the idea of having to look before he leaps should let the stock market stay right where it is.”
- “Only a few of us are naturally so lazy that we are willing to study and work desperately hard at times, in the hope of working less hard later on.”
- The danger of early success is it makes investing seem easier and less risky than it really is.
- “It is a simple process of reasoning to prove that the majority of us must always be wrong in the market and are certain to lose. To begin with, we know that to gain profit one must buy when prices are comparatively low and sell when prices are higher. But if most people had the foresight to take advantage of low prices and buy, then the low prices wouldn’t exist since there would then be more buyers than sellers. Likewise, if the majority of us were cagey enough to sell the instant that stocks are priced beyond their worth, then peak prices would never be reached. In short, if everybody were truly intelligent, no one would sell too cheaply or pay too much, and the result would be that the wide swings in prices could not occur. Price ranges would be confined to such narrow limits that no speculator would pay much attention to the market. There wouldn’t be a market! Speculation can be worthwhile only when a few are taking advantage of the stupidity of the many.”
