If an investment opportunity seems too good to be true, it probably is. In his latest post, Mark Ford shares some cautionary tales for investors, and the three essential rules for rational, profitable investing.
Are investors no better than lab monkeys?
By Mark Ford
It’s because you are “one of his favorite people” that Melvin, your broker, is telling you about it.
It’s AgriCorp, a little-known company that has developed a new natural herbicide that’s 150 percent better than the chemical treatments currently used.
“But get this,” he whispers furtively into the phone. “In three months, a bill goes to Congress banning most of the herbicidal chemicals currently used. When that passes, AgriCorp’s revenues will skyrocket.”
“Where do you see the share price going if that happens?” you ask.
“Based on projected P/E ratios,” Melvin says, “our analysts figure 3,000 percent. Every thousand invested will become $30,000!”
“But I can only give you 500 shares,” Melvin says apologetically.
Some primitive part of your brain is upset to hear about this scarcity. It fears starvation. But another part, the rational part, is saying, “Be cautious.”
You double-check the story. Melvin’s account of both the product and the pending legislation are accurate.
“What did I tell you?!” your greedy, primitive brain shouts. You buy 500 shares at $10.
Three months later, Melvin calls to tell you that “some big chemical companies have temporarily held up the bill.” There is frustration in his voice. “But it’s going to happen.”
But the share price drops to $5. So your $5,000 investment is now worth $2,500.
“You should double down,” Melvin tells you.
“I can get you another 1,000 shares. Invest another five Gs. It will bring down your average cost from $10 to about $6.65. It’s safer, don’t you see?”
“Plus, with three times as many shares at $6.65, you stand to make more than three times the money!”
“Go for it!” your greedy brain is screaming. “Take caution,” another part of your brain whispers.
“This law,” you say. “You’re sure it’s going to happen?”
“It’s a lock,” Melvin says confidently.
Your primitive, greedy brain likes the sound of “lock.” You write Melvin a check for another $5,000.
Two years later the bill finally passes.
No. In the meantime, another company, AgriStar, has developed a similar product that is better and cheaper.
You call Melvin for advice.
“Just to be safe, put five Gs in AgriStar,” he says.
Great. Your $10,000 investment is now worth $800 and sinking. Melvin wants you to invest more. But you have no more. Life sucks. You consider selling but the $800 won’t exactly change your life. You decide to hold on to those shares and hope for the best. But you know, deep down inside, that you’ve lost a small fortune. You can’t figure out whether you are angry or embarrassed. Probably both.
Picking up pennies in front of steamrollers
There’s a moral to this story, and it’s one thing every wealth builder should know:
When the outcome of an investment depends heavily on some expected future event, it is inherently risky. When that anticipated event comes with a time frame, the risk is exponentially greater.
The good news: You can shorten those odds by being rational.
The bad news: It will be hard for you to do this because your brain is wired to respond to investment opportunities in non-rational ways. (We’ve written about this here).
Many studies have shown this. One of my favorites was conducted at the UNSW Australia Business School by Elise Payzan-LeNestour.
She tracked the decisions of investors given speculative opportunities. And then she compared their behavior with the responses of lab monkeys.
The monkeys were presented with two levers. One always dispensed a small amount of sugar. Another sometimes provided double the sugar and other times gave an electric shock.
Time and time again, the monkeys took the gamble and ended up with lots of shocks and less sugar than they would have received from the safe lever.
The same pattern was evident with the investors. When given the choice between risky investments that offered high returns and safer investments with lower returns, they favored the risk. As Payzan-LeNestour put it, “Investors pick pennies in front of steamrollers because they overlook the possibility of a loss.”
When it comes to choosing safe versus risky investments, Payzan-LeNestour concluded that investors are no better than lab monkeys.
Trust me… I know. I’ve done it. And it’s embarrassing…
I’ve made my share of monkey-brained investments in my life. And almost every one of them involved speculation—the anticipation of some future event with a specific time frame.
My first real estate investment is one that comes to mind. When I was starting our family in Washington, D.C., our landlord came to my wife and me with a “fantastic” moneymaking opportunity.
She showed us charts and graphs illustrating how local real estate prices had been rising for years with lines projected into the future. She also gave us lists of facts that seemed to prove a continuing bull market in property.
According to her calculations, I would double my money in less than three years by buying one of her properties. Knowing nothing about real estate at the time, I acquiesced. I invested about five grand, which was the entirety of our savings at the time, and waited expectantly.
You can guess what happened.
The market went the other way. I quickly lost my $5,000 and continued to lose money as property values tanked. It took me several years and $30,000 to dig myself out of that hole.
I have a recent example and this one is particularly embarrassing. On the advice of a colleague (a very well-known and respected investment guru), I met with a businessman who spent an hour telling me about how much money his business was going to make. He pitched to me based on deals he was making with people—very influential people in our industry that I knew were “good.” He showed me the numbers. They looked promising. So I had one of my businesses lend him a hundred grand.
A month later I learned he was a serial con artist—that he made his living suckering wealthy, successful business people (like me and the guy that recommended him), taking their money, spending it, and then declaring personal bankruptcy. He did it two or three times before he did it to us. Now I’m spending money trying to put him in jail.
What was my mistake?
I collateralized the loan on his business. But the valuation I gave it was not based on its then-current income but on what he persuasively argued it would become.
Had I obeyed my rule about sticking to the present and not betting on the future, I would have asked for some other form of collateral or said no.
Shame on me.
And here’s one final example: I was a member of an informal group of investors for about a dozen years. These were all investment insiders and experts—business owners and specialists and analysts and several financial gurus.
Every so often, one of us would bring something to the table. They were always speculations. But they were within the scope of the expert’s knowledge, so they all seemed like good bets.
How did we do?
I like to say that our track record was “perfect.” We lost 100 percent of our money on every deal.
Rules for rational investors
I said before that when it comes to investment opportunities, most of us do not act rationally, however much we tell ourselves that we do.
Here’s why: Neurobiologists say the human brain is really an organic network. Some parts of the brain do the rational thinking, others facilitate our emotional and primitive instincts.
Emotional intelligence can be extremely useful. And good decisions are made when our rational conclusions, emotional impulses, and primitive instincts line up.
But to make good decisions consistently, we must control our primitive instincts. The part of us that always goes for more sugar and ignores the possibility of loss.
We must tether our impulses to some rational thinking and emotional constraint. As Seth Godin put it, “The amygdala isn’t going away. Your [primitive] brain is here to stay, and your job is to figure out how to quiet it and ignore it.”
And the best way to do this, when it comes to investing, is to adhere to rules of engagement that reduce risk.
I’ve developed three such rules:
Don’t invest in anything you don’t understand. This one is probably the most important, but also the easiest to ignore. The challenge here being that it’s sometimes easy to convince yourself that you understand something when you don’t. When I say you should “understand” a business, I mean you must know it inside and out. You must know how it makes its money, which products are most profitable, what particular problems it faces, what sort of financing it needs, etc.
Never invest a lot of money in any single asset. When it comes to stocks, this is called “position sizing.” You might say, for example, that you will not spend more than 5 percent of the money you have allocated for stocks on any particular stock or no more than 1 percent of your net worth on any particular stock.
To reduce risk further, always diversify your investing across a broad range of asset classes. This is called asset allocation, and some studies suggest it is the single most important factor in long-term wealth acquisition.
These rules are what will prevent my monkey-brained instincts from getting the better of me.
(We’ve written a free report about how to prevent your emotions from getting in the way of your investment decisions… click here to learn more.)