Luck was a servant and not a master. Luck had to be accepted with a shrug or taken advantage of up to the hilt…Bond saw luck as a woman, to be softly wooed or brutally ravaged, never pandered to or pursued…
Casino Royale – by Ian Fleming
Although lifted from a fictional adventure of 007, created by Ian Fleming, the above quote vividly illustrates how a gentleman should tango with Lady Luck; whether you are betting on the stock market or on the green velvet card table in Monte Carlo.
Many people may believe that betting in a card game is risky and highly dependent on the mood of Lady Luck. However, a layman investor may be making the same mistakes as an oblivious gambler.
A game like Poker is in fact a perfect simulation of what goes on in the grand scheme of the investment universe. The same emotional traps set at the card table are very well the same traps that devour many investors.
Let us examine the vices of investors by using the game of Poker as a referential case study.
Vice #1 Future can be predicted
Card players like to predict what cards will turn up next based on cards already shown on the table. This is the same mistake as how investors become overly optimistic based on past information about a stock or a fund.
If a card player is trying to make a flush (five cards of the same suit) and he is holding two hearts with two others showing as community cards on the table, the card player is very tempted to think the next card turning up would be heart. However, hearts are only one of the four suits, and his odds are in reality less than 18.75% (given one deck of cards, and no other players). Four hearts have already turned up, so in the deck of cards, only nine more hearts are present.
Similarly, emotional investors are overly optimistic about past winners and overly pessimistic about past losers. Certain investments, especially mutual funds, are advertised with high historical returns which may not have any impact on the future returns. Certain stocks also meet the criteria of investor emotional bias, e.g common stock of Ford Motor Co. was trading @ $1.43 in 2008, with a recent high of $12.51, and not much has changed in the fundamentals of the company, only the emotions are stabilized.
When investing with a portfolio, one must examine the long term. Examine the 10 year or 8 year history, and not just how the stock or fund performs in the past couple of years. For a fund, examine the fund size, fees, turnover, and manager tenure. For mutual funds, an investor must be diligent in conducting their research regarding the funds that have been closed by the company. Mutual funds with consistent losses are closed and do not show in the historical rate of return as presented in the pamphlets.
For a stock, look at the inherent value of the company, just like good old Mr. Buffett would. Do not invest in a stock just because the price has been rising. “Value Investing”, anyone?
Trying to form a pattern based on random past information is as reliable as a naïve woman trying to predict your future by reading horoscopes. If you still believe in horoscopes, then perhaps you should never be allowed to approach the card table at Monte Carlo or the stock market. Please go back to watching the “Twilight” series.