Making mistakes is an inevitable part of anyone’s investing journey, but being able to learn from history and other people’s mistakes can help us reduce them and make it way easier for us.
Interestingly, the main thing we have learnt from history is that people tend to not learn from history, and although the circumstances are not the exact same, and the asset classes may change, the mistakes that happen in the present are the same mistakes that people have made in the past getting repeated over and over, as John Kenneth mentions in the following paragraph:
“Contributing to . . . euphoria are two further factors little noted in our time or in past times. The first is the extreme brevity of the financial memory. . . . There can be few fields of human endeavor in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present”
And the importance of this, is that we can the use the fact that most people repeat the same mistakes to our advantage. When their mistakes end up taking assets prices to extremes our job is to abstain from joining the herd, and that’s when big profits can be made.
After you finish reading this post you will learn what are the most common investing mistakes people tend to make and how to avoid being a victim of them too.
“It’s Different This Time”
Investing trends are carried to the most extreme and dangerous points when the belief that something has changed leads people to believe that the rules applied in the past are now useless because of new circumstances.
Example: In the dot-com bubble stocks prices were taken to extremes on the basis that traditional standards for reasonable valuations weren’t applicable to shares in tech companies whose products were likely to change the world.
The belief that something “can’t miss”
At the extreme points of the market cycle, people fall for the trap of thinking that a certain asset is so good or a certain trend so strong that you can’t lose money by betting on it.
And the thing is, no assets class or investment has the birthright of a high return, they can only be attractive when priced right, and when everyone on social media is talking about a certain trend or stock (think EVs and Tesla in 2021 for example) this is most likely not going to be the case.
Thinking a trend will keep going forever
There’s little we can be certain of when it comes to investing, but one of those things is that cycles will always eventually prevail.
“Trees don't grow to the sky. Few things go to zero.”
-Howard Marks
We must always be aware that trends can’t go unabated forever, and when investors in an upbeat market become willing to pay prices that assume success forever and indefinite growth (of a certain trend or industry) , that’s when we should be the most careful.
Extrapolating the positives of today to tomorrow
Whenever greed and optimism get together, they tend to convince people that favorable elements in an economic environment which have led to high assets prices (Quantitative easing or low interest rates in the past for example) will stay that way indefinitely.
Eventually though, disappointment comes when those conditions are taken away.
Using past returns as a guide to future returns
The greatest asset bubbles arise from the belief that high returns in the past will serve as indicators of future high returns, when in reality the most successful investors know that the just the opposite is true, which is that returns regress to the mean.
Example: Think of past events like the south sea bubble, the tulip mania or the recent crypto bubble. The cycle always follows a similar pattern:
1) A group people pick up on an interesting idea which attracts some capital.
2) After a while, these ideas provide some unusually high short-term returns,
3) People begin hearing about these returns, which in turns attracts big amounts of capital from more “investors” (speculators),
4) Eventually what happens is the inevitable result of too much capital chasing too few ideas, and with purchases prices that were way too high big losses arise.
Investing with Borrowed Money
When speculative behavior leads to the belief that assets will always appreciate faster than the rate of interest paid on a borrowed money to buy them with, that’s when big problems happen.
"Volatility + leverage = dynamite.”
-Howard Marks
As investors, our goal should be to avoid investing with borrowed money at all cost, instead we should strive to have an adequately sized emergency fund. This will serve as the foundation of our portfolio and will prevent us from being in a position where we are forced to sell shares in a losing market in order to raise cash.
Higher risk means higher returns….. right?
A lot of people tend to think of riskier investments as those who will invariably lead to higher returns, the thing is that if this were the case, they wouldn’t be called riskier. Thus it isn’t that they guarantee higher returns, they simply have a wider range of outcomes which could lead to higher returns, but also to bigger losses.
Note: I don’t believe the frequently used beta metric is an accurate representation of an investment’s risk nor do I ever use it, I will further elaborate my position on investment risk on a future article.
This can be better understood by analyzing the following charts which show us the relationship between risk and return, with the latter being the most accurate.
Cash is Trash
Because cash is the assets that carries with it the least risk, this means the prospective return on cash will also be lower than other alternatives, but that doesn’t mean that we should avoid or despise holding cash.
There will always be time when valuations become so exuberant that there won’t be any attractive investment opportunities available, and we must be willing to hold cash while we wait for an opportunity to arise.
"It takes character to sit there with all that cash and do nothing. I didn't get to where I am by going after mediocre opportunities."
-Charlie Munger
“Our capital is underutilized now . . . . It’s a painful condition to be in – but not as painful as doing something stupid.”
-Warren Buffett after BRK’s cash balance tripled in 2003
Fear of Missing Out
A lot of people end up jumping onto a trend, even when they are aware that something is unlikely to keep working. This happens either because they think it still has a small runaway left or like most cases, the pain of watching from the sidelines while everyone is getting rich “investing” in the latest fad becomes unbearable, and they decide to jump on the bandwagon too.
As I have mentioned in my past articles and as we have learnt from history, any investor who wishes to become successful must avoid herd behavior.
Summary
“It’s Different This Time”
The belief that something “can’t miss”
Thinking a trend will keep going forever.
Extrapolating the positives of today to tomorrow.
Using past returns as a guide to future returns.
Investing with Borrowed Money.
Higher risk means higher returns….. right?
Cash is Trash
Fear of Missing Out.
Conclusion
The main takeaway from this article is that we must recognize that we are unable to accurately predict the future (at least I know I can’t) and therefore the best we can do as investors is to try to understand the lessons of the past.
Our journey can become much easier if we read and analyze mistakes made in the past and the behavior that led to them from big events like:
The tulip mania
The south sea bubble
The dot-com bubble
The real estate bubble
The japan stock market bubble
I would highly suggest you investigate these and try to extract some lessons from them, I could also cover them in the future if you are interested, so let me know your thoughts in the following poll:
Closing
And that’s all from me today! I hope you found this post valuable, and if you did I would greatly appreciate if you could share it in the button below.
If you are interested on long-term investing & market psychology you can subscribe to this newsletter where you’ll receive weekly posts sharing valuable insights on these topics for free.
And you can also follow me on Twitter where I share short-form content on a daily basis.
Further Reading
If you are interested on reading more of my work, below are some articles you may find interesting:
Good stuff! I see you’ve been brushing up on you Howard Marks and John Kenneth Galbraith! I’ve always liked Marks’a point about how higher risk does no equal higher returns a. He does a great job putting a mail into that idea.