Saturday, August 16, 2008

The Insidious Nature of Greed

Most of us are probably aware that emotions can be the downfall of traders. The markets undoubtedly react to fear and greed. All we need do is recall the tech bubble of the late 1990's when traders were paying exorbitant prices for stocks of companies that had no earnings, and in some cases, barely a business plan. Greed fueled the fire and people bought positions with no thought that things might turn south. Instead, the drive for profit controlled their actions. Risk awareness and risk aversion went out the window and, for many, so did large portions of their portfolios when the markets turned over and headed south.

As I considered writing an article about the dangers of greed, I was reminded of a man I casually knew and whom I watched at a gambling casino in San Juan many years ago. The fellow was a fairly well known and pretty well-heeled lawyer back east. He was playing roulette at a high stakes table and was apparently using the Martingale approach where he doubled his bet whenever he lost. The strategy often may work since the gambler starts with a bet of one unit and doubles it after each loss so that when he finally does win, he wins his original unit. As those familiar with the strategy are probably aware, it may often yield success, but it definitely can produce catastrophe if the gambler has enough losses, he will come up against the table limit and no longer be able or permitted to double his bet. As I came upon the table, I noticed that the lawyer was flushed and sweating profusely. What I learned was that he had gambled and lost thousands and he was reaching the table limit. I heard him ask the pit boss to increase the limit and saw his face drop even farther when the request was denied. The wheel spun and he lost.

What motivated this fellow? Certainly greed or he probably would not have thought of high stakes gambling in the first place and probably also a belief in infallibility of his system. The two often go hand in hand and often result in disaster. I recall another trader who once called me and told me he had just bought 200 short-term call contracts (that controls 20,000 shares of stock) on a company whose earnings were to be announced the next morning. I asked him why he did that and he told me it was because he knew the earnings were going to be good and he knew the stock would go up. I said: "How do you know that? Do you have insider information?" He didn't have insider information, he just "knew" it. When I suggested that the price of a stock often dips when earnings are announced even if they are relatively good, he ignored the possibility and told me to just watch the next day. I did. The stock price fell and the phone rang asking how he could fix what had become an awful trade. This guy had made his trade purely on the basis of greed and his belief that he could predict the future. He was mistaken and the greed turned to fear and anguish in a nano second.

Both those examples are somewhat extreme, but they should be a warning to all of us. No matter what we think, we can't know the future and no matter how infallible we believe a system to be, it isn't.

Something I have observed many times over the years of teaching seminars, coaching, and just communicating with traders is that there are an awful lot of people trying to use strategies that they haven't learned. I've seen people in trading groups go to a talk about some strategy that is new to them and immediately put real money at risk using the strategy without any idea of the risks or whether or how the strategy might need to be adjusted in the event things didn't go the way they "hoped."

In my individual coaching sessions and in my book, "Trade Your Way to Wealth", I try to make it a point to invite traders' attention to risk and how it might be managed. In trading as in life, it isn't all going to be good. We need to be aware that almost all of us have a streak of greed and that it can suck us into some pretty bad situations if we don't take measures to discipline our trades and control our losses.

And as a last note, if you don’t yet have plans for October 26, why not come and hear me speak at the Traders' Library 2008 Traders' Forum in Chicago. In my session, I will use current examples to show you how to make limited risk and even no risk trades to protect capital while putting yourself in a position to enjoy significant profits. Featuring some of the top minds in the investment world, this 2-day event will be a great place to learn more tricks of the trade and to meet and mingle with smart active traders. I would be pleased to meet you there—visit www.tlforum.com for more information and to register today.

by Bill Kraft, Editor
Copyright 2008, Makin' Hay, Inc.
All Rights Reserved


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To comment on Bill's article click on the "comments" link below.

5 comments:

Anonymous said...

BULLS AND BEARS MAKE MONEY IN WALL STREET, BUT PIGS NEVER DO

bill102205 said...

Bill: Your articles are well written, clear, but sometimes not concise enough.

I do appreciate your articles each week.

I was wondering if you might build an article for a retired person, such as me.
I am 74, with $200K in an IRA at Scottrade, anther $10K in an IRA invested in commercial property.
My wife and my income consist of SS $1950/month), oil royalty ($200-$300/month), retirement
annuity ($500/month), and we usually withdraw $1300/month from the IRA.

As you can see, we are making it okay, but IRA is decreasing each month. I have the IRA in 3 month CD's at 3% interest.

Now, finally my question: what should a portfolio for a person like me look like.

I know that there are many aspects of my financials, besides my current.

I have considered subscribing to your Dividend Investor. But the question that I have is how much should a person put into the individual stocks, if I wanted to invest a total of $50K, so that there is a balance. Should I just take the first 5 stocks you recommend and put $10K in each, or should I spread it out over say 10 stocks, with $5K in each.

Keeping the $150K in 3 month CD's.

Well you get an idea of what I am getting at.

Thanks for your time. Know you are busy.

William D. Stockwell
133 SE Fenway Avenue
Bartlesville, OK 74006-2706
(918) 335-2673
Email: wdstockwell@gmail.com

Bill Kraft, MarketFN.com said...

Thanks for writing, Mr. Stockwell. Unfortunately, I can only speak in generalities since I am not permitted to give individual financial advice and I am afraid that designing a portfolio for you specifically would violate that prohibition. As you know, I am a trader and the portfolio may change fairly frequently depending on market direction since I would use different strategies depending upon market conditions. Some strategies such as writing covered calls in an IRA are available to produce income and I regularly find candidates that pay 2% to 5% a month in call premium.
Bill Kraft

Alexander said...

Fear and Greed are what creates volatility in the market. These emotions are hard to suppress but when you use the SML, fundamental analysis, and Value investing as your basis it is possible to determine which stocks are inflated by these emotions and determine worthy investments. Warren Buffett was heavily criticized for not investing in .com stocks but once the .com bubble burst he was the one with the last laugh. By sticking to your long term plan and using financial tools available to every investor it is possible to not only harness these emotions, but to profit from their presence.

Bill Kraft, MarketFN.com said...

I have to agree, Alexander, but, for many it is easier said than done.
Bill Kraft