Saturday, January 21, 2017

How Small Investers Screw Themselves

Why do small investors screw themselves most of the time?

Small investors often screw themselves out of most, if not all of their money. Why this is, isn't hard to figure out. They are not sophisticated and they don't have investment smart  They are also more prone to greed and fear. And they are in denial about reality most of the time - which is why they are small investors in the first place.

One of the mantras of my blog is to act rationally in an irrational world.   If you perceive reality as it is, rather than what you'd like it to be, you will come out ahead.   People who make fantastic amounts of money in this world are merely those who perceive reality correctly most of the time.

Warren Buffet isn't some genius inventor who invented a new gadget (those never make money) or some stock whiz with a new system for making dough.  He merely is a person who can more accurately perceive where value lies while others see only risk - at least more than half the time. He invests in things that others eschew, and usually comes out ahead. While the great unwashed go after the latest IPO, he is doing "dumb" things like investing in hometown newspapers or airline stocks. And sometimes he gets it right, sometimes wrong.  Most of the time, right.

Small investors, on the other hand, are often disassociated from reality.  They watch television and think it is real.  They believe whatever convenient thing they want to believe - like urban legends and fake news.   They have no real grasp on reality, and thus reality to them seems like a harsh mistress.

And they make a number of mistakes.  Here are a few:
1.  Starting a Business:  The single largest mistake small investors make is trying to start or run a business.   The media hypes the "be your own boss!" nonsense, and every television show aimed at the working class depicts them starting a business - rarely with accurate results.   Archie buys a bar, Rosanne opens a cafe, while her husband opens a bike shop (which in the series is accurately depicted as failing).  Fred and Barney open a hamburger stand.   Ralph and Norton have a number of get-rich quick schemes.  At least in those latter shows, they are realistically shown as failing.

Why is running your own business such a bad idea?   Well, first of all, about 90% of small businesses fail in the first year, so the risk factor is high.   The capital needed to run such a business is steep, and when the business fails, it generally takes you out financially, leaving you broke and bankrupt - without even retirement savings.   If you were foolish enough to borrow money from employee's withholding, you may in fact end up in jail.

The second thing is most of us are shitty businessmen.   When I started my law practice, I had the legal part pretty much locked up.   I was able to set up an office and efficiently docket my cases and write applications and amendments and whatnot.   The skill part was not the issue - the business part was.

You may be a great chef and can cook amazing meals and get crowds to come to your restaurant - but if you can't balance the books, it will all be for naught.   I had to learn bookkeeping, billing, and hundreds, if not thousands of skills that it takes to run a successful business.   Like most amateurs, I spent more on overhead that I should have ("wouldn't it be nice to have....?").   I also had no skills in hiring and managing people, which is key to running a business.

Worst of all, I still harbored naive ideas from my days as a salary drone.   I was not going to be like my stingy mean bosses, but instead be nice to people!   Not only was this a horrific business plan, I ended up not being nice to people, as people don't want "nice" in an employment scenario, they want a structured environment with stated expectations and performance goals.

It worked out for me because I pulled the plug fairly early on, before I went into debt.   I also had a fairly good cash-flow business, although I wish I had more of that cash at this point in my life!   Other businesses, more marginal with higher overheads, can hemorrhage cash very quickly.   Restaurants are the worst, and once people stop coming, things can go South in a real hurry.

2.  IPO stocks:  Greed is the biggest fault of the small investor.  It is one reason they want to run a business of their own - convinced that others are "raking in the dough" instead of barely hanging on or going bust - as most small businesses are.

IPO stocks are the next-best-thing to starting a business of their own, they think.   There is going to be a new product or company that is going to hit it big!  And if you are in on the ground floor, you will be the next Paul Allen (who was an original investor in Microsoft).   

The problem is, spotting the next big thing! is damn hard to do, and even if you can spot that, spotting the right company to invest in is even harder to do.   Motley Fool hyped 3-D printing as the next big thing! but it turned out only to be a thing and not a game-changer of anything.  Not only that, some 3-D printing companies have already gone bankrupt as it turned out to be a competitive industry and no one company could corner the market.

Compounding this is the nature of the modern IPO.   IPO's used to be about raising capital to found a company.  Today, they are all about "going public" so the founders can cash-out of their founding shares and get suckers - I mean investors - to buy these shares from them.

I have invested in one and only one new company, and that was a bank some friends of mine were starting.   And I invested for four reasons.   First, they were all investing their life savings in the bank which was a good sign they would make it work.   Second, they knew what they were doing and had a good business model - commercial banking in the DC area is a pretty solid business, and they even survived the mortgage meltdown without much difficulty.   Third, as a real estate investor, it helps to own stock in a bank - they had indicated that they could loan me money for my investments, which made owning stock in the bank a good idea.   Fourth, I didn't invest much, and I could afford to lose what I invested.   I put in $10,000 which I borrowed on my life insurance to get (I was cash-poor at the time, stupidly).   I made over $50,000 on that investment.

And a fifth thing - they were not starting the bank to "go public" and cash out, but to raise capital to start the bank.   In other words, it was a real IPO, not some faked-up deal to snooker the public into buying overpriced stock from venture capitalists who invested early.

Such opportunities are hard to come by.  They are rare.  And in retrospect, of course, I wish I had cashed in my 401(k) to invest in it.   Or in that AVIS stock that went up 7000%.   But not having a working time machine, I cannot do either.   The best we can do is diversify and make a little money here and there.

Both of those "high yield" investments could have gone horribly wrong, too.   My banker friends could have over-invested in residential mortgages just as the market crashed.  AVIS could have gone bankrupt.  It never pays to invest a lot in risky things - you could lose it all.

But one way to avoid risky bets is just to walk away from IPOs entirely - it is almost a sure thing you will lose out.  At best, you might make back a little money.  Few provide spectacular results.

3.  Crowdfunding Nonsense:  This is the latest form of "fun" investing and for the life of me, I don't understand it one bit.   You give someone money, either just for the hell of it, or because they promise to pay you back somehow, with free products or something later on.   Like most small businesses, these sorts of places go belly-up in short order leaving people with nothing to show for their "investment".

What irks me about crowdfunding is that it is not taking investment seriously.   If you really want to invest in the next big thing! then you should get more out of the deal than a poorly made prototype in the end.   You should have stock in this.   When did investors just give up entirely on equity?

The same is true for the Elio "deposits" - you are gambling money for not a lot - a chance to buy a car later on that may or may not be made.   Of course, in that case, actually buying the stock isn't a good deal either

4.  Political Investing:  Some folks think they should "vote with their money" and invest only in politically correct things.   For example, there are funds for companies that are "sustainable" or "women-owned" or "cruelty-free" or whatever.   Some of these funds do well, some do not.  In an expanding market, nearly all funds do well, of course.   Some folks invest in companies that they think are doing social good or changing the world - again the Elio "investors".

What this sort of "investing" loses track of, is the bottom line.  In addition, the idea that somehow by investing in certain things these things will succeed, is somewhat flawed.  You can throw your life savings at the Elio, for example, but that doesn't make the product or business model viable.

Similarly, withdrawing your money from cigarette stocks or oil stocks isn't going to change these industries one bit.   Some pension funds have made big deals about liquidating "politically incorrect" investments to great fanfare, which might make people feel good, but doesn't curb America's appetite for oil or the world's appetite for cigarettes.   The decline in demand for these products will come from the supply side not the investor side.   

These are not start-up companies looking for capital, but established companies paying out dividends.  If liquidating from these investments depresses the stock price (and there is no evidence that it does) it just makes the dividend ratio that much more attractive for other investors.

Like me, for example.  Yes, I have minor holdings in Exxon and Altria.  Both pay a nice dividend, thank you very much.   And no, I have no trouble sleeping at night.   We all burn fossil fuels, and if that is going to change, it won't be because the stock price of Exxon went down a dollar.  And people smoke by choice, worldwide.   What will kill off tobacco is the supply-side.   In America, we've made smoking a white-trash endeavor - to the point people are embarrassed to do it.  And no, vaping just makes you look like a hipster jerk.   Cigarettes will die off - even the tobacco companies realize this.  Not investing in these companies isn't what will cause change, though.

Keep your politics and investing separate.   If you think a company is a shitty investment, that is a good reason not to invest in it.   But PC investing?   Probably a bad idea.  It will probably result in a lower rate of return on your investment, but also not really "change the world" one iota.   It may make you feel better about yourself, and maybe make yourself feel superior to others, but that is just self-delusion at work, not to mention huge ego stroking.

5.  Real Estate:  People are already forgetting about the Real Estate meltdown of 2008.   Many tell me the bubble of 1989 never happened.   And others, while acknowledging "problems" in the economy around late 2008 and early 2009, tell me (with a straight face) that these were caused by Bill Clinton and President Obama.

People live in denial.  They want to live in an alternate reality.  And those who fail to perceive reality end up screwed, every time.

The reality of the 2008 meltdown was that a lot of schmucks got into real estate just as I was getting out.  I perceived that real estate was far overpriced, as no one could buy a rental property and rent it out at a profit unless they paid cash for it - and even then, their rate of return would be paltry.   I did the math and sold.

A lot of small investors - friends of mine - did the opposite.  One bought condos and didn't bother renting them out, but instead assumed that like Elvis Collectible Plates or Beanie Babies he could just "hold on to them" and they would double in value in a matter of months.

Another had some luck with this buy-and-flip mentality, which illustrates the problem.   During a bubble, just like during early stages of a Ponzi scheme (same thing, really) the "early investors" cash out and make out big - which encourages others to invest.

When I sold out and told people how I was making money, they said, "Gee, I should get into this!" - not realizing it was too late.   Yes, I should have kept my mouth shut - I caused the bubble of 2008!

Amateurs get stung in Real Estate a lot.  And this starts with their principal residence which they think is an investment and not just a place to live.   A house is an expense, not an investment, and as I have noted before, it can be a good deal if you stay there a long time, don't over-improve it, and then cash out some day.   You may get back all the money you paid in over the years, nothing more.   Better than renting, but hardly a big "investment".

6.  Gold and Other Collectibles:   The lower classes love things like Elvis Plates, Beanie Babies, and Gold. Yes Gold - it is no different than Beanie babies.  You may think gold is special or in limited supply, but it is still subject to the laws of supply and demand.  When the price goes up, people start digging for it, in the ground and in your grandma's jewelry box.   Poor people get caught up in other sketchy "investments" that make no sense, such as pyramid schemes and BitCoin.   BitCoin may be a great way to launder your drug money, but as an "investment" it has a rocky, rocky history.

The problem for the plebes is that they tend to buy this crap after it has already gone up in value.   I received a 5-gallon  pail of ugly little bears from a friend who bought them as "collectibles" and then gave them away when the market crashed.  I sold them on eBay for a few dollars each - about what they were worth.  Collectibles in general are just crappy investments.  In fact, they are not "investments" but just junk you buy.  And you can't make money buying things, period.

Most of these sorts of things are not "investing" but gambling - gambling that someone else  will perceive the value of these things to increase, and thus pay you more for them.  The problem with this is twofold.  First, the values generally do not go up much.  Even when gold "shot up" during the recession, it really didn't do better than the stock market unless you timed your trades and bought gold low and sold high and then bought stocks low.   Without a working time machine, this is impossible.   You also have to hope that "a greater fool" than you will buy the thing in question, and the great fool shortage of 2008 showed how that can backfire.

The other problem is investments are things that actually make money.  I own stock in Exxon not because I think someone is collecting the stock certificates and someday they will be rare "collectibles" or that somehow the stock has an "inherent value" because of its rarity - that is the collectible mentality.

Rather, I realize that the company, using hundreds of thousands of employees and billions in assets, is pumping oil out of the ground, refining it into gasoline and selling it to the public.   They make a profit and create wealth by taking raw materials, invested capital (machinery) and labor to produce something worth more than the sum of its parts.   I use Exxon as an example - it applies to any profit-making venture.

Collectibles, Gold, and Bitcoin, on the other hand are merely things you hope increase in value based on perception - which is one reason people hype the snot out of these things to increase their perceived value.   They will never earn profits or pay dividends or even pay taxes or pay employees.   Do you see the difference between buying inert objects and investing in enterprises?  Most do not.

Now granted, there are people making money at these things - and making things.  The company making collectibles makes a profit and pays shareholders.  The people buying the product do not earn money.  The mining company makes a profit converting ore into gold (much as Exxon does, and yes, oil is considered a mineral).   The people running bitcoin exchanges make money converting currency and taking a percentage off the top.   The folks who hold bitcoins only make money if the perception of their value increases - again, something hype helps sell.

Merely buying and holding objects is rarely - very rarely - a profitable venture, and even then, only by happy accident.  Perception-based investing is not really investing at all.
So how does the "little guy" make money investing?   Well, if by "making money" you mean making millions overnight, that just ain't gonna happen.  Believe it or not, I get e-mails from young people (mostly young men) asking me how to make a lot of money in a short period of time.  They clearly don't read my blog.   They are convinced there is a "secret" or "system" out there to make wads of cash with no work, no labor, and no investment. 

If there was such a "secret" do you think I would ever tell them?  Of course not - it goes without saying that such secrets don't exist, and if they did, telling them would make them no longer secrets, and thus dilute their value down to nothing.   And once more than one person knows such a "secret", everyone would know, and thus that is why there are no such secrets.

And sadly, small investors fall for schemes and seminars selling "secrets to investing!" or prosperity theology, or how to buy ugly houses or timeshare seminars - or est.   The plebes think that life is just a series of "hacks" to learn, and you spend enough money, people will clue you in on the secrets of life.

It really isn't that simple - but actually simpler.  The secret is there is no secret.   Work hard, save money, invest it wisely, live within your means, accumulate wealth over time.  Bam.  That's the big secret, here for you, free of charge.

But since you didn't pay for it, you will not value it, and certainly, it can't be the right answer, can it?