People naturally hope they can think their way to wealth. In stock investing this can be seen in efforts to use the power of the mind to gain an advantage over the market. Investors think that if they can gather enough information and develop a system they can predict where prices will go. But just as often we are mislead by the things going on in our heads.
Let's look at an example of how easy it is to think we know more than we do, and how our minds can limit our access to more information that we need. The following description (including all the stock quotes) comes from a piece I wrote a few years ago when I was actively investing in the stock market (I am not now). I had begun to think I had a great strategy using covered calls, which are options that I would sell on stocks that I own. A call option gives the buyer the right, but not the obligation, to buy the underlying stock at a given price by a certain date. This should become clearer as we continue...
Sunoco (symbol SUN) is selling at $23.42 per share. It's a solid company that analyst say is selling for about 8 times next years projected earnings. It's relatively cheap, in other words. If I buy 200 shares I'll invest a total of $4,689 ($23.42 times 200 shares plus a $5 commission).
As soon as I buy I can sell 2 options contracts (each one covers 100 shares) giving someone else the right to buy the stock from me at $24 on or before the third Friday of next month (32 days from now). The options buyer is gambling on the stock going higher, and the market price is $85 for each option right now. After the $7 commission for selling the options I would get $163 deposited into my account (2 options sold for $85 each minus the commission). In other words, I will really only have invested $4,526 total as of today ($4,689 for the stock minus the $163 I was paid for the options).
Now, suppose the stock rises to $26 by the time the options expire. The option holder, who has the right to buy my stock for $24 per share, will certainly exercise those options, and so give me $4,800 ($24 times 200 shares). He can immediately sell the stock for $5,200 (the current price of $26 times 200 shares), for a gross gain of $400. After commissions he has more than doubled the money he invested in the options, and in about a month.
As for myself, after the $10 assignment commission I get $4,790. That's a profit of $264, or a return of 5.8% in 32 days ($264 divided by $4,526). What if the stock doesn't go above $24 by the expiration date of the options? I'll still own my shares, and at a net cost of only $22.63 per share because of the option income.
Think about this for a moment. It's a company I like and I either make 5.8% in a month or I get it for .79 per share less than the current price. If I wasn't "called out" I could also sell 2 more options to make more money while I hold the stock for another month. It is possible to make 30% or 40% in year by repeatedly selling options, and so be ahead even if the underlying stock drops in value. By the way, these kind of opportunities are available all the time in many different stocks.
I've been making money doing this, but the market has been up recently, making it easy for almost any strategy to show a profit. Now, I like to think I'm careful in how I think about these things, so I asked the question "What if the high option price means there is a greater probability that the price will rise?" If that's the case, is it a better strategy to just buy the stock when the options selling for a high price? After all, in the example given I would have done better holding the stock as it went to $26 per share.
But there is no evidence that anyone can consistently predict what the price of a stock will be a month from now. And since they can go down, I like the protection of that .79 per-share discount (the net premium I received for the options lowered my cost). Sunoco could lose 3% of it's value (70 cents) and I would still have a small profit.
My theory then, was that if stock prices in the near term are no more predictable using option prices than by any other means, and I can either get a better than average return for the month or get the stock cheaper than the current price, this has to improve my odds. I figure that most option buyers are essentially gambling and pushing the prices of some options beyond any value based on the true odds. If the odds are then bad for the buyer (and most options do expire worthless) they must be good for the seller; so I want to be on that side of the deal. And if the price of the stock drops a lot, I can wait for a rebound that usually occurs with solid companies.
Now to get back to how the mind works, what tried to enter my mind unsuccessfully for weeks was the nature of the way the stock market delivers returns. My mind told me that it has an upward bias, of course, to the tune of about 7% annually. So making 3% in month (or 36% annually) on stocks that nobody can predict with any certainty will go down seems like a good bet. Even though there are bound to be losses, the gains should outweigh them. Unless...
Stocks may average 7% returns annually, but they can rise and fall that much in a week (in fact the market was up 7% last week). And by using those options I am limiting the upside. The most I can make on Sunoco in the example is $264. This is true even if the stock went to $40 per share, making thousands of dollars for those who didn't sell options on their shares! Meanwhile my losses are limited only slightly. Even a good company can have its stock price drop in half in a month for a variety of reasons. If that happened in the example above, and the price did not rebound over time, I would lose a couple thousand dollars, which wipes out a lot of $264 gains!
I hope that my strategy continues to work. I have experienced some losses, but the gains have outweighed them so far. But then there is another factor which I did not anticipate. When a stock drops in price and the options I can sell on it are no longer high-priced, it is very difficult to generate much option income as I hold and wait for a rebound (which may not come). But I don't want to bore you with more details of stock trading.
The point is that I thought I knew more than I did, and my mind in its infatuation with that investing idea didn't easily allow contradictory information to enter for quite a while. In fact, I clearly recall a moment as I was shaving when the idea of the potentially large losses versus limited gains started to present itself to me, and I recall that I quickly moved on to other thoughts! Only later did I make it a point to think about this possible flaw in my theory.
Mind and Money Lessons
We don't know that we don't know, which is a very difficult concept to really integrate into our thinking. Our unacknowledged ignorance allows for some big mistakes. Of course we have to make decisions at some point even with incomplete information. But we should keep in mind that no matter how certain we feel about what we know, our knowledge is always incomplete. If we do not understand this, the money we might make might temporarily boost our confidence and so encourage us to do more of the same. But the confidence is largely false, and the success somewhat random, so confidence can simply increase the risks we take without increasing our investing skill or business acumen. The money affects the mind, in other words, possibly pushing us to make even worse decisions.
To counteract this we should make it a habit to look for the flaws in our own thinking. The mind wants to hold up an image of itself as more than it really is -- our ego at work. The result is an unconscious screening of inputs so that only evidence which confirms our thinking is allowed in easily. Facts and ideas that suggest we might be wrong are easily ignored, leaving us very vulnerable to making big money mistakes. To combat this universally human problem, we need to become more aware of how our minds are working, and we need to habitually look for the biases that are there and where those may be leading. In other words, we need to constantly challenge and doubt our own minds to use them most effectively.
Still, decisions need to be made. Should you buy that stock, start that business, or take that job? We can never have all the relevant information in any situation, and we can endlessly analyze our own thinking processes. We face what has been called "decision paralysis." What's worse, some research shows that decisions get worse when we gather too much information -- even when it is all accurate. So if you want to exercise the power of your mind in the pursuit of money, try this formula:
1. Set a deadline for making a decision.
2. Gather a limited amount of the most important information.
3. Do your analysis.
4. Watch for and adjust for any selective evidence gathering and biases in your thinking (and analyze everything all over again if necessary).
5. Make a decision and act. Don't move that deadline too easily either; you will never have all the relevant information and your fears will remind you of this causing procrastination or outright inability to do anything (decision paralysis).
6. Adjust course as you learn more.
This is about the mind and money, but of course it might be applicable in other areas of your life as well.