FOOL'S EYE VIEW
Why Do You Lose Money In Shares?

By Stephen Bland (TMFPyad)
December 18, 2000

This is really addressed to short-term investors, rather than those looking to hold for the long term. Long term holders are less likely to lose money, I suspect, than those that try and take advantage of short-term movements. In fact I believe that literal long-term hold, where you more or less forget about the shares, paying little attention to press or other comment, is a fine way to invest, provided some sort of attention is paid to the original selection.

But I believe that there are a large number of small investors out there who are interested in short-term investing, but who on balance lose money. I am not talking of day traders, but those holding for a few weeks or months, maybe a year or two, in the hope of making a quick return. Here I must confess to being one of the latter myself, in the sense of being a short(ish) term investor for most of the shares I buy. However this article is not about my style, more on the reasons why a lot of people go wrong.

The reason, in theory at least, is simple I think. It is a failure to appreciate the odds of winning, to fail in matching risk against potential reward. In other words, to take excessive risk.

Suppose you were offered two short-term plays, possibly expecting to hold for say a year. One you judge to have a low downside, for whatever reason, but you reckon it might produce a gain of 50%. The other is a high-risk share, with almost 100% downside, but against that it could perhaps take off in some fad boom that is already under way and create an immense return of many times its cost over the year.

What would you do?

You probably already know my answer. To me, the chance of a huge gain is not worth the high risk of massive loss. Losing is no way to make money. To make 50% in a year is itself a tremendous return. I am more than happy with that, particularly if I can repeat it. Almost nobody achieves that kind of return repeatedly. But to a large number of inexperienced small investors, the second option appears the better bet. "Bet" being the operative word, because they are gambling not investing.

Actually I see the words gambling and investing as just different places on a risk spectrum rather than completely different animals. They are not in fact that dissimilar, from a mathematical viewpoint. But if you want to be a good short-term investor you have to be more like a professional gambler than a mug punter. The pro bets according to a disciplined plan: only occasionally, only when she perceives the odds as being in her favour, as much as is possible in anything that involves risk at all. The latter, the mug punter, has little or no strategy, does not weigh up the risks involved, listens to others too much, goes in too often and when the odds are against her.

If I wanted to invest in very high-risk shares, then I would evolve a strategy of investing in a number of them. Normally I am not a portfolio player, preferring to invest in only one share at a time, maybe two if I am feeling particularly wild. But this would change if I became a growth stock player, especially if I were one of the very high-risk type. New technology perhaps, or maybe small mining shares: that kind of thing. The only way I can see to turn the odds in my favour with this approach is to hold a lot of them, knowing that many will collapse but hoping that one might score so big that it gives me a handsome return, despite the other losses.

But I doubt that people going this route consider the odds. They may follow a fad, taken in by the previous huge rise of a share and pub stories about how much others claim to have made. And hence a large number will lose money. To become successful at investing, you have to turn the odds in your favour as far as is possible. Easy to say, not so easy in practice to follow.

I love films and stories about gambling. The whole subject, which is intimately tied up with investing and also insurance, fascinates me, always has ever since my mates from school used to come round my house most weekends for sessions of card games like shoot pontoon or brag that sometimes went on all night whilst my long-suffering mum would ply us with tea and sandwiches. In the film Rain Man, Dustin Hoffman plays an autistic man who is a genius at mental arithmetic. Knowing this, his brother, played by Tom Cruise, takes him to a casino to play blackjack. Unlike pure chance games like roulette or craps, you can improve the odds against you at blackjack by trying to remember the number of tens, royal cards and aces that have gone and thus how many remain with the dealer. You can then adjust your bets in the light of this knowledge. Hoffman in the film does this so successfully that the casino eventually bars him from playing because he is just such a "counter".

To win at short-term investing then, you need to find a way of improving the odds. You can't get rid of them, there are no certainties with shares, but you can improve them. Value investing is one way. But even if that is not your style, then there is a way of improving the odds, as I show above. If you have, say, £10,000 to invest in outrageously risky shares, you are better off buying ten of them than one. But this requires that you first acquaint yourself with the ultra-low success rate of outrageously risky shares.

The first step, then, is to try and put a risk level on your style. Think before you buy what the chances are of it going wrong. Be honest. If the chances are very high, then either don't make the play and find a lower risk one, or try and find a way of reducing that risk.

Here's an example. We have been discussing gold shares on the value board. All gold shares are more risky than the average shares because they are tied to the price of gold bullion -- in fact, geared to it, because in general they move much more than the bullion price, up or down. Some readers have suggested small cap shares in this industry whilst I have been interested in one of the largest companies in the world. Now this is not just a value shares point. To me it makes no sense to buy small gold shares when there are big ones available. The possibility of higher reward is nowhere near an adequate reason. The latter are far less risky, by a very large margin, in what is a risky business in the first place, for many reasons which I don't have space to go into here.

The first step in making money in shares is not losing it. And not only for value players, either: for anyone.

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