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Why You Win or Lose
The Psychology of Speculation
By Fred C. Kelly
Dover Publications, Inc.Copyright © 2003 Dover Publications, Inc.
All rights reserved.
MY ADVENTURE IN TOPSY-TURVY LAND
For several years now, including much of 1929, I have had the astounding experience of being in the stock market most of the time without losing anything. Indeed, I even made a little. I have journeyed through the enemy's country at their expense. It would have been a wonderful adventure even if I had lost, for I had opportunity to learn of quirks and foibles of human nature in the greatest human laboratory on earth. It was like going to college, tuition free, with an occasional bonus for encouragement. Whenever the Wall Street boys have given me back a little more than I entrusted to them, I think it was because, having an insatiable curiosity about what human beings are likely to do, I have looked at the stock market in terms of crowd behavior.
In the pages that follow, I am going to try to tell what appear to be the mental hazards that make most people lose. I even hope to show just how it should be possible to take a profit from Wall Street. For the benefit of impatient readers, there is no harm in saying right now that I believe the way to win is to do exactly the opposite from what nearly everybody else is doing. In other words, one must be contrary!
Yet I know, simple as this formula seems, few will ever follow it. Indeed, if many followed it, then it wouldn't work. If everybody tried to buy when prices are low, then bargains would never exist. A few find bargains only because the majority never recognize bargains. The crowd always loses because the crowd is always wrong. It is wrong because it behaves normally. Every natural human impulse seems to be a foe to success in stocks. And that is why success is so difficult. If you think it is easy to do invariably the opposite of what seems to be the sensible thing that everybody else is doing, just try it. At every step, one is tempted to do that which seems logical, but which is nevertheless unwise. But of all this, more later.
Looking back on my first ventures in the market, I marvel that such a greenhorn as I was ever dared to step in at all. What a lot I didn't know! I never even suspected that good news about a stock is likely to lower its price. Neither did I know that bad news may force prices upward. I had not yet found out definite reasons why men dabbling in stocks are far more likely to lose than to win. The important part played by vanity in stock losses was still a sealed book to me. Little did I suppose that the danger of losing is greatest on Monday. Neither did I understand why men are inclined to sell their good securities and keep poor ones. When I saw prices at the lowest point for the day around one o'clock in the afternoon I supposed this was mere chance.
I learned that men win or lose not so much because of economic conditions as because of human psychology. Certain mental traits that we nearly all have are barriers to success. Why, when I had a profit on a certain stock, didn't I sell it? Why did I stand by and see my profit reduced as prices went lower and lower without ever offering to sell?
It dawned on me that my behavior was almost exactly the same as that of an old man I knew in boyhood. He had a turkey trap, a crude contrivance consisting of a big box with the door hinged at the top. This door was kept open by a prop to which was tied a piece of twine leading back a hundred feet or more to the operator. A thin trail of corn scattered along a path lured turkeys to the box. Once inside they found an even more plentiful supply of corn. When enough turkeys had wandered inside the box, my friend would jerk away the prop and let the door fall shut.
Having once shut the door, he couldn't open it again without going up to the box and this would scare away any turkeys lurking outside. The time to pull away the prop was when as many turkeys were inside as one could reasonably expect.
I remember going out with the old man one day and seeing a dozen turkeys in his box. Then one sauntered out, leaving eleven.
"Gosh, I wish I had pulled the string when all twelve were there," said the old man. "I'll wait a minute and maybe the other one will go back."
But while he waited for the twelfth turkey to return, two more walked out on him.
"I should have been satisfied with eleven," the trapper said. "Just as soon as I get one more back I'll pull the string."
But three more walked out. Still the man waited. Having once had twelve turkeys, he disliked going home with less than eight. He couldn't give up the idea that some of the original number would return. When finally only one turkey was left in the trap, he said:
"I'll wait until he walks out or another goes in, and then I'll quit."
The solitary turkey went to join the others and the man returned empty-handed.
I think the analogy to the stock market is close. When I had seen a stock go to $80 a share, I was reluctant to sell at $78. By the time it had sunk to $75, I would gladly have taken $77. When obliged to let go at $65, I wondered what had ever induced me to wait so long.
I first became interested in the stock market partly because of a lurking natural disrelish for arduous toil; also, because my curiosity was piqued by the fact that nearly everything anybody chanced to tell me about stocks turned out, in the light of later events, to be almost incredibly wrong.
While following my trade as a writing man, I was exposed, as nearly everybody is, to tips on the market.
Few of these predictions seemed to come true and I wondered why nearly every man I knew should be so crammed with misinformation. To satisfy my curiosity, I began to write down secretly in a little note-book all the stock tips I heard presumably intelligent people discussing. If a friend said to buy United States Steel for a quick move, down went his suggestion in the little book. Months later I looked over the notes thus collected to see how the advance information tallied with what actually had happened. Thus I confirmed my suspicions that most of what one hears about stocks is untrue. Even after disregarding information from irresponsible people, or those who seemed unlikely to know what they were talking about, if I had bought ten shares of each stock I was advised to buy, I would have lost heavily.
Finding that the stocks people expected to go up almost invariably went down, I began to study the market to try to find out why. Was it because people were inclined to buy poor stocks or because they merely bought good stocks at the wrong time? I convinced myself that it was good stocks bought at the wrong time far more often than hopelessly poor stocks. To my astonishment, I learned that it is almost as easy to lose money on good stocks as on poor.
For a long time I studied market trends, business cycles, industrial conditions, reactions, rallies, various causes and effects. I learned that it is of no value to know that a stock is comparatively cheap unless one knows also whether it is cheap on the way up or on the way down. As Col. Leonard P. Ayres expresses it: "The man who buys a stock solely because of its seemingly bargain price is like a farmer with a thermometer but no almanac who thinks a hot day in autumn must be time to plant spring crops."
I discovered, also, that stocks are a little like weather. If you're experiencing the hottest day in several years, you may cheer up over the thought that it will surely be cooler tomorrow. Likewise when stocks are unusually high they are almost certain to drop.
These studies interested me more and more. I began to make imaginary transactions in the market and carefully recorded them in my note-book. When information about a certain stock and market conditions seemed to warrant, I bought; then if the stock advanced to a point where the price seemed high enough, I sold. I also sold if the stock turned sour and seemed destined to keep on going down rather than up.
Since I had no psychological handicap of fear, no danger of exhausting limited capital in such paper transactions, I had an advantage over the fellow who plays with real money. I realized that it is one thing to be able to hit a target right in the bull's-eye, but quite another thing to do so if several men are shooting at you. (In due course I was to learn that a person carrying stocks on margin is himself a target—always under fire.) Yet notwithstanding my advantage of safety, I regularly lost.
Whenever I lost, I tried to find out the reason and to make capital of my mistakes. After a few weeks or months, during which I must have been a terrible nuisance to my friends by asking so many questions about the market, I did succeed in limiting losses from my hypothetical operations. One month I had a net profit of more than $200. The following month also showed a profit. Evidently I was beginning to learn how the trick was done. But born of Scotch ancestry, with a decided reluctance to engage in losing ventures, I continued to confine my buying and selling to my note-book. Finally, at the end of a year, I was astonished to observe how much I had made theoretically from my little solitaire game of make-believe. True, it was only on paper, but I had been beating the market.
As a result of such experience, I gradually acquired a willingness to buy stocks with actual money. I drew from the bank a small but neat roll of my modest, hard-wrung savings, and had a friend introduce me to a broker. It was with hang-dog air I went to the broker's office. The minute I was inside the door I glanced about furtively, fearing I might see somebody I knew. I couldn't have felt any more sneaking if the place had been a negro honky-tonk. It seemed to me that everybody was secretly saying: "Another sucker has just arrived."
The broker courteously explained to me how one buys on margin. Having stock on a margin, I gathered, is a little like having a home subject to a big mortgage, but with this important difference: When real-estate values are temporarily low one is not asked to put up more money to protect the man who holds the mortgage against you; but with stocks one is compelled to give the broker a little more margin money whenever prices fall.
Having bought a list of stocks, I picked up the paper that evening fully expecting to find either that the entire list had dropped enough to wipe out my margin, or that my broker's firm had suddenly gone into bankruptcy. Instead, I found that I already had a profit of nearly $300. "Gracious," I thought, "how ridiculous for me to have engaged all these years in honest toil! How long has this been going on!"
The next day, I didn't wait for the newspaper to give the day's fluctuations but called up my broker every few minutes. I was already discovering how difficult it is to have stocks on margin and think of anything else.
Ever since that first contact with brokers, I have somehow muddled through with more profits than losses. If my losses had been heavier I should have had to quit thinking about the market and if my profits had been greater I might have become too sure of myself and quit trying to learn. Hence, I often try to reconcile myself to only modest profits with the thought that I have at least had a valuable education at Wall Street's expense.
In the course of my several years' observations, I have discovered a long list of market blunders that nearly every one commits—blunders that may almost be considered normal crowd behavior. The Lord knows that I have made, and still make, my share. In the following chapters, I am going to review some of the commonest mistakes made by myself and others, just by way of pointing out what an average person is most likely to do.
Summing it up in advance, a brief outline of the average man's behavior in a good advancing market, with ample opportunity for profits, is something like this: Buys timidly at first, very little, if any, at low prices, but gains confidence as advance continues and buys more. He takes small profits, but noting that stocks still advance, he is sorry he sold and buys same stocks back higher up. This time he determines to get more profits, but waits too long to sell, and sees prices decline. Then he mistakes each lower price for a bargain and buys more to average up. Later, when financial pages of newspapers are full of discouragement and stocks have touched bottom, he gets scared and sells entire holdings for less than lowest price he paid. And remember that for each transaction he must contribute a fee to the kitty! Brokers' commissions are more than a million dollars a day. Small wonder that one may lose even when the market is headed upward.CHAPTER 2
HOW OUR VANITY MAKES US LOSE
Vanity, one's own personal vanity, is probably the greatest single enemy to stock market success. It is vanity that leads us to take small profits but large losses. Even a fraction of a point profit is all right, because, small as it is, you have nevertheless beaten the game, and this is a sop to vanity. But a fractional loss hurts your pride and instead of accepting this small loss after a stock begins to look sour, you say you'll wait until you get out even. To take a loss is a confession that your original judgment was wrong and that is not a nice thing to admit. You hate to have your broker know that you were a victim. Worse, you shrink from having yourself know it. Unconsciously, a man often says to himself: "I'm going to make up that $100 loss if it costs me $1,000!" While you are waiting to get out even, the price sinks to a point where the facts are too painful to face. You don't sell then until your broker orders you to sell.
Look into any broker's office and you may see a number of men sitting about, calm and collected, with their feet on chairs. These probably have losses to which they have long become accustomed. They are still hoping to appease vanity by getting out even and are prepared to wait. On the other hand, if you see a nervous, fidgety man, evidently not quite sure what to do, he is probably trying to make up his mind to sell and thus cinch a small profit before his vanity is in jeopardy.
Brokers, in going over their books, sometimes observe that of all completed transactions more show a profit than a loss. Yet, paradoxically, the total losses vastly exceed the profits—simply because nearly every loss is large while every profit is small. In other words, the tendency is to take small profits but let losses run.
Because of vanity, men hate to be compelled to do anything. We hate to concede that even a panic can make us sell stocks that we hadn't planned to sell. Hence men mortgage their homes to raise more money to give to the broker, when swallowing pride a little sooner and taking a small loss would have avoided most of the trouble.
It is vanity that makes men sell good stocks and keep poor ones in time of distress. They won't sell the poor ones, because these represent a loss; but they dispose of the gilt-edged things which still show a profit, the very ones which would eventually make up the losses. Of this we shall say more in a later chapter.
It is vanity which makes nine people out of ten, in a declining market, persistently buy more of the same identical stock in which they took a licking. Your friends who lost their homes by holding Chrysler which went from 135 down to 26 didn't lose so much on what they bought at first as on what they bought later to even up. Instead of quitting a stock which seems to prefer to go down and climbing aboard one which shows resistance to the decline, they say to themselves: "I'll teach that stock a thing or two; it needn't think it can throw me for a loss." The weaker the stock is, the more they buy as it slides downward. They return to kiss the hand that struck them.
Usually it is far safer to average upward than downward. I have found it to be a wise rule, in ordinary times, never to buy more of a stock until the original purchase shows a profit. After it has confirmed my belief that it would go up by actually doing so may be time enough to get a little more. The beauty of averaging on the way up—providing you keep within bounds—is that you are buying with profits—using the other fellow's money instead of your own. But even though you have a profit, your vanity is hurt somewhat by the knowledge that you didn't do all your buying at the bottom.
It must be vanity which makes a man carry stocks on margin—since by that method he can buy 100 shares when he can really afford to buy only 30 shares.
Perhaps it is vanity which makes a man believe all the stories put out for public consumption by professional stock market pools. Every one likes to be on the inside, behind the scenes, and when he hears a story, in strict confidence, that his pet stock, now selling at 80, is going to 150, because of a certain merger in the offing, he believes the story. Pools must always make the public believe that a stock will sell much higher, else they couldn't force it to the more modest price that is their real goal. Except for vanity, men wouldn't believe so much supposed inside information. They would know that the whole success of stock market manipulation must depend on secrecy. The greater a man's vanity, the surer he is of his shrewdness in picking up inside information, and hence he is just that much more likely to hang on longer and lose more.
Excerpted from Why You Win or Lose by Fred C. Kelly. Copyright © 2003 Dover Publications, Inc.. Excerpted by permission of Dover Publications, Inc..
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