Learn Finance with Memes: How Not to Get Blown Up
When investing, protecting yourself from large losses is arguably more important than picking the right investments. If you lose all your money, you can’t invest! We’ll cover just 3 things here. Master them and you’ll be well on your way to becoming a great investor.
Rule 1: Diversification
The best tool in your Don’t Get Blown Up toolbox? Diversification.
To put simply, own multiple things! One of the key principles in investing is nothing is guaranteed. There’s a risk associated with every investment. Because you can’t know anything for sure, not putting all your chili in one pot is the sensible thing to do.
How much should you diversify? This is a personal decision and relates to your risk tolerance.
If you have a very high risk tolerance and want to only invest in individual stocks, you could get away with as little as 5 different holdings, although 20–30 is probably better for most. The fewer holdings, the higher the potential gains but also the more gut wrenching the volatility. It’s not uncommon to see huge drops in individual company stocks. Even great companies like Amazon have fallen 90% at a point in their history.
On the other end of the spectrum, say if you’re looking for safer investments in a retirement account, a common diversification strategy is to diversify not only within an asset class but to diversify across different asset classes. For example, you would not only hold a wide variety of stocks but also own a variety of bonds. You could diversify further by additionally owning real estate, gold, and even crypto if you wanted. Thinking internationally for investments provides even further diversification for your portfolio. Owning a bit of everything won’t net you the biggest returns, but you’ll be well positioned for whatever the future brings.
Finding the balance here that matches up with your temperament and investment goals is what is most important.
Rule 2: Be humble. You are probably not as good at investing as you think you are
In general, people have a higher opinions of themselves than what reality dictates. And sorry reader, this includes you. All those things you think you’re good at? You’re merely average at a lot of them and in some cases below average.
I’m sure there’s some marketing textbook out there that says the best way to keep readers doesn’t involve insulting them, but hey I think it’s better for someone to tell you the truth now. And if it makes you feel any better, this applies to me as well and is backed by years of scientific research. Let’s look at a couple examples:
In 1986, a psychological study asked drivers to rate their driving skills. 80% of those surveyed responded and said that they were “above average” on characteristics that would make good drivers (predictability, safe, considerate, etc). It doesn’t take a mathematician to see that these numbers don’t quite add up. Only 50% can be above average by the definition of the word average. There was an overconfidence bias when it came to measuring one’s own skills.
I decided to sneakily perform my own similar test and asked some friends (sorry!) to read one of my previous articles and answer the following question:
“How would your rank your financial knowledge in comparison to others that will read this article?”
50% answered above average, 37.5% said average, and the last 12.5% below average. Sorry friends, someone’s gotta be wrong here too!
In fact, this finding has been replicated many times over the years. The tendency to think we’re better at things than we really are is a cognitive bias named the Dunning-Kruger effect.
Many times we think we know something well, but the further we dig in the more we realize there’s more to it than we thought.
“That’s cute” you might say. “I’m an outlier, I’m an expert and all those other idiots that took the survey are wrong!”
Are you though? Think hard about this answer, because it’s very important. A little self-delusion about your driving skills doesn’t really make that big of a difference in your life. But underestimating your investment skills can lead you to make a costly mistake, like taking on hidden risk, and subsequently getting blown up.
Rule 3: Control Your Emotions
Most people have this idea in their head that they’re going to buy at the bottom and sell at the top. What happens if you’re not prepared to control your emotions is the exact opposite.
There are two big bad guys here. The first of which is FOMO.
Imagine you have a solid investment strategy, a diversified portfolio of companies that you think will change the world and make significant returns over the next 3–5 years. Everything is great until one day…
Everyone and their mom is talking about this new investment. It’s gone up 100% already and will surely go up another 5 times higher! They’re telling you that you should get in too before it’s too late!
Don’t take the bait!
The problem with jumping into a trade like this is that you’re no longer following your strategy, and you are now gambling. All premade plans no longer apply.
Yes, it’s hard not to do what everyone else is doing, very hard! This is why this is the most commonly broken rule and the hardest to master.
Up next is big emotional baddie number two, panic selling.
Going through a drawdown is stomach turning. You’ll start to think that you’ll never see that money again and that it’d be best if you cut your losses right now. It’s impossible to show you what a 20% drawdown feels like. Or a 50% one for that matter. You have to experience it for yourself.
The good news is if you have a solid investment plan, you will have prepared a risk management strategy for this instance and be better equipped to fight the fear. Diamond hands you shall have.
One way to fight the urge is to simply stop checking prices so much. If you were trying to lose weight, it certainly wouldn’t help to stare at a piece of chocolate cake 10 times a day, so why are you doing the same with stocks?
If you bought something in FOMO and it starts to tank, then well you’re probably fucked. You made the FOMO trade without a concrete exit strategy and now you’re really sweating it out. All the diamond hand emojis in the world aren’t going to help because you have no strategy.
FOMO buying and Panic selling when combined together, make for the worst possible combination.
In summary, to not get blown up, diversify, stay humble, and keep your emotions in check. The concepts are all thankfully easy to understand. Unfortunately, in reality they can be difficult to practice. (We all know it’s a lot easier to say “don’t eat the cake” than to actually not eat it.) But learning about these things is a huuuuge first step. Keep learning, surround yourself with good advice, and you’ll stand a fighting chance!
Next time we’ll discuss how to Beat the Markets (and your Neighbor)