Why Playing the Markets Is Different from Other Businesses

 A portfolio or trading account at a broker should be run just as any other business. Operating principles should be established, goals should be set, plans should be followed, and the risks and rewards from potential transactions ascertained. We have already discussed that the perceived cost of entry into the investment business is far lower than any other business and that this encourages the inexperienced to try their hand. People who would never take a plunge in a business in the "real" economy are often willing to commit a large proportion of their net worth to the markets. This is due not only to the ease of entry and the view that playing the markets is relatively simple but also to the fact that markets are very liquid.

Let's compare the ease of buying and selling a stock or bond with that of buying and selling any other business. For example, you might purchase a small retail store and then find that running the business is not as easy as you had thought. Perhaps the hours are inconvenient, personnel problems are more difficult than you had originally estimated, and the tangle of government regulations becomes a burden. For whatever reason, getting out is not as easy as getting in. Retail stores are not that liquid, and no buyers are waiting with cash in hand. If there are, you may not like the bid and decide to wait for another one. You will probably have to pay a substantial commission to a business broker, normally 10% of the price. All these considerations add up to the fact that most businesses take time and money to liquidate.

On the other hand, in a financial market there is always a bid-and-ask, meaning that our asset can be readily priced. This liquidity is a powerful reason investing in the market is far more attractive than investing in any other business.

Unfortunately, this readily available pricing mechanism also has its downside. Every time you look at price quotes in the paper or call your broker, you know exactly how much your investment is worth. You can watch it when the price goes up, which will make you happy; and you can follow it when it goes down, which will depress you. This constant access to the pricing mechanism draws you into the market emotionally. Since it is very easy and relatively inexpensive to liquidate the position when your "business" temporarily hits the skids, the temptation is to do just that. So you sell. The odds are strong that you are responding emotionally to the fluctuation in the price rather than the change in the underlying market conditions.

On the other hand, consider the example of a person who buys a manufacturing business for which there is no easily available pricing mechanism. Initially, he may find that things go well. The cost-cutting measures that he takes immediately increase his cash flow. He uses the savings as capital to invest in more plant capacity and equipment to spur future growth. After awhile, though, he runs into problems; sales slow down and the economy looks weak. Our entrepreneur may decide to sell his business, but he is less likely to do so because he cannot find a suitable buyer. Eventually, he no longer experiences the urge to sell and hangs on until retirement several years later. When he finally liquidates the business after 15 years, he finds that it has appreciated in value to a considerable extent and he now has a wonderful nest egg. In this example, the business owner concentrated on running his business. He was not constantly looking to see how much it was worth each day for the principal reason that he couldn't. The nature of his business was such that it forced him to be patient. He could, of course, have sold it any time during those 15 years, but the costs and difficulties involved in selling were strong enough to keep him from taking that step.

Investing in the stock market, on the other hand, is much different. There, the constant price fluctuations, the market's addictive response to news, and its emphasis on short-term performance drag us in by our emotions, causing us to make hasty and ill-considered decisions. The liquidity and pricing mechanism that make it easy to enter the financial markets have their downside: They literally try our patience. We have a tendency to think that to be successful we need to have constant access to prices and other information. As we have seen in previous chapters, too much access actually works against our best interests.

* From Investment Psychology Explained