Short stories and lessons for investors

Story 1: The Emperor’s New Clothes

This story talks about a vain emperor who was exceedingly fond of new clothes and was known to spend lavishly on them. To exploit his vanity, two con men disguised as weavers, promised to design magical clothes that were only visible to the smartest people in the kingdom. Enthused, the emperor funded them.

Every day, court members would see the looms working without any clothes! Not wanting to be thought of as stupid, they kept quiet. Finally, the emperor visited the looms and not wanting to be considered foolish, pretended to be very impressed and paid a large sum of money to the con men.

“Dressed” in his new clothes, the emperor ventured out on the street. Fearing his wrath, citizens also joined in praising him and his new royal look.

This continued till inadvertently a small kid blurted out “The Emperor has no clothes!”

What can investors learn from this?

For anyone thinking what this has to do with markets, here are a few things you need to ask:

• How many times have you brought shares just because people recommended it and didn't do any research of your own?

• How many small and mid-cap companies have you added to your portfolio, without assessing their risk or management quality?

• How many times have you purchased shares at exorbitant valuations knowing full well that, this would not be sustainable?

• Investors should realise that while a rising tide lifts all boats, when the tide recedes all the boats sink. Investments made purely by following the herd are likely to result in losses. Investments should always be made based on the merits of the stock or security.

If you still think, this was just a tale and would not happen in reality - read up on the Tulip Bulb Mani of the 1600s!

Story 2: The one horse race

Okay, this one is not such a long story, but the moral is equally deep. Famous investor Howard Marks tells this story he heard from his father.

It's the story of a gambler who lost regularly in horse races. One day he heard that the race was only going to have one horse - so he bet the house rent on it. In the middle of the race, the horse jumped over the fence and ran away!

What can investors learn from this?

The most obvious moral of the story is things can always get worse. Most investors unfortunately don't plan for the worst case and simply dream of the best case.

Besides, this is also a lesson for those who are very certain how the markets or a particular stock will behave! Investors should be wary of pundits and analysts who don't even make room for an error in their judgment, let alone the absolute worst case!

To make this point, I am reminded of another small story about Mr. J. Pierporint Morgan (or JP Morgan)

John Pierpont Morgan Sr, was an American financier and investment banker who dominated on Wall Street.

Next time you invest, make plans about what you will do, just in case you are wrong!

Story 3: Failure of Long-Term Capital Management

This one is not a story, but a real-life event that goes to say that a higher IQ does not guarantee investment success.

Ever heard of Long-Term Capital Management (LTCM)? It was a hedge fund founded in 1994. It was founded by Mr. John Meriwether, the former vice-chairman and head of bond trading at Salomon Brothers (one of the largest investment firms of its time).

LTCM's board of directors included Myron Scholes and Robert C. Merton. In 1997, they were awarded the Nobel Prize in Economics for developing the Black–Scholes model of financial dynamics.

For those not familiar with Black–Scholes model, it is a mathematical equation that's used for pricing options contracts and other derivatives.

Coming back to LTCM - in the first few years of its operations, the firm managed to generate strong returns.

However, in 1998 it lost $4.6 billion in less than four months due to a combination of high leverage and exposure to Asian markets which collapsed due to the Asian financial crisis.

Some of the smartest people of their time and market veterans were not able to foresee one of the biggest collapses in the Asian markets!

What can investors learn from this?

A few key learnings from this:

• Investing is probably the only discipline where success is not proportional to a higher IQ. Common sense and patience are some of the best friends for an investor.

• Just because an investment security is fancy, does not really guarantee any success. Disciplined and long-term investment in simple and cheap index funds, can yield fantastic results

• Finally, making a mistake or losing money on an investment is not a sign of any smartness or stupidity. It is simply a learning process. Everyone makes mistakes and it is part and parcel of learning! What one must be aware of - the worst case! In case of a loss, just how much would you lose and what would it do to your fortunes? Take positions only where you can bear the loss without significantly impacting your life