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8 Signs You're "Dumb Money"

By  +Follow October 15, 2013 5:50AM
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In the 1998 classic poker film Rounders, Matt Damon’s character Mike McDermott says “If you can’t spot the sucker in your first half hour at the table, then you are the sucker.” Or, as the more traditional saying puts it: “A fool and his money are soon parted.”

That’s the funny thing about being a sucker: you never know you’re one. At least certainly not until it’s too late (lest we forget the powerful educational tool that money lost can be).  But this begs the question: is there some way you can figure out you’re making a sucker bet ahead of time? If you’re making a series of terrible investment plays that won’t pay off, can you figure it out in time to park all your assets in T-bills and SPDR S&P 500 ETF ($SPY) and just get out of your own way?

Just the fact that you’re even thinking about it is probably a good sign, as there’s a certain level of arrogance and delusion that contribute to being a sucker. However, Wall Street has long used the phrase “dumb money” to describe retail investors who make similar, naïve mistakes in their investing decisions. The professional analysts, brokers, and traders sit back and quietly titter to themselves as they watch the unwitting crowd looking to get ahead continue making foolish moves.

Of course, these are mostly the same people that crashed the entire economy in 2008, so take it with a grain of salt, but there’s still some mistakes that a lot of novice investors make. For those of you sporting the tell-tale signs of an investor in over his or her head, it starts to sound a lot like a Jeff Foxworthy routine.

1.       If you make emotional, split-second decisions about your portfolio…

…you might be dumb money. You’ve just found a tech company that, after weeks of research, you determined to be a solid buy. You invest a healthy chunk of change and jump in with both feet. Then, two days later, the most recent earnings report comes out and they miss earnings estimates. The stock drops 15 percent in one day. Disaster! SELL! SELL! FOR THE LOVE OF GOD, SELL! And what’s this? Another tech company released its earnings report the same day and beat expectations. It’s up 25 percent. BUY! BUY! PLEASE, GOD, LET ME JUMP ABOARD THIS ROCKET SHIP! IT’S TAKING OFF, DESINATION: EARLY RETIREMENT! AND I DO NOT WANT TO MISS IT! WHO CARES WHAT THIS COMPANY MAKES OR DOES? IT’S WHERE THE MONEY’S AT AND I WANT IN!

Probably not a good idea. This is not to say that either decision would be wrong. It could be that your research failed to recognize fatal flaws in the former company, or that the latter is a strong buy even if you haven’t put in the time necessary to know why. But your thought process is what’s at issue.

Listen, clearly there’s a reason you bought that first stock. And unless it was very specifically “I’m expecting them to report an earnings beat in a few days,” most of what made you arrive at that decision probably hasn’t changed. If your research turned up reasons for optimism, cutting bait because of one bad day is pretty silly. This isn’t to say that your research can’t be wrong. It definitely could be. But if you don’t trust your own research, why are you picking stocks in the first place?

And the second company could be a great buy, but you wouldn’t really know, would you? You’re just jumping on because you’re excited. The morale of the story is that emotional decisions made in the heat of the moment usually aren’t wise. And when they are, it’s usually blind luck that gets you there. Even if you’re making the right choice, you’re not making it for the right reasons. You’re better off taking your time, being patient, and trying to make the best choice you can. This lesson, incidentally, applies other aspects of one's life. Most notably in drinking and marriages. Or some combination of both.

2. If you refuse to sell a falling stock because you’re hoping to recover your losses…

…you might be dumb money. In a lot of ways, this is a direct contradiction to the previous sign. However, in some other, crucial ways, it’s not. While one can miss out on big returns by bailing way too early, it’s actually a lot more common to compound a mistake by refusing to get out of an investment even after it’s clear that it’s a loser.

In 1998, University of California, Berkley professor of behavioral research Terrance Odean printed his influential research on investor behavior. In it, he revealed that investors were 50 percent more likely to sell a winning stock than a losing one. Why? Because selling a stock you’ve lost money on is admitting that you were wrong. And people hate doing that.

As Odean observes, reluctance in selling losing stocks “isn’t primarily about economic loss, it’s about emotional loss.” Once you’ve cut bait, there's no longer a chance you could be right about your decision to initially invest.

The thing is, sometimes it doesn’t come back. This isn’t to say that one should simply bail on any investment once it start to go south (see sign #1), just that recognizing when it’s time to let go is pretty important. Again, when research and careful consideration result in you believing the time has come to get out, don’t let the lure of making back the money you’ve already lost keep you from making the right decision. “Don’t throw good money after bad,” if we're sticking with our idioms theme.

In the end, signs #1 and #2 show why many poker players have traits similar to good investors (see David Einhorn). More than anything, emotional stability and the ability to continue rooting decisions in careful, rational consideration is what usually makes winner in the long run.

3. If you’re always trying to find a great deal…

…you might be dumb money. Emphasis on "might," here. Value investing in the model of Ben Graham or Warren Buffett is typically a pretty solid idea. Examining a company’s underlying assets and seeking out those that have a stock price that’s pretty low when compared to those assets is pretty solid as long-term investing strategies go. Just ask Warren Buffett.

But that doesn’t mean it’s a good idea to go out chasing each and every solid value out there. Just because a company’s price to earnings ratio is microscopic does not immediately make it a solid buy. A lot of stocks fall into the category of “value trap.” Value traps look attractive, with great valuations, but they aren’t going anywhere. Their underlying industry may be in bad shape or going obsolete, or they aren’t producing any new products or ideas that could give the company a future. So no matter how cheap they look, the fundamental problems beneath the price means they aren’t a good buy. Which leads us to…

4. If you’re always trying to catch a falling knife…

…you might be dumb money. This is sort of the reverse of sign #2.

The thought behind this classic mistake is pretty solidly illustrated by what happened to Netflix (NFLX) over the last two years. In July of 2011, Netflix announced some major changes to its business model, splitting its streaming service from its DVD service. The company lost a lot of customers, and angered those that remained, and proceeded to lose almost 80 percent of its share value by Thanksgiving. Since then, though? Well, between some new episodes of Arrested Development, Kevin Spacey, and a handful of Emmys, people have decide Netflix had it right all along. The company’s shares are up over 315 percent since bottoming out two years ago and has cruised right by the high of about $300 a share it was at in July of 2011 to almost $325 a share. It's like Warren Buffett said, "Be fearful when others are greedy and greedy when others are fearful."

So every time you see a stock plummeting you should jump on board when it bottoms out? It’s a chance to get in cheap and then make huge profits. Buy low, sell high, right?

Actually, probably not. Netflix is more of the exception that proves the rule. The temptation to find a solid value buy in a plummeting stock is obvious, and it clearly pays off at least some of the time. However, there’s a reason why someone coined the term “falling knife” to describe crashing stocks. For every Netflix there’s dozens of examples of companies that lost a large part of their market cap and never recovered it again. Or, worse, appeared to bottom out only to keep plummeting. And unless you can be sure you know where that bottom is, you’re taking a big risk.

Signs #3 and #4 work in conjunction for one other lesson: if you think you’re smarter than everyone else, you should really have a good reason. If you’ve spotted a stock that appears to be an incredible buy at a rock-bottom price, ask yourself: “why isn’t this more expensive?” Is it because you have a jeweler’s eye that’s allowed you to pluck this diamond in the rough that no one else has noticed? Or is it possible that the rest of the market has seen this stock and wisely determined it’s cubic zirconium? Likewise, when a company’s stock is hit by a massive sell off, it’s entirely possible that it’s coming for a very good reason. And if that reason has to do with a fundamentally flawed business plan, or a broader trend in its industry that’s going to sap future profits, you should probably stay away.

This isn’t to say that one should not look for stocks at a good value or companies with falling values that are likely to bounce back, simply that you should have a specific reason for why you think the rest of the market is wrong and you're right. A great price is relative, and what might appear a value now could prove anything but in the long run.

5. If you’re always trying to time the market…

…you might be dumb money. The simple fact of the matter is that almost no one can really time the market effectively. A great many people recognized that the housing market was in a massive bubble in 2006 and 2007 and assumed that they would be able to get out prior to the bubble popping. Then they didn’t.

And keep in mind that investment banks around the world employ armies of analysts who, equipped with complicated mathematical formulas and oceans of data, attempt to determine precise price targets and estimations of where a stock’s price is headed. And these people are routinely wrong. And if they, with virtually unlimited time, resources, and expertise, can’t seem to get a consistently accurate handle on these things, what makes you think you can?

It’s almost impossible to be able to determine precisely when a stock is peaking or bottoming out, even with the most rigorous methods of technical and fundamental analysis. As such, attempting to time the market is usually a fool’s errand. More often than not, an investment that requires you to buy and/or sell on the right week, day, or hour, it’s not going to be worth it.

6. If you’re always reading articles online and making investments based on the advice you find there…

…you might be dumb money. Yes, seriously. Listen, anyone who’s online claiming that they know what makes stocks move up and down and proclaiming that they can predict what the market’s going to do is…lying. Because if they really had that precise a grasp on picking stocks, they wouldn’t be writing about it. They would be picking stocks and making a fortune doing it. Note that Warren Buffett does not have a blog.

This isn’t to say that there isn’t a lot of valuable information available online or in other publications. Just because a person’s not plucking winners out of thin air on a regular basis doesn’t mean they won’t have a lot of solid observations about the market. But if making solid investments were as easy as reading a few articles and buying the stocks listed in them, everyone would be rich. And we’re not, so suffice to say there’s a bit more to it. Like any other investing strategy or concept, it’s best to take expert advice with a grain of salt and to seek out as many different opinions as possible, weighing the merits of each.

7. If you’re investing in things you don’t completely understand…

…you might be dumb money. If you only read about the Thai Bhat for the first time last week, why are you thinking it’s a good idea to jump into currency investing? If you only vaguely understand how they calculate the VIX, why would you throw money into ETFs tracking it? If you’re not entirely sure why the price of gold moves from day to day, what would possess you to start looking into buying bullion?

If there’s one thing dumb money does very consistently, it’s fail to gather enough information. Stay away from complicated investment vehicles unless you’re really sure that you know what you’re doing. And if you're pretty sure you know what you're doing, stop and really think that over. Because if there's another thing that's true about dumb money, it's that it's really sure it knows what it's doing when it really doesn't.

8. If you’re consistently losing money on your investments…

…you might be dumb money. In fact, you’re probably dumb money. As indicators go, this one’s the gold standard.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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