About 90% of retail investors begin their career as traders or as speculators without having a key understanding of the difference between investing, trading and speculating. More importantly, the methodologies they try to apply e.g. technical analysis and firm-foundation analysis always begin with the wrong unit of analysis. While, there is no doubt that having a sound theoretical foundation can improve decision-making, most retail investors are unaware for what the theory which they are applying is actually used (i.e. technical analysis can say a lot, if applied properly, but there are also many things which cannot be said based on technical analysis – cases where there are multiple options). When applying these tools, investors always make mistakes due to trying to “predict” what the pattern will be based on their desires (not the actual evidence).
Usually mistakes in trading, investing and speculating are associated with investor-related not investment-related factors. And while most of us begin our studies with investment-related factors as particular investments interest us, and this drives us to invest. Few of us, have actually attended investment and banking classes and have understood the importance of investor-related factors. The biggest reason for making mistakes is not psychological biases (while it is true that herd mentality, overconfidence bias, positivity bias can all hurt the investor), the biggest mistakes are usually made due to an unclear risk capacity. In this case, risk capacity is = the balance or disbalance between risk appetite and risk tolerance. Most people have not even heard this terms, let alone evaluate their own risk capacity.
Risk appetite is our willingness to take risk. This can be thought of the aggressiveness we think we should have (this is the psychological ability to tolerate losses)
Risk tolerance is the actual ability to take risk based on limiting factors such as age, income, or the physical inability to tolerate losses because this would threaten the person’s livelihood
Before an investor commits any capital, an assessment of whether the person’s risk tolerance and risk appetite are matching or experiencing a miss match, plays probably the biggest role in determining return for the investor (not on investment, but per investor). There have been many who speculated with crypto prices in 2018 (yes, the proper term is not invested but speculated; investing is usually about dividends (assuming future payouts due to increase in productivity, market share, etc.) and speculating is about predicting a change in price). Most of these people said “they would hold Bitcoin (or other cryptocurrencies) forever regardless of what happens to price. When price dipped to $5,000 so many people were discouraged and actually sold the bitcoin which they bought at $10,000. While I was looking for price to go down to about $3,000, every time price went up amateurs picked up Bitcoin at about $7,000-$9,000 and when Bitcoin dipped to 3,2000, they sold again.
This buying and selling of Bitcoin left many people with permanent losses due to not understanding their own personal psychological set-up. They were “confident” they would not sell, but seeing their capital at -50% or having personal problems (e.g. losing a job) forced them out of the market. Some would say, this is an investment mistake that is caused by not sizing investment position properly or by over investing. While these would be true, they are both the cause of the bigger and more important reason – the mismatch between the psychological desire to take risk and the individual’s actual ability to take risk.
Regarding crypto markets speculation, most mistakes were made by people whose risk appetite severely exceeded their risk tolerance. Wanting to put $1,000 or $5,000 to get a Lamborghini (as most say) while not having any other investments or savings represents clearly the situation of how people who do not have the tolerance took on more risk due to their appetite, leaving them with permanent losses in most cases.
A different and subtler mismatch could be having $200,000 at 40, and wanting to retire with $1,000,000 at 50 but having low risk appetite. In this case, either a lot of saving has to be applied or the risk appetite of this person has to increase in order for this person to be willing to “risk more” to achieve this “bigger objective”.
Investing, Speculating, Trading and mistakes due to mismatch of risk appetite and tolerance
Another symptom of having too high risk appetite is that usually people are unaware of what they are doing – investing, speculating or trading. Due to overly aggressive appetite most people actually thought they invest in “cryptocurrencies”. In financial investing, the term investing has a very specific meaning and that refers to the process of 1) giving capital for a new venture or 2) expect an increase in earning in an existing company and buying it in anticipation that these increased earnings will be paid out in terms of higher dividend. That’s why in investing, earnings, dividends, dividend growth and earnings growth are considered some of the key variables to “value” companies and their cash flows, earnings and so on to determine whether these cash flows are likely to increase and produce positive increase in dividends.
Since Bitcoin does not have dividends and is not a company, buying Bitcoin is not investing but rather speculating that its price will increase. In the crypto space, buying “NEO” which pays out dividend in GAS could be considered as a form of investment in the company for its dividend. However, buying most other cryptocurrencies which do not produce dividends would classify this under speculation.
Speculation refers to trying to predict large swings in different assets such as oil, gold, currencies or bitcoin. Speculation by definition relies on analysis of psychological factors related to the market and exploiting opportunities due to irrationality (positive – euphoria, negative – panic).
Trading – refers to the process of setting up positions, position sizing, stop-losses, profit-taking levels and ability to adjust to the situation if the trade does not go our way.
Speculation requires trading skills and technical analysis skills. Technical analysis skills refer to using charts (e.g. Elliot Wave theory or more traditional technical tools) to predict unexplainable increases in price. Trading skills to actually be able to set up positions, stop-losses and profit-taking to make the most of this market opportunity.
In many cases, people can find access to charts. I have myself given charts to many of my friends. However, they do not stick to them. That could be because they do not believe in them. However, more often it is the result of “trying to do better” which is the “greed” caused by having a high risk appetite. In this way, people who have no “trading skills” use the technical analysis skills of someone else, but also often end up at a loss because they have a very high risk appetite. This high risk appetite leaves them blind to the importance of having trading skills to actually benefit from this market opportunity.
In investing, trading skills are less important but still play a role. Even if technical analysis is not used, there are statistical methods of calculating variance of price which allow an investor to make reasonable assumptions around what price zones, prices are likely to move. Since investors are more focused on dividends, the key question is to understand how many years it takes to achieve a 100% return from dividend or what is the percentage dividend per year (and how it is likely to go in the future). In this case, trading is used to usually average out the price when dips are available and to sell if more permanent tops are in order.
However, due to overly high risk appetite, some “investors” become too willing to “trade” every market move. In this sense, they move away from the essence of investing – investing in dividends and the future growth of the company to speculation about short-term prices. The high risk appetite can turn investors into unprofessional and unqualified traders.
Lastly, investors with risk appetite and risk tolerance which are not in balance, usually are unaware of what risk is, the types of risk they are taking and lack a method of evaluating whether this is the risk they should be taking.
Let us define the types of risks before moving onto the mistakes caused by high risk appetite in terms of taking risk.
Risk – the probability of a negative event with negative impact on us (or on our investment)
Relative Investment Risk –refers to the degree of change in a company’s share price usually measured in terms of percentages (or with statistical variance – measurement in terms of standard deviations)
Absolute Investment – risk of absolute loss of investment due to company bankruptcy or criminal behavior and inability to make return/loss of life/loss of a job, etc.
Risk myopia – wanting only small fluctuations in capital (risk) but risking to miss larger returns (in life known as winning the battle to lose the war)
Speculation risk – that price will not move in the anticipated direction
Trading risk – that the price moves according to our expectation but we still did not make money due to selling out of panic (when prices goes lower) or not taking enough profit (as price went further higher).
In many cases where investors should not be able to have “permanent losses” such as investing in technological companies like Tesla, Netflix, Google, Amazon, Apple and Nvidia inexperienced retail investors with high risk appetite manage to take “the wrong level and type of risk”, which leaves them with permanent losses. Instead of having relative investment risk (experiencing price volatility of -20%), many people sell their shares in order to 1) try to buy at a lower price or 2) try to buy another instrument. By making this a few times, instead of having a temporary drop of their investment of say 10%-20%, they actually make the losses permanent – absolute investment losses. This again one ugly consequence of a bad match between risk appetite and risk tolerance. Even during the 1998-2002 famous NASDAQ bubble, Amazon is famous for having lost -98% of share price, but if people had invested in the company and looked at earning they would have seen that earnings actually increased by 100-200-500%, so it is not surprising that the price not only rebounded but also is near astronomical levels at about $3,000 relative to its “bubble price” of about $120 in 2002. Due to lack of knowledge regarding what investing is about, people took actions – selling their Amazon stock. This led to permanent losses to many who invested in Amazon stock because of increased risk appetite – i.e. not to experience so much volatility and wanting to win from another company or buy Amazon at a better price. This should have been a temporary volatility, but for many it was an absolute loss of 20-30-50-60% of their capital invested in the company (simply because due to increased risk appetite investors became non-qualified traders).
With cryptocurrencies, speculation risk and trading risk also caused many people to bet on wrong moves or to close losing trades due to other investor-related factors.
Having a proper match between risk appetite and risk tolerance is not hard. It usually requires us to face a harsh reality, that we are “much further away” than we want to relative to our “goals”. That is okay and instead of having an increased risk appetite to aim to “correct for this gap” (gambling behavior), it is usually more prudent to understand our risk tolerance and adjust our risk appetite or choose an additional avenue to compensate (e.g. extra income from another job, from renting, from starting a company).
Many people attempt to “get rich” and bypass this process by deciding to buy something (e.g. Bitcoin) and waiting to make “some money” (by its nature this a doomed endeavor, because the lack of definition of “some” usually leads people to make trading mistakes). Others “consider themselves more prepared” and seek information from online sources such as TradingView to find ready technical analyses on instruments such as bitcoin. Due to their lack of knowledge and education regarding these methods they cannot evaluate the likelihood that this analysis is correct but their high risk appetite makes them take action which usually they regret. Or even worse, even due if due to some miracle the analysis is correct, due to the lack of trading skills they make mistakes and suffer permanent losses again. Both of these types of mistakes are related to taking improper levels of risk due to high risk appetite.
Some try to find “the hidden edge” by going to YouTube and looking at video analyses of YouTubers. These believe that YouTube people sometimes find “hidden information upon which can be profited”. The basic failure to understand that “analyzing news” to predict price is useless because by the time information becomes news and is analyzed by YouTubers it is already included in price leads them to believe in the content “too strongly” and strengthen their “heard” bias. However, it is not until the point that a person perceives an “imagined return” which might be or might not be obtainable based on the technical, trading, investing skills of the person that most viewers of this content enter a phase of disbalanced risk capacity. The content entices them to act on their increased appetite due to their increased conviction that they are right but still leads to mistakes due to lack trading skills or acting too quickly (selling before prices increase or selling at a loss). In essence, this information is not dangerous by itself but when it becomes a trigger to act due to increased risk appetite (given that most of this content is not financial advice), people end up experiencing permanent (absolute) losses in cases where they should have never had.
Have you ever invested? I have. Have you ever lost money? I have. Probably every single one of us has. However, the final important question is: Have you understood the reasons driving your behavior which caused you to lose money? Have you understood that your risk tolerance and appetite are probably out of balance and have you corrected this disbalance? I have, and since then, I have had only relative investment losses (i.e. volatility in prices) and 1 bankrupt company (absolute loss) of an 80 instrument portfolio. I am also on my way to increasing my happiness further by achieving my life goals through investing to accomplish my financial goals. By having the right balance between risk appetite and risk tolerance I am able to stick to a plan which is crafted to accomplish my financial objective and deviating from it is not possible for me because my risk appetite and risk tolerance are in balance.
Are you unaware of your risk capacity? Have you never thought about this important investor-related factor? Maybe you have heard about it but did not find an actionable way to use this knowledge in your everyday life-style. Click here and answer a few questions to understand if your risk appetite and risk tolerance are in balance and to learn how to use the insights from this survey into minimizing investment mistakes due to the wrong risk capacity.