19 Investing and Trading Lessons I’ve learned
I originally designed this article as a way to remember all the things I’ve learned through my years in business school, books, personal trading/investing experience. As I acquire more knowledge recently, I’ve realized that I am having information overload and it gets harder to retain the lessons I’ve learned in the past years in my head. Also, since my school journey is coming to an end, I would like to summarise all the things I’ve learned that have been put into practical use. My journey in school may have come to an end but my learning journey is just beginning.
Some of my friends have asked me about investing and trading and I always find it hard to explain it verbally to them. So since I am already gonna type this, I thought I might as well share it with others so that they can learn from me as well. So if you are reading this, then lucky for you!!! You are probably one of my closer friends.
Many of these lessons I’ve typed are from some of my favourite investors/traders, books, personal experience, school (well maybe not from school but you get to see soon), and there are even theories and concept I developed myself (I will let you guess which are the ones). Right, so I’ve made it as simple as possible so that even someone without a finance background can understand (I hope). Most of these lessons are about investing in stocks, but they can be applied to trading as well.
So I would like to first say that whatever you read is based on my current opinion and I may be wrong. So to my readers, it is still your responsibility to research and make an appropriate judgment of my content (feel free to disagree with me). So… without further ado…. LESKO
1. Markets are inefficient, emotional, and irrational
One of the first lessons I was taught in business school is supply and demand, and it states that it was based on the assumption that markets are efficient. However, in practical terms, this is far from the truth.
Let’s take Black Monday as an example, one of the most studied events in economics history. The Dow Jones plunged almost 22% in a single day on no apparent news (although some attribute it to portfolio insurance). When you think about it logically, it is impossible for all the companies in the Dow Jones to lose 22% of its earnings in a day. Later studies were made and found out that based on historic volatility if the market had been open since the beginning of the universe and repeated 1000 times, it would still be very highly unlikely that it would happen.
The most logical explanation for this is that a key condition of random events is that each new event must be independent of the previous one. Like a coin flip which is 50–50, but market events are not independent and markets have memories. It just takes 3 bad “flips” to cause fear and panic in the market. Resulting in the dumping of positions and extreme price movements.
Such events occur more often than you think and across all instruments, it happened Japanese asset price bubble in the late 1980s, in credit spread in 1998, the dot com bubble in the late 1990s, USD/JPY and AUD/USD flash crash in 2019.
By far, investing and trading is still more of an art than a science.
2. Using “Your” efficient market hypothesis to invest
Whenever my friends ask me how to invest, I love to use lemonade stand as an example. I would ask them, “If a lemonade stand makes $1000 a year for perpetuity, how much would you pay for it”. They would give me a price that they are willing to pay, let’s say $10,000. Then I would ask “if this lemonade increases its profit by 10% annually, how much would you pay?”, they would naturally give a number higher than $10,000. This is called growth. Then I would add on another question, “if there’s a law saying that you are the only person who could sell lemonade in Singapore, now how much would you pay?” They would give a number higher than the previous one. This is called competitive advantage. The question goes on and on. You can do this with any business with every underlying factor imaginable (profit margin, ROE, innovation, management, etc.) and this would teach you how to value a company.
Whatever price you are willing to pay (or sell) would be considered “Your” efficient market (intrinsic value). As mentioned earlier, markets move wildly, so there are times where the market offers you a price above or below “Your” efficient market. If it offers you below those prices, you should buy it, and if it goes above them, you should sell it (if you own any), or not, for reasons discussed later in lesson 6.
Note: You might want to buy them 20% below intrinsic value in case you are wrong. This is known as the Margin of Safety and the number is subjected to personal preference.
3. Logically, stocks should go up over a long period
The average compounded return in the S&P500 from 1926 to 2018 is about 10%-11%. Any individual without knowledge of investing can make a significant return in the stock market just by buying and holding the S&P500.
“Don’t look for the needle in the haystack. Just buy the haystack!”
-John C. Bogle
It may seem illogical and senseless when you think about it. Like “Why can’t stocks trend downwards?” Well, the explanation is simple, or at least what I’ve concluded thus far.
Stocks are companies, and they make products that impact our lives. As time passes products improve and so does our quality of life. Take mode of transport as an example, we used to travel in horses from point A to B. Years later, Henry Ford came out with T-Model which people value and pay a higher price for a car rather than a horse. As the years pass, cars get safer and faster (today it even goes green and drives itself). You can do this with any product, a handphone gets from a Nokia to a smartphone, your computer is running faster today compared to 10 years ago. Blah blah blah, point being, companies make products and products are constantly improving, which makes people value them more which makes sense that the value of companies always goes up in the long-term.
4. Investing/Trading can be an enormously advantageous game
It always bothers me when people are always in a rush to buy stocks. They can hear an investing opportunity from their friend and put in half their life savings before sunset (and they wonder why they lose money).
In investing, I can always sit there and watch markets move every day, and only when I see a stock I like (according to fundamentals) and if it is selling below fair value, I would buy it.
As the degenerate that I am, I like to use poker as an analogy for this lesson. Think about it as you’re playing poker without blinds where it literally costs you nothing to fold a hand. You can keep folding a hand until you are dealt pocket Aces (Aces representing that you understand the company and valuation) before you put money in. There is some chance that Aces gets beaten in poker but overall, it is an enormously advantageous game.
5. Everyone has an edge, they just don’t know it
Edges can be found everywhere in investing and it differs for different individual. Take, for example, if you are a pharmacist, you would know which drugs are selling and which company is doing well because you understand the industry first-hand.
Even if you do not work in such industries, being a user of different products and services gives you an edge. You could be a user at Shopee and realize how they are better e-commerce platforms than their competitors, or an iPhone user, or a Facebook user. And it is so strange that people can buy an iPhone every year and never once thought to make money by buying an Apple share. Apple’s share price jumped from $4 a share to $134 since the first release of the iPhone in 2007.
6. There is no law to say how high stocks can go
Stock prices can soar way past valuation a lot of the time. Think about it this way, anyone can say “I think Company X is going to triple its profit every year and therefore it is worth buying it at a 200 P/E ratio”. Basically, the reason why there’s no law on how high stocks can go is because of speculation and anyone can speculate. We have seen this happen a lot of times (Dot Com Bubble, Tilray in 2018).
7. But there is a law to say how low stocks can go
I always like to think that there is an invisible “force” that will always push stocks up or rather, let it not sink too low. That “force” is known as Earnings. Let’s use lesson 2 example of a lemonade stand. For simplicity and hypothetical purposes, imagine it produces $1000 of earnings per year, and prices in the market drop to $1000 (P/E ratio 1). Theoretically, by investing in the lemonade stand, you are making a 100% annual return every year. Even if it stays at the price for a long time, if it gives a dividend pay-out ratio of 50%, you would make a 50% realized return.
Such a scenario is either too nonsensical to happen or it would give you a high return through dividend. In either case, it is acting in your favour. This is why I believe, there’s a law to say how low a stock can go.
8. Stocks can stay overvalued for a long time
When you look at the dot com bubble era, stocks have been overvalued for about 5 years. If you look at Amazon’s share price during the height of the dot com bubble, it is worth $100 a share, it later dropped to $10 when the bubble burst, and today it is worth $3400 per share. That is a 34x return (way higher than the S&P500).
To me, sometimes it is worth paying a premium for fantastic companies as compared to market sentiment. In the above scenario, I am being generous with the numbers and being extreme in the numbers. But the lesson being, it is better to pay a small premium for a fantastic company than to miss out on an opportunity as a whole, as long as you understand the company and its future. This applies to selling great companies as well, it may be better to hold great companies even if the market is giving you a huge discount to sell.
9. Stocks can stay undervalued for a long time
As mentioned earlier, there’s a law to say how low stocks can go, but that does not mean they can’t be undervalued for a long time. Sometimes it can take years for markets to realize the true value of a company and this can put you in a very illiquid position as an investor (especially if it doesn’t pay dividend). The best way to protect yourself in such a scenario is to invest in companies that have constant growth in earnings. Therefore, growth in earnings can act as a pushing “Force” as to how low your stock can go.
You can check out Activision’s share price and EPS from 2009–2013 for a real-life example of how EPS “forces” share prices upwards.
10. Reading beyond Finance
I always believe, to be a great investor, one must read beyond finance. There are so many industries in the market that just learning finance alone is not enough.
For example, in the digital tech industry, there is a competitive advantage known as “System Lock-in”. Basically, it is hard for an individual to switch software because people need to relearn it. Take Microsoft Office for example, if another company were to come out with a cheaper, easier-to-use platform that serves the same function as Microsoft Office, would you switch products? Probably not, because you have to relearn how to use the software, and in cases for businesses, they have to reprogramme all their computers in their office and on top of it they would be using software no one else in the world use!!
Such a competitive advantage cannot be seen in other companies such as Coca-Cola, Walmart, or ExxonMobil.
Learning beyond finance doesn’t just teach you an industry or a business, it develops you in other aspects as an investor/trade as well. Other examples include Charles Darwin’s theory of evolution teaches you how a company should adapt, Sun Tzu’s Art of War can be applied to trading and business, geopolitics teaches you FX more than you think, so on and so forth.
11. The big can always get bigger
I think there is a myth that needs to debunk among investors, the common myth of “big companies are too matured and I can’t profit as much”.
Home Depot went IPO in 1981, and if you have invested $1000 back then, the same position would be worth $11.5 million today (with reinvested dividends). I know it’s hard to wrap your hand around these numbers, the point being is that Home Depot constantly beats the S&P500 throughout the past 40 years. Now let’s rewind 5 years, Home Depot is already an established company and if you had invested in it you would have about 2.5x your money by today (again, easily beating the S&P500).
I am not going to work out the numbers and charts to prove to you my numbers because honestly, I am too lazy to do it, but I’m sure you are smart enough to figure it out. So here’s my food for thought: if these matured companies with 40 years of history can beat the S&P500 constantly, what about newer established companies like Facebook and Google?
12. The dangers of leveraging
I’m sure everyone has heard of someone who made tons of money through leveraging. Well, there’s a simple explanation as to why these people probably won’t last for the next 5 to 10 years in the market.
As mentioned in lesson 1, markets move irrationally and they happen pretty often. One may have the best models or mathematical predictions or whatever fundamentals they like to use, but by far no one can predict emotions with 100% accuracy. If you leverage 5 times, it takes an irrational movement of 20% to make you go broke (which we have seen on Black Monday).
Peter Lynch, one of the greatest investors, had his fund dropped 12 billion to 8 billion in the events of Black Monday. If he had leverage just 3 times, we would have not known him as a GOAT in investing but as a greedy investor who went broke.
Even the brightest of minds with all their mathematical predictive models and 2 Nobel prize winners in LTCM went broke through a highly leverage operation in 1998 because the market went irrational over credit spread. So my question to you is if 16 of the brightest minds in Finance pooled together with their 100s of years of experience in the field could go broke through leveraging, what makes you think you as a retail investor can beat them?
And again, we see it with Archegos Capital Management in 2021, where the fund lost $20 billion in 2 days (according to Bloomberg) by leveraging 5–1. I mean how the fuck do you lose $20 billion in 2 days (Answer: Leverage). Kinda think about it, it would probably take more than 2 days to burn that same amount of cash.
With this explanation, logically speaking, if someone ever told you they constantly 3 or 4 times their return over 10 years with leverage, they are either lying to you or extremely rare and the former is the more probable one.
13. The dangers of shorting
The nature of shorting a stock has 2 features. One: you can profit a maximum of 100%, Two: Your losses are potentially unlimited. These two factors themselves are already scary enough.
But you will realize it is even scarier knowing what is taught in lessons 1 (irrational markets) and 6 (no law to say how high stocks can go). The irrationality of markets can cause speculative stocks to go as high as they want, without limits. This means that you can be right about a company all you want but if the markets speculate and dictate that prices should go up, it will go up.
One of the most famous examples happened recently when shorting GameStop cost Melvin Capital $4 billion. Other examples include Manhatten Investment Fund who tried to short the dot com bubble.
14. A tighter return spread gives you a better return when compounded
Would you take a bet where you have a 90% chance of winning $20 and a 10% chance of losing $80 or take a 100% chance to win $10?
If you ever studied Expected Value (EV), you would be able to understand that both choices essentially do not make a difference. Here’s a table to help you better understand:
X = Value
P(Xi) = Probability of the outcome
Even though both choices will result in a $10 increase, according to expected value, the profit you make through a compounded earning can look very different. Now let’s picture it differently, where you have a 90% chance of earning 20% and a 10% chance of losing 80% in your portfolio over 10 years. Similarly, another portfolio offers a 100% chance to earn 10% over 10 years. Which portfolio would you choose? The answer should be the second portfolio, and here is the mathematical proof of why tighter return spread gives you a better return when compounded:
Portfolio 1 (90% chance of earning 20% and a 10% chance of losing 80%)
$100*1.2⁹*(1–0.8) =$103.20
Portfolio 2 (100% chance of earning 10%)
$100*1.1¹⁰= $259.37
You can try this with different numbers and play around with it. But what I’ve figured out is that the tighter your return spread the more you earn compounded. If you do figure out that I am wrong, please do let me know.
15. Volatility is not risk
If you have ever taken any Finance model you would have probably been taught about Markowitz Portfolio Theory and Sharpe Ratio. In simple terms, it says that the expected return of a portfolio is based on how volatile your portfolio is (Higher volatility should give a higher return, vice versa). Personally, I think it’s a flawed model. Many people have come out with different formulas to circumvent this flaw such as the Pain to Gain Ratio formula but none of them still give an accurate picture.
For investors, we are more concerned about making money. In fact, it should be the proper way to view it should be how much returns we should expect based on the probability of losing X amount. Of course, it is by far impossible to calculate such things numerically. I mean how can you say that there is an X percentage chance of Walmart losing 20% in value tomorrow? It’s subjective.
But there are certain ways to take advantage of it with such a mindset. For example, bonds get riskier as more time passes (that’s why as maturity increases, interest rate increases). On the other hand, stocks get less risky as more time passes (look at the S&P500). What is more intriguing is that stocks give a better return than bonds do. This itself is proof that an individual can lower its risk and increase its return just by switching instruments. Therefore, by rethinking risk as to the probability of losing money, the efficient frontier in Markowitz Portfolio Theory can look very different from a long-term perspective.
16. No one can predict a market crash
I think it’s safe to say that we have seen or heard of many “Prophets” trying to justify and predict a market crash and when it happens they would probably say things like “See, I told you”. But yea… after they predicted it every year for the past 10 years.
No one can predict a market crash, or at least not with significant accuracy. For every Covid-19 case that crashed the stock market, many other diseases could have potentially done the same in the past decade but didn’t (Ebola, H1N1, Zika, MERS). Similarly, for the debt crisis in 2007–2008, there are others like the LDC debt crisis which didn’t crash the market. There are even some which are considered unexplainable such as Black Monday.
The key takeaway is to not bother with market crashes, it is going to happen and it will happen in your investing life. And as Peter Lynch says:
“Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in corrections themselves.”
17. Correlation is constantly changing
This is an important lesson that I took away from relatively small years of trading experience. Not just a lesson but a painful one, and yes I’ve lost quite a fair bit of money to learn this.
Gold was strongly correlated with instability within the markets in the months before the trade war and it is what we consider a “safe-haven”. However, when trade war happens it acted in an opposite fashion, the more tariff was being thrown at each other (US & China), the lower the price of gold went. It turns out that traders started to see USD as a safe-haven instead of gold and USD became to soar (Which if you understand commodity, the price of gold fell because it was price against USD). This has happened countless times (EUR and JPY during the euro debt crisis, AUD & JPY during trade war, etc.)
Ray Dalio, the master of trading uncorrelated products emphasizes much on this topic. He shows how correlation can change. For example, during inflationary times, prices of gold would go up but prices of bonds would fall (inversely correlated) but in the early stage of deleveraging cycle, gold would go up (due to fear of Feds printing money) and so would bond prices (correlated).
18. It only takes a 100% loss to make you go broke
Yes, I know this sounds stupid, and it’s common sense. But I’m sure you would realize by now that common sense is not so common after all. I mean even the brightest people and the biggest institution still fall for this trap (LTCM and Lehman Brothers).
By definition, any trading or investment strategy that you have should not have the slightest chance of you losing 100% of your money. Another implication of this is that a 100% loss in trading is not equivalent to a 100% gain. Similarly, a 50% gain should not be an equivalent loss of 50%. Yes, I know it may seem complicated but it’s not, let me illustrate it in a chart:
I know the chart looks ugly, but I just pluck it off from Google images. But think logically, you lose 50% of your capital, the next trade requires you to make 100% to break even and this applies to other percentage loss in any of your trade.
19. Everyone makes money differently
If you ever studied all the successful investors, you would realize every one of them does it differently. From Edward Thorp (the inventor of card counting) who made money through finding the mathematical edge to Joel Greenblatt (Value Investor) to Ray Dalio (Diversifying). Even Warren Buffett holds about 50 stocks at any one time, while Peter Lynch holds 1,400 stocks.
I think to conclude off, I would like to say that everyone makes money differently. Whatever I learn and apply may not be as effective when applied to you as an investor/trader. At the end of the day, you are not me and you have your different way of investing/trading that might fit your personality. This article is a reference point for people to learn investing/trading and not a holy grail. Again, I may be wrong about certain stuff and it is still your responsibility to research and make a proper judgment of my lessons. After all, I am only just a 23-year-old who is graduating in a few months.
