Super Gann Trader Academy, which conducts share market classes in Chennai, offers free trader awareness lessons.
Mr. Shyam is a grocery shop owner. He runs his business in a small town. He has been saving money for the future of his family. His friends have been investing in the stock market. They keep boasting of the money they made in various stocks. He hears them talk only about their winnings. He begins to feel that he is missing out on this easy money making idea. He opens a brokerage account. His broker gives him more confidence by describing how good the market has been. He informs him about their advisory services. Shyam invests all his savings on the next tip his friends and brokers have given. He initially makes money on paper as the market is going to higher and higher level. Suddenly, he gets a jolt when the market experiences a severe fall. He is now losing money. He checks with his friends, but they too are holding on to their losing positions. They advise him to stay put and even buy more as this is a good opportunity.
Now, one year has passed. His investments are down by 80%. He has lost his hope on recovering the money. His friends are selling all their stock. He too sells all his stock holdings and returns to his life of saving and putting money in the banks.
Why did Shyam lose money?
Shyam lost money because he displayed a classic herd behavior. He invested in the market because others were doing it and did so without any study. He believed that if everyone is doing something, then it has to be correct.
Most of the animals display herd behavior. In the animal world, there is safety in numbers. This behavior has helped our ancestors survive harsh jungle environment filled with predators. This behavior is part of our genes.
Imitative behavior is deeply embedded in us. Common examples of human imitative behavior are fashion, movies, new product, Dining restaurants etc.
However when we invest in stock market, gold, real estate just because others are doing it, is a behavior pattern that is harmful to our wealth.
How is advice from knowledgeable brokers and expert mutual fund managers harmful?
Simple answer is conflict of interest.
Brokers may give us free advice. But they earn money from commissions. When the investor loses money, brokers do not lose anything; they still get their commissions and actually earn.
Mutual fund managers make money by charging fees (year after year) on our invested fund. They get their fees even if investors lose money. Their fees are dependent on the total money invested with them not on their performance.
During the internet bubble of 2000, a number of new technology funds were launched. These fund managers advertised previous market performances and collected a vast amount of public money (from average investors) and bought technology/internet companies at astronomical prices. These fund managers knew that past performances cannot be easily replicated. But they still collected the funds because they knew that they will get 2-3% of collected funds as their management fees every year.
This shows that the fund managers took advantage of herd behavior of the public to earn money. These financially educated fund managers also displayed herd behavior themselves by buying companies that other fund managers were investing in.
Herd behavior is detrimental to our wealth. We can protect ourselves only when we are aware of this. Trading systems are designed to be independent and guide our investment decisions in the stock market. They are tested to confirm profitability before risking any money in the market. Using trading systems prevent us from following others like herd.
We train the traders/investors to trade on the basis of trading systems. We train them to become independent. Trading on the basis of a system is a method of compounding your savings to generate wealth.
Here the List of Blogs in this Series
- Why do we need rules in trading?
- Mentality of people while they are doing trading
- The Magical Power of compounding
- Ignorance is not bliss
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