I really enjoyed reading other replies as they cover many important aspects of building wealth, however,I think there are 3 additional extremely important things that people are generally unaware of that prevent them from becoming and staying wealthy. Just like Charles Tips emphasized, you can’t expect to become really financially wealthy by simply working for a living. At some point this would require financial investments and in many (if not most) cases this will involve investment in capital markets, alternative investments or in any other markets where it’s imperative to know how to judge performance of others and how to make decisions that are as unbiased as possible. That’s much more important than it seems – believe me.
Very often one – either when becoming or when already being financially wealthy – will have to choose markets, strategies and analysts or advisors. There are several psychological biases that can (and often do) distort the true picture and make one take incorrect decisions. The key decisions regarding one of the most important aspects (if not the key one) of one’s financial life can make a difference between being very wealthy in 10 years and being in the middle class, working to make up for the wrong decisions of the past. Yet – and I’m writing this from my own experience, having been working with wealthy people for years – so few people are aware of these psychological traps.
Knowing them can also help do detect if an “analyst” is simply a salesperson trying to earn his commission without regard to client’s best interest (remember the humming scene from Wolf of the Wall Street?).
You want to avoid these kind of people and knowing a little more can make a huge difference in case of your ability of detecting them.
Serious, experienced, and – most importantly – caring professional will be aware of the biases and you will never (or barely ever) find them being a victim thereof. However, if you can detect these biases in the people that are supposed to help you becoming wealthy – it might be better to looks for help somewhere else.
What are they exactly? I don’t want this reply to be a whole chapter from a book, so I’ll provide a few links where you can start your own research (it’s worth it) and I’ll briefly discuss a few issues that I find most common and a few ideas that one can implement to avoid some of the biases.
1. Learn to avoid biases that make it more difficult to make money through trading and investing:
One of the most effective techniques to deal with some of these issues is to “forget” that you already own something or when you bought it. The thing that determines if an asset is worth buying or selling depends on the outlook for that asset, not on your individual past (losses, gains, entry price etc.) and consequently, shouldn’t be a factorwhen making an investment decision. Sounds easy and logical right? So what would you do if a price of a stock that you just bought at $40 declined to $30. Sell it and cut losses? Buy more? That’s a tricky question, because the fact that the price decreased doesn’t say anything about the outlook. If you decided to cut your losses it probably was due to loss aversion. The question that you would need to ask is what changed regarding the outlook and are the reasons, due to which you decided to buy the asset in the first place, still in place. If they are then holding the stock remains justified. If they don’t – it doesn’t. It’s simple as that and yet almost everyone will say what about mylosses/gains? No. The outlook and the investment potential don’t depend on and the market doesn’t care about your losses or gains. If you have losses, it’s better to have smaller than bigger ones and if you have gains it’s better to have bigger gains than smaller ones. If the outlook deteriorated to a point when buying this asset at this point doesn’t seem to be a good idea (if you didn’t have this asset already), it’s a good idea to sell this asset and that’s it.
In other words, on each day – regardless of the outcome of a given investment or trade – one should ask themselves if the outlook for a given asset remains so favorable that they would invest in it, if they weren’t already invested in it. If not – exit the investment – don’t wait for the market to agree with you as when it does, you will likely no longer be able to exit at such a favorable price.
The above approach is very helpful because you stop thinking about yourself (and about gains and losses, which leads to emotional reactions and emotional decisions) and focus on the investment and the outlook for it. By limiting the emotionality associated with trading and investment, you’ll also limit the level of stress, which is also very important for your health.
2. In case of trading, limiting the size of one’s trades is usually a very profitable idea.
At the beginning of their trading activities, almost everyone takes on too much risk by putting too much on the table for each trade, so knowing that it’s dangerousto do so, can greatly contribute to one’s financial wealth. Depending on the probability of success, the optimum size of the trade can be bigger or smaller, but it’s safer to assume that the probability is lower than it really is and to trade with less capital than seems optimal. I don’t want to get into details here (you can read my report on this issue on the following page:) but please keep in mind that if you lose 50% of your capital, you’ll have to then gain 100% to just come even – twice as much and it’s twice as difficult. If you lost only 5%, you’d only have to gain back about 5.26%. The bigger the size of the trade, the bigger the risk of a big loss, and that’s what you need to avoid.
3. Estimating the performance and potential value that an analyst or advisor can generate is much more difficult than it seems and it’s worth to do it correctly.
There is a profit-decreasing tendency of viewing portfolio managers, investment advisors and analysts as show-business stars that are only as good as their last market call. Mr. X called the top and now we’ll hear what he hasto say about everything else. Ms. Y said that the Fed will stop raise rates andthat’s what happened – let’s hear what’s in store for the rest of the year. Things like that are not reported because they are useful. They are reported, because they are exciting and people want to watch exciting news (I discussed the implications in greater detail here:). People want to look up to champions and think that they discovered a Holy Grailof the investment world – that would make things so much easier. The problem is that investing is not that easy and if one doesn’t care enough about learning more about it, they will not benefit much.
I don’t want to discuss why this is harmful to the business (ok, one word: short-termism –) – I’ll focus on how it can be harmful to one’s financial wealth. When you are choosing a car, you wouldn’t just simply buy a car that won just one competition or based on just one advertisement. You’d knew that there’s much more that needs to be investigated. People tend to focus more on selecting a car model than on selecting proper investments or investment advisors. How is that harmful to the investor? In the same way as buying a random car would be to the one making the purchase (only more) – the odds are that what you saw was just a tip of the iceberg and the rest that you received is not necessarily best for you or good at all.
So, what’s important and what’s not important? Definitely focusing on the most recent performance or how perfect the most recent market call was, is not really important (if you covered point 1 from the above, you already know that as that’s recency bias).
What is important then?
A) Long-term performance. In case of short-term trading, it means at least a year, but preferably a few of them and in case of long-term investments (which is usually the core of one’sportfolio) the 5-year and 10-year (if available) performance scores. While checking performance it’s important to look at it compared to the proxy. If the analyst / investment manager was investing in tech stocks, compare the performance to NASDAQ or other tech index. In my long-term investment calls I’m focusing on the precious metals market and I’m comparing the performance to aportfolio consisting of gold (1/3), silver (1/3) and the HUI Index (proxy forgold stocks; also weight of 1/3) – if you’re interested, you’ll find details onthe bottom of this page:. If the analyst outperforms the proxy it’s time to consider if there was some sort of automatic leverage used – if it was, then it was not only analyst’s skills that caused the portfolio to outperform – it might have been a combination of poor performance and leverage. Additionally, it’s a good idea to check down years separately from the up years. The ability to limit losses is generally more impressive than the ability to multiply gains.
It is usually good to apply Sharpe ratio or other similar measure to check performance – but it makes sense to only apply it for the long term. Short-term-based numbers could be rather random and misleading.
B) Reviewing given analyst’s articles, reports, interviews etc. in order to get to know not only their approach and way of thinking (they should be able to demonstrate a throughunderstanding of the sector they specialize in), but to detect inconsistencies and psychological biases. In case of portfolio managers it will be difficult to find them as they usually put much effort into communication with their clients, but in case of analysts and especially, mainstream analysts, it can happen quite often that you’ll find them ignoring things that they don’t agree with instead of discussing them and proving them incorrect. What’s even worse, you’ll see that quite often they strive to explain even the tiny price swings (like <0.5%) that are more or less random – this is suspicious as it shows that they want brag about the ability to make up justifications instead of digging for the truth even if truth is boring. You want your money to be managed by someone who’ll care about the truth, about your capital and about you – not someone who will not care and who will be focusing on providing you with justifications of why something didn’twork (naturally, skilled and careful managers will also lose money from time to time and they will discuss that with their clients, but the above type of comments suggest that it would be one’s goal to mislead their clients instead of making money for them). At times analysts will argue about something – those that base their investment decisions on “beliefs” instead of cold analysis will be easy to spot during these arguments – following them could be dangerous.
Oh, and here’s a bonus info that is connected with the above and that should be helpful in case of analysts, especially mainstream analysts and those from investment banks that might be issuing shares of companies that they analyze later on. Anything else than a “buy” or “aggressive buy” (depending on what is the most bullish suggestionthat a given analyst can have) is often a “sell”. On what does the suggestion depend? On the analyst’s opinion regarding the outlook. Why would you want to own anything but the assets with the best outlook? With 50 assets on “hold” or “accumulate” and 20 assets on “strong buy” why would you waste your capital on the one’s that the analyst is expecting to underperform?
Disclaimer: the above is provided for educational purposes only and is only my opinion. It is not an investment advice.