1 of the Toughest Sins to Avoid in Investing

There is an old saying that the share market is driven by two primary emotions: fear and greed. The thing is — when it comes to greed, it is not easy to avoid. Jason Zweig, an award winning financial columnist for the Wall Street Journal, delved further in his book “Your Money and Your Brain”. Zweig quoted economist George Loewenstein who explained why financial greed can be such an overwhelming emotion:

“You’re likely to have some vivid imagery of piles of money and fantasies about how you’ll spend it. But your brain isn’t designed to form a mental imagery of a probability. The pleasure you anticipate feeling if you win the money would change enormously if you multiplied or divided the amount of the jackpot by 10 or 100 or 1000, but your reaction to similar changes in probability would trigger very little emotion.”

Said another way, when the perceived financial payoff increases, greed may eventually overcome the individual investor, and blindside him or her from the actual probability of getting it. The reason for this, as Loewenstein points out, is that probabilities are hard to imagine.

Hitting the Jackpot

Take the weekly TOTO Jackpot draw for instance. The queues at the TOTO counter are likely to grow longer if the prize for a unwon Jackpot gets rolled over to the following week. In this case, the image of a larger financial pay-off is easy to imagine, and be highly enticing. However, the fact remains that the odds of hitting the TOTO Jackpot remains exceedingly rare.

To be sure, Singapore Pools lists the odds of winning the Jackpot at almost 14 million to one. With this kind of odds, we may have a better chance of celebrating Christmas with a panda bear dressed as Santa at Orchard Road. On the other hand, when it comes to investing, our odds may be much better. As my fellow Fool, Ser Jing pointed out:

Let’s consider an investor who ploughed money into the Straits Times Index (SGX: ^STI) at the start of every month starting from 1988. From then till now, that would represent 189 rolling-10-year periods. Out of these 189 periods, here are some of the important statistics related to the returns the investor would have gotten (dividends not included):

+ Proportion of losing periods: 35 out of 189 (or 18.5% of the time)

+ Average total return over all 186 periods: 42.3%

+ Worst return: -28.8%

+ Best return: 219.9%

But, what happens if we now look at rolling 20-year periods instead, of which there are 69 of them starting from 1988? Let’s find out:

+ Proportion of losing periods: 0 out of 69

+ Average total return over all 69 periods: 110%

+ Worst return: 42.9%

+ Best return: 240.5%

Comparing the odds between the two (TOTO and STI), I would gladly take my chances with the STI for the potential returns of between 42.9% to 240.5% over rolling 20 year periods.

Foolish take away

Greed can often lead us to take more risk that we can afford. To avoid being misled by the mirage of large financial payoffs, the individual investor would do well to put a bearish view alongside every bullish thesis for a company. For example, this is the latest Tug-of-Fools’ bull and bear thesis for Dairy Farm Holdings International Ltd (SGX: D01).

The bull-bear thesis gives the Foolish investor a broader context. If done it well, we may find ourselves keeping our eyes on our odds of success instead of images of big piles of money.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chin Hui Leong doesn’t own shares in any companies mentioned.