Jim Paul (now deceased) was a young man who, like so many others, landed on Wall Street hoping to make a fortune. After a run of bull markets, strokes of luck and smart investments, he thrived in the industry and made a name for himself. But his arrogance grew as much as his success, and he began making terrible investment decisions that led to his downfall in 1983.
The investment firm he worked for fired him, and his reputation as an investor was in tatters. He lost a total of $1.6 million, $400,000 of which was money he had borrowed from friends.
But after seven years of struggle, by 1990 he was working again in Morgan Stanley’s futures research department, and he ended up once again leading a team as an investment adviser. There he met Brendan Moynihan, who would later write with Jim Paul the book What I Learned Losing a Million Dollars, a book widely used to discuss investor psychology and biases and the mistakes we make that have nothing to do with our knowledge of investing.
Moynihan used Paul’s career to talk about these issues, and these are three of the lessons that appear in the book.
1. Internalising failure
While it is very advisable to take ownership of a mistake without blaming anyone else, when it comes to investing, investors tend to internalise those mistakes in a different way. According to Moynihan, investors often equate their self-esteem with their net worth, which is a way of equating failures with your identity.
If you lose a large amount of money or suffer another major setback, you have to change your attitude. Considering yourself a failure is not the same as considering yourself a person who failed once or several times. For our minds, there is a world of difference.
And it was that fear of failing again that haunted Paul. On one occasion it made him abort a speculative investment because several indicators didn’t fit, even though his professional instinct told him he was right: Paul wanted to be certain about the investment so he wouldn’t fail again. By aborting that trade he lost the chance to bounce back. And he lost it solely out of fear of failing again.
2. There is a huge difference between taking risks and gambling
Being a smart investor requires taking a lot of risks, and not all of them will end in success. Even so, smart high-risk decisions are very different from bets. Gamblers tie their ego to the money, which, according to Moynihan, is what Paul did.
Gamblers want to be right. It isn’t about the money; it’s an illness. Money is just a ticket to get into the game. What gamblers really love is the adrenaline of bets that might go their way.
3. Emotional decision-making is very dangerous, especially in a group
You are a human being, so it’s natural to have emotional reactions to situations, for better or worse. But in investing, you have to learn to set your feelings aside and look at something objectively before making a decision.
How did Jim Paul lose $1 million?
Ego and emotions played a nasty trick on him in one trade. In 1980, Paul bought large quantities of options, selling for a few cents, to buy at $60 a share. The options were very close to their expiry date. He told his clients to do the same.
Within three weeks the stock had risen to $38 and the options were worth $4. If he had sold at that moment he would have made an astonishing profit of $7.5 million, but he decided not to sell because of some rumours, and he pushed his clients to hold on, thinking the price could go much higher.
Paul and his colleagues agreed to hold and not sell yet, and even started talking about where they would go on holiday with the money they were going to make from the trade and everything they were going to buy. That is how the markets closed on Friday.
On Monday the stock opened below $6 and the options were worthless.
The decision to hold those options instead of selling them rested on a rumour circulating about the company. Going from making $7 million to losing more than $1 million is an enormous difference. On Wall Street, it literally means going from guru and legend to failure.
But in the book, Paul explains this episode as the danger of groupthink. The whole group of investors backed him based solely on information that wasn’t reliable. It was just a rumour. Perhaps if someone had pressed him to sell, it wouldn’t have ended that way.
The mistake he describes is also about a kind of fantasy of the quick jackpot that will let you buy a private jet and join the exclusive club of “Wall Street stars”.
In hindsight, from every rational investment angle, the smartest thing would have been to sell that Friday and pocket that hefty return.
And I admit that when you could lock in a large profit but decide to hold the shares instead, and they then start to fall until your gains shrink or even turn into losses, the feeling of having been a complete idiot is something no university can describe to you.
Further reading
- The best investment advice an investor can get
- It’s not about what you buy, it’s about what you pay for what you buy
- 10 stock market investing lessons from Jim Rogers
- The Warren Buffett myth and how value investing is misunderstood
- What I learned about stock market investing in a gym
Featured image: Watts, Public domain, via Flickr.
