Investment questions from a friend and my e-mail replies

After participating in an investment simulation, one of my friends had some follow-up questions for me regarding his investment experience. My friend has minimal investment experience and is a college student. But after you read their questions, you'll probably get the sense that they're thoughtful and very analytical (and possibly a psychology major)!

They threw their questions at a "fast speed and with a dangerous curve," challenging me to dig deep into what I knew about investments and other related fields. I'd like to share with you the short e-mail conversation we had:

FRIEND: 1. Buy low sell high, right? Or is it buy low and keep high?
ME: It's buy low, sell high.

Ideally, it's buy low and never sell i.e. you want to buy a business that will keep growing in value forever. But in reality, value investors often sell their investments for various reasons. Some reasons to sell include: 1) the original analysis of the investment was incorrect, 2) you find a better investment vehicle or, 3) your investment has become grossly overpriced.

2. Does macro economics help?
Very good question and one that is arguable for some folks.

Here are my thoughts: when I evaluate information, Warren Buffett asks if a) is the information important?, and b) is it understandable? There's no doubt that macro-economics is important, but I don't understand it. To me, macro-economics is the oversimplification of a very complex system ... which is the reason why I think people who make investment decisions based on macro-economics often get things wrong.

Going further, I found that you can usually figure out what's going on in the macro level by studying micro level stuff i.e. you can typically make a semi-accurate analysis of macro level phenomenon by knowing and understanding micro level stuff. If you have any questions about what I consider "micro level stuff," please let me know -- that's a detailed conversation in itself.

3. I remember in our business plan our guest speakers used a lot of macro economics to explain why our pricing strategy didn't work. How much of stocks is psychology opposed to economics?
My oh my ... you have wonderful insight! Economics and psychology are very much intertwined -- actually, there's a field called "behavioral finance" that studies the overlap between economics and psychology. You might be interested to study that subject. I've studied it too; it's interesting stuff.

Psychology is very intertwined in stock purchasing. After all, you're talking about a market that is made-up of average investors ... these average investors have wives, children, sit in traffic after work, get mad when their cappuccino is cold, etc. And yes, economics is also involved with stocks ... but to a limited extent. Understanding the main theories of economics is very important, but it's even more important to know when economic theories don't work in investments and to know its limitations.

4. Stocks seem to be partially dependent on demand which is dictated by what people think will be profitable. Does it even make sense at times? Can something so complex be mapped? Is there a field of psychology that tracks the mental processes of investors?
The field of psychology that tracks financial mental process is behavioral finance.

Your question regarding "Can something so complex be mapped?" addresses the concepts of prediction and touches on Efficient Market Theory. In short, I don't think such a complex system such as the market can be mapped and that its behavior is not predictable. That question addresses the subject of complex systems (which the market is) and how to properly act and think in complex systems. I'm a firm believer that something so complex as the stock market cannot be mapped, but with a solid framework you can beat the market return.

Three steps (so far) to a solid investment foundation

This article is my response to the handful of SDSU students pledging for Alpha Kappa Psi who have asked me questions regarding investing.

Where and how do you start? And which of the 296,318 books on Amazon.com (searched for “investment” in Amazon Books) is the right book to get you started?

This article is purposely general. And if you find it helpless because it doesn't provide you a "formula" to beat the market, then my lack of helpfulness makes up in my honesty: there is no "formula" that will beat the market. But there is a framework that will get you in the right direction, and this framework is roughly outlined below:

Read The Intelligent Investor by Benjamin Graham
After mindlessly studying technical analysis, candlesticks, pennants, the capital asset pricing model, efficient market theory, etc., I stumbled-upon this book when I was 19 years old. If you’re looking for the “Rosetta Stone” to investing, this is it – read it, learn from it, and use it as a solid foundation for investing.

Benjamin Graham taught security analysis in Columbia University throughout the 20^th century and some of his students later became very successful investors, for example, Charles Brandes, Martin Whitman, and Warren Buffett. If you’re scrunched for time, focus on the book’s two chapters on investor and market fluctuations, and the margin of safety principle.

Read Influence: The Psychology of Persuasion by Robert Cialdini
As an investor, your biggest enemy is the person that stares back at you when you look at the mirror. And many famous investors have said it before: the most important requirements to be a successful investor are related to your character and demeanor. For example: discipline, patient, rational, psychologically mature and humble about your "circle of competence."

Your biggest advantage as a lay-investor is your ability to be completely independent of the hustle-and-bustle that is Wall Street. But with the army of analysts, brokers, and forecasters who promise you answers, it’s no surprise why you'd give up your decision making independence to Wall Street’s equivalent of fortune tellers and palm readers. When a Security Analyst is yelling at you to “BUY BUY BUY!!! Predicted to quadruple in 3 weeks!!!”, it’s easy to get caught-up in the excitement.

So, read Robert Cialdini’s book on psychology and you’ll become not only a more independent decision maker, but you’ll have more fun and happiness in life too.

Prepare to “live and fight another day”
Before you invest any money, make sure it’s absolutely extra. You want to be financially ready in case something goes wrong with your investment so you’ll still be able to “live and fight another day.” And aside from being financially responsible, if the money you’re investing isn’t absolutely extra, you run the risk of “caring” about it too much – making you psychologically handicapped from making wise decisions.