Do you find your emotions dictating your investment decisions, or use margin trading or derivatives to try to magnify your investment returns? In difficult market conditions with growth stocks facing significant drawdowns almost daily, are you tempted to chase your losers, hoping to get even? If so, you may be falling prey to one or more of the ‘seven deadly sins during a market selloff’!

In this episode of the 7investing podcast, Lead Advisors Anirban Mahanti and Luke Hallard discuss seven products and habits that can cause tremendous damage to an investor’s long-term returns. Not only will these behaviours likely cause you to lose sleep at night, but they can also have a big impact on your portfolio.

Publicly-traded companies mentioned in this podcast include GameStop, Apple, Netflix and Tesla. 7investing Lead Advisors Anirban Mahanti and Luke Hallard may own shares in the companies mentioned in the podcast.

Timestamps

00:00 – Introduction

01:35 – Using Margin

03:50 – Shorting Stocks

06:57 – Short-Term Options

11:48 – Emotional Trading/FOMO

13:31 – Growth Investors Chasing Defensive Stocks

16:28 – Selling Positions to Start or Add to Positions

18:25 – Chasing Your Losers

Transcript

Anirban Mahanti  0:00

Hello, everyone, and welcome to today’s edition of the 7investing Podcast. I’m 7investing Lead Advisor Anirban Mahanti, and it’s my pleasure today that I am joined by my newest Lead Advisor, Luke Hallard. What’s interesting is that I’m joining in from Sydney and he’s joining in from London. So this is truly an international podcast that goes from the northern hemisphere, the southern hemisphere. Welcome, Luke.

Luke Hallard  0:25

Thank you Anirban, and it’s great to do that global link up for my first podcast for 7investing. And actually, I’m just about to light the barbecue. I think that’s a very Sydney thing to do. And I guess you’ve just about had your breakfast.

Anirban Mahanti  0:36

I’ve actually not had my breakfast! Just had my coffee. It’s like 630 in the morning. But yeah, I’ll have my breakfast after doing this podcast.

Luke Hallard  0:45

Today, we’re going to have a bit of a chat about the Seven Deadly Sins of investing. Do you know what the original seven deadly sins were Anirban?

Anirban Mahanti  0:54

I do! I do! So I know. I know that there are lust, gluttony, greed, sloth, wrath, envy, pride, (but) what are the seven deadly sins then for investing?

Luke Hallard  1:04

Well, we’ve got seven terrible behaviors that you should really steer clear of. But particularly when markets are pretty volatile, just like they are right now when your growth stocks are in the slump and your portfolio’s taken a bit of a nosedive, we can sometimes be tempted to take quite rash actions to get unstuck, get out of the hole. And often those can just make things worse. So we thought we’d have a chat today, about seven of the things that we can tend to do that can make that bad situation even worse.

Anirban Mahanti  1:35

The first one that we’re gonna talk about is using money that shouldn’t be in the market right now. For those who don’t know, what does using margin mean? Margin effectively means you’re borrowing money from your broker to buy securities and use your cash or securities that you already own, essentially as collateral. Now, this might sound like a good idea, if let’s assume that the market is down like 30% and you’re buying stocks on the cheap effectively. And if you’re borrowing at a relatively low interest rate, and you think that the stock is going to rebound, this might sound like a great idea. The problem with this is that the market is down to 30% – that doesn’t stop it from going down another 30%. And in fact, at that point, you might get a margin call, which means that your account, the cash that you hold, or the securities or hold, do not cover the amount you have borrowed. And in that case, you might be issued a margin call. And your broker might say okay, give me this much amount of cash in this account by this time; usually you get 24 to 48 hours to do that. Or they can sell your stock to actually bring your account in line with what needs to be the account balance for cash. That can be problematic because what might happen is they might sell a long term holding of yours. Worse off, you might be looking to borrow or find this additional cash from somewhere. It’s just a position that you don’t want to be, and I think it’s a position that is going to give you a lot of stress, and when you’re stressed you’re likely to make some wrong decisions. So yeah, that’s something I think I definitely say is to be avoided.

Luke Hallard  3:05

Well, I’ve never used margin actually. I’m fairly innocent of most of the sins we’re going to talk about today, perhaps, rather than one or two. But the bit that really scares me the most about something like using margin is that forced sell aspects you described. You could have a great position, and it gets closed out at a terrible price just because of a sudden fluctuation in the share price. I hate the idea of someone else taking my decision making power away from me.

Anirban Mahanti  3:30

Unlike Luke who is very clean on almost all of these things, I actually have probably touched upon all of these in I do actually use margin sometimes. But I’m very careful in terms of how much margin I use. And I use this very selectively and have a threshold that I would not go beyond that.

Luke Hallard  3:50

If we talk about our second sin. It’s not that dissimilar to margin, but slightly different, and this is going short for shorting stocks. So what does that mean? Basically, you’re selling a stock you don’t currently own, and your intention is to buy it back at a cheaper price later and pocket the difference. So actually, the best case is the company literally goes to zero, it goes bankrupt. And you don’t have to buy back anything at all. But it costs you to borrow that stock. So you can go short. And what that means is you have to have quite a lot of money in your account, typically 150% of the value of the stock to cover that volatility in a short term. You can get a margin call when you’re short, and again, you can get forced perhaps to sell other very healthy positions to pick up the shortfall on your short position. There’s quite an interesting effect. I think that happens to some stocks that are very heavily shorted and they can get something called a short squeeze. This is where if you have a huge volume of short position on a particular stock, if the stock price starts to rise, well all those traders and investors that are short, suddenly have to buy the stock to cover those rising prices – to cover their position. And you can imagine you get into this vicious cycle where as more people buy to cover their positions, the price rises even further. And then the guys are left holding the bag really can be in a lot of trouble.

Anirban Mahanti  5:13

I should have seen this phenomenon work for some stocks like GameStop. And for some odd reason, the percentage of stocks that was short was more than 100%. How that happens is another conversation, but when that when that phenomena happens, where you have more shares short than shares actually available, that can cause a short squeeze. As you just described that can be deadly. One of the things I want to say about shorting, which is sort of different from the first one is, let’s say you use margin to buy shares in a company or stock in a company, you own an asset in that case, whereas when you’re short, you actually don’t own an asset. That’s number one. It’s a big difference there. The number two thing is that when you are shorting your effective gain is typically 100%. Right? Let’s say you short at $100 per share, that’s the price of the stock at that time, then your effective maximum gain is $100 per share, right? There is no cap to the loss because the stock could go to $1,000 per share, and then that case, you’re actually on the hook, you know, basically for $1,000. So I called shorting limited upside and unlimited downside, and it’s the type of trade I absolutely hate doing.

Luke Hallard  6:23

It’s almost the opposite of investing. Because when we invest, we have unlimited upside in a fantastic case where a stock becomes a multi bagger. And our downside is really only limited to our initial investment, when you’re short is completely the opposite way around. I think it should be noted though, there is a purpose of short traders in the market. Sometimes it can help create transparency around a stock price. And if some players some investors are incentivized to look for the sale case, or sometimes that does uncover shenanigans or fraud. But just like yourself, I prefer not to be one of those players.

Anirban Mahanti  6:57

The next one we’re going to talk about is short term options. Options basically are financial instruments that derive their value from an underlying security. Okay, so that’s basically the definition, but what they basically mean is there a derivative, you basically have two types of options, you have a call option. Call option gives you the ability to buy a stock at a certain price by a certain date. And a put option effectively gives you the option to sell a certain stock by a certain date. And again, a certain price without going to too much detail. Because you can be long a call and short a call. And similarly, you can be long a put and short a put. If you are short a put, that’s a bullish position, because what that basically means is you’re saying to somebody else, because the thing to remember with options is just like stocks, it’s a two sided transaction, right? So the person selling a put effectively means that there’s another person or a market maker or someone buying the put, the person buying the put effectively is bearish. To some extent, the person selling the put is actually bullish to some extent. And that’s the transaction. So you can actually go short a stock by going long puts or buying a put, you can go long, effectively long by going short a put. Now, the thing with options is that options often involve two things, they involve a strike price, which is effectively the price at which you either you’re buying or selling that particular stock, and an expiry date, which basically says that, well, this needs to happen by a certain date in the market. You’ll find that for any given stock, there’s there are options that are, you know, short term, which might go out for 15 days, 20 days, one month, three months, six months. And then there’s some that go a year, some people go two years maximum, you might see things that go maybe two and a half years or so. So that’s the longest dated options you can get fundamentally. There’s nothing wrong with options except for one of the things which is you are working with limited time, and when you’re working with limited time, you have to just remember the market might not come around to your viewpoint. Which means that you might have a higher potential for losing money. That doesn’t mean that people shouldn’t use options, you just need to know how to use them. The most famous example I like to give for options is during the financial crisis, Warren Buffett actually, I believe sold puts on the S&P 500, and I think bought calls as well, which is effectively a synthetic way of going long the stock market. I think those options, you know, the counterparty for them but some banks, Buffett actually made a killing on those options at the depth of the financial crisis. The thing to realize with options again, is that there’s a lot of leverage there. It’s a derivative asset. And therefore, sometimes for example, if you get lucky, you can get 100% gain for the stock movement that has only been 20%, right. But you also need to realize that if that 40% movement has not happened, you lose actually all the capital that you put in. So leverage works to the upside as it works to the downside, and that’s the thing to realize. If you’re over leveraged with puts, again, you can get a margin call from your broker. I’ll give an example in 2016, I think the stock market had pulled back maybe 16%  – my account was actually down 45%, I was heavily leveraged with puts. And that’s not a very comfortable position to be in at that point, you know, it just makes you very uncomfortable. You don’t sleep well at night. So you need to know again, what you’re doing. So that you’re able to weather, the storm.

Luke Hallard  10:39

If that sounds complex, it’s because it is. And I think tools like, really all these derivatives are particularly options, particularly if you’re writing options, they can be legitimate tools, and you can use them for hedging or maybe more tax efficient ways of managing your portfolio. But if you really, really don’t understand what you’re doing, you can get in a hell of a lot of trouble. You know, learning those lessons early in your investing career and deciding if those products are right for you is quite an important thing to do.

Anirban Mahanti  11:09

I know of a story where an investor actually sold puts on Apple. Now Apple might sound like a very stable company – a cash rich company is like a cash machine. Well, the market can sell off and even Apple can be down like 30-40% from its all time high. And you know, that person I think ended up owning a portfolio that was like 60% Apple, and it was a very uncomfortable situation to be in. Because you know, you like selling other stuff to buy Apple, ultimately, I think it worked out well, because Apple is Apple, but it’s a very uncomfortable position. And it could have been a scenario where it doesn’t actually work out for you. So you just have to be careful with these things.

Luke Hallard  11:48

To talk about being uncomfortable is a great lead in to our fourth sin. And I guess we’re coming away from products now and we’re starting to talk a bit more about sinful behaviors. Things that you may do or think that can be detrimental to your long term returns. Well, our fourth sin is emotional trading, or knee jerk reactions, the term my wife will probably use is FOMO, fear of missing out. And we can feel these emotions for lots of reasons. Sometimes it’s loss aversion. We place a lot more weight on losing money than we do when we gain money. And that can make us feel emotions that are actually quite counterproductive to our long term returns. Maybe just fear, as you say, your friend who had a huge Apple position, unexpectedly, might have been terrified about the market dropping a bit further. And that could trigger almost our fight or flight response. Rather than being able to be rational and think your way through a situation. Or perhaps coming back to that seventh deadly sin of greed, maybe we get a bit exuberant. And when markets are soaring, we might get caught up in the excitement, and perhaps take on more risks to pursue again, I think the main lesson here is it’s good to acknowledge your emotions, but try hard to avoid acting on them. If you’re really far from retirement, that actually falling stock prices and valuations we’re seeing right now, they help you. The key tool to managing your emotions is make sure you’re not investing money in the stock market that you’re going to need in let’s say in the next five years, and try and have a plan for your portfolio and work through that. Rather than letting your emotions dictate what your next trade is going to be.

Anirban Mahanti  13:31

I 100% agree. Be more deliberate then be driven by emotion. That’s very important for actually investing. Level headedness is very important. You know, you don’t want to be an emotional investor buying and selling and just following every other person’s trade, absolutely agree in situations such as now where the market has actually pulled back and it’s selling off growth stocks, there could be tendency for a growth investor – a person who generally invests in growth stocks, to actually chase defensive stocks. You know, I’m not saying that growth investors should own only growth stocks, but the thing to realize is that when the market sells off, what happens is, especially if they’re selling off like growth stocks, then those are the companies that have been hardest hit. And actually at that time, because there’s flight for safety, the companies that are deemed to be safe or defensive are the ones that get all the money flowing in. So the money is basically cycling from the growth stocks to sort of the defensive stocks, which is giving a lift to the defensive stocks, so they aren’t selling off as much. And that’s probably the wrong time to be cycling your money. So basically, you’re just following the herd, the herd is selling this and buying that and you’re moving your cash from this side to that side. If one is a growth investor, then they basically should be buying the growth stocks it needs in my opinion, when the market is selling off. You know, what I thought I’d say is that you want to play offense when the market and everybody else is playing defense. And the best time to buy defense is effectively when those defensive stocks are out of favor, or some defensive company has been sold off for the wrong reason. That’s a great time to add those defensive companies. The other thing I want to point out is often defensive companies are more tightly valued. It’s easier to actually assign a valuation, which is has a tight range, then for a growth stock when the valuation range is actually quite wide, for obvious reasons, because there’s a lot more uncertainty. A lot of the value is actually the terminal value which is further out. And then therefore, that increases uncertainty in terms of interest rates, and how much is the terminal growth rate and how much is the growth rate between now and say year 10. So that’s just my feeling about investors chasing the wrong asset at the wrong time. Know what type of investor you are and stay true to your investing philosophy.,

Luke Hallard  15:48

It is a great reminder. It’s actually a sin that I was almost guilty of this week. Simon told us about a really fantastic value stock that really excited me because as someone who was very briefly in retirement, I’ve been almost exclusively a growth investor for the last 18 years, I definitely feel like it’s time to build a bit of a value income portfolio. Well, I nearly fell foul of this fits in by buying and building that sub portfolio now. And I think, standing back from where the markets at, probably something I should do in six months or a year’s time when we’ve come through the bottom of this cycle.

Anirban Mahanti  16:27

Alright, what’s the sixth one, Luke?

Luke Hallard  16:28

Well, six is an interesting one. Again, a behavioral sin, and it’s selling a position to start a new position or add to a position.  It’s quite interesting, I suppose, if you’re adding money to your portfolio month after month, you’re actually in quite a nice situation. Because every month, you can pick your favorite stock, hopefully one from the 7investing recommendations list, and add little bit of money to maybe add some money to a stock you already have. But if you don’t have new money to add, in some ways, you’re forcing yourself to make two decisions: you found a great stock you want to buy, but you have to sell something to buy that stock. And maybe in selling, you’re making a mistake, perhaps you’re reducing or eliminating something that you really should have held on to. So I think a good way to avoid this is to either be adding new money, or just run a bit of a cash buffer that allows you to separate those selling and buying decisions and make them independently at the time that’s right for them.

Anirban Mahanti  17:24

Absolutely love this one. I call cash a beautiful hedge. Because you know, when the market goes down, your cash doesn’t go down. So effectively, a cash position actually goes up and acts as a hedge in a market downturn, and you can deploy it on the cash. Having a little bit of cash is good. Of course, the thing is that market over the long term keeps going up. So if you have a lot of cash, and that’s just a drag, so you have to find a balance. And the final thing is we mental animals in some ways, right? You know, we need to be calm. And if the cash helps you be calm and make the right decisions, then it’s absolutely worth it. Even if it’s a little bit of a drag, because the right decisions, you can probably make up for the drag that you otherwise have.

Luke Hallard  18:05

I really love that point. I almost see cash as a bit of an emotional hedge. If you have the right level of cash in your portfolio, and it’s different for everybody, then actually you can be happy whether the markets going up or down. If the markets going up great, stocks are growing. If the markets going down, great. The power of my cash is much more impactful. Absolutely love it.

Anirban Mahanti  18:25

Alrighty, the last one! This one is we are calling it chasing a loser. So catching the falling knife. This is a bit like what Luke has already talked about with loss aversion, you see a portfolio position that’s in red, let’s say it’s been cut in 50% by 50%. And you think, well, maybe now is the right time to add more money to it, and you know, that’s going to help. A, probably the upside is more, and B, going to help cover for some of the loss. The issue here is twofold. More often than not, the market has a reason why a company gets sold off, okay? That can be anything from high valuation to valuation correcting itself to poor execution, right? One of the things that happens, especially when companies have poor execution, the market sells it off. you think well, it happens to certain analysts all the time. You think, well, you know, now the market has adapted for the change in the future, and maybe the stock is fairly valued. And again, then the company poorly executed market sells itself. And then at some point, what happens is what you might think that the sell off is overdone, and it could be the case itself is over, then maybe there’s value there, but takes a while for that value to be realized until the company actually turns around its execution and turning it on execution. Those can actually be great opportunities, if you’re willing to, you know, maintain your sanity through the volatility, right. So, this has happened a lot. The companies that get sold off for example, like you Netflix has been sold off many times, and many, many times many of those times have been actually excellent opportunity to buy Tesla is another example. You know, sometimes it’s down like 70 – 80% has been at points down 70 to 80%. From its all time highs, and those have now in the view, the benefit of hindsight, looked like great opportunities to buy into the circumstance has happened with Apple, I think in 2015/2016 was sold off a lot. But then there are many examples where companies get sold off, and they don’t come back. So the one thing I want to distinguish is, the way I would define a loser here is not necessarily by stock price, although stock price is actually indicated in you know, the magnitude, you might disagree with the magnitude of the sell off, stock prices indicated, because the market generally gets the direction, right is my thing. You know, they might, they might overshoot to the upside and overshoot to the downside, sometimes the market doesn’t get it. So what you want to look at is you don’t want to buy into companies that are executing poorly, it’s actually okay probably to buy into companies whose shares are going down, but the company is actually executing just fine or the execution is in the right direction. But buying a companies which are poorly executing is effectively buying a falling knife that’s going to generally has the tendency of making your hands bleed. I don’t like my hands to bleed. And there’s a very common tendencies, it’s a hard one to avoid. I’ve done it myself many times. So you know, I repeat myself, okay, my hands are gonna bleed hands are gonna be, don’t do this, it’s gonna hurt. And that’s how I stopped myself.

Luke Hallard  21:29

I love this one, too, and it’s one I’ve been guilty of in the past. I think as you said very clearly, though, if you understand why the stock price is declining, and if it’s maybe a broad market sell off, and every stock in that category in that industry is going down. Or maybe it’s okay to add to that position at a better value point. But if the company is declining, because it’s fundamentally broken, the thesis is broken, something very material has happened to the company’s really damages long term prospects. Well, that’s, as you say, when you can get your hands quite bloody chasing that loser.

Anirban Mahanti  22:01

Okay, so I’m gonna actually turn it back to you to give a quick takeaway, quick summary for our chat today.

Luke Hallard  22:08

Well, I think in summary, all of these trading strategies we described, they can have their uses, but you have to be aware of the risks. And particularly if you’re using exotic products, like shorting options and derivatives, really need to understand what you’re doing and make sure you’re using those appropriately. And when it comes to managing your emotions and managing your portfolio, I think just bear in mind, any trade that allows you to get rich quick, it’s probably going to allow you to get poor quick at the same time. So be aware of that, and how you’re thinking about your own investments.

Anirban Mahanti  22:43

In closing, it was a pleasure actually to chat with Luke. The first time we have actually cohosted a podcast episode together, and it’s lots of fun. Especially because we’re doing it across different time zones from the northern to the southern hemisphere. It’s great for those who are interested to to have a subscription to 7investing, especially to get Luke’s first stock. Pick for 7investing are coming on the first of February, you could go to actually 7investing.com/subscribe and check out what we do. I’m really excited about Luke’s first recommendation. I love it. The team loves it. Great growth story. And it’s a company for the future. So that I’ll say goodbye. And we’ll talk to you guys again.

Luke Hallard  23:30

Thanks, pleasure talking to you today.