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Fortune Favours The Brave

My five year old has a funny sense of logic.

He has taken to climbing one of our bookshelves — something that not only drives me crazy, but that I see as an inherently risky game. Maybe I’m being overly worried as a parent, but given the state and position of the bookshelf, not to mention his (as yet) unhoned climbing skills, my fear is that he’ll end up hurting himself.

But everytime I tell him to get down his instant rejoinder is:

“It’s not dangerous, I do it all the time and I’ve never hurt myself!”

Well, he’s right, in a way. At least, until he isn’t…

What are the odds?

What my boy fails to understand is that it’s difficult to measure the probability of something happening using a relatively small sample.

For example, it’s entirely possible that I could flip ‘heads’ a total of seven times after ten coin tosses. That doesn’t mean that the odds of flipping ‘heads’ is 70%, just that the true odds will take longer to reveal themselves (if I flipped the coin 100 times, i’d get very close to the true odds of 50%).

I don’t expect my five year old to get that, but it seems something that more investors should understand.

Skill or luck?

A while back, a friend of mine started dabbling in ‘Contracts For Difference’ — or CFDs. A highly leveraged derivative product that, essentially, lets you bet on share price movements. They are, in my view, incredibly dangerous products, and have burnt many a finger of those silly enough to get involved.

Not one to be deterred by the risk, let alone his complete lack of sharemarket experience or knowledge, my mate dived right on in… And promptly made a fortune.

It was early 2007 and the market was flying. Everything he touched kept soaring higher, with already substantial gains made even more substantial due to the leverage provided by the CFDs.

Buoyed by his early success, my mate continued to increase the size of his trades. What point is there making a 60% return on a $2,000 investment, when you could do it with $20,000, or $40,000? And so he did.

There’s no prizes for guessing how this story ends — he lost the lot and then, due to the leverage involved, a whole lot more — but the point is the risks he was flirting with were masked by his early success. I told him (as delicately as I could) that this was bound to end in tears, but he thought I was crazy — after all, look how well he was doing!

In hindsight, the best thing that could have happened to him was to have his first few trades go against him. Yes, he would have lost some money, but it would be nothing compared to his ultimate losses, and it would have taught him an important lesson.

The same problem, inverted

Another friend of mine, a few years later when the sharemarket bulls had gone into hiding, decided he wanted to make some sensible, long-term investments in quality, dividend paying shares.

Great, I said, that’s a wonderful idea. Your future self will thank you!

My mate did everything right. She built a diversified range of solid companies, paying sensible prices and intending to hold for many years. But, as luck would have it, her portfolio managed to score a (paper) loss of 18% or so within the first few months.

She was devastated. My friend had worked hard to save all that money and in a mere blink of the eye she had lost nearly one fifth of it.

The lesson for her was clear — shares are super risky and best avoided. She sold out of her holdings and put the money into a term deposit.

The tragedy here is that today, had she kept her shares, she would have averaged a near 10% per annum capital gain (even though a couple have never managed to recover), and received a good bevvy of dividends along the way.

One swallow does not a summer make

There are few guarantees with investing in shares; even the bluest of the blue chips can prove poor investments in time.

Some things are certain though; the price of your shares will fluctuate all over the place in the short term, with no regard to what is happening with the underlying business. Losses can be severe, and can take a long time to recover. Some never will.

What you can’t do is take a small number of examples, over a short period of time, and use that as a basis for your future expectations. Fortunately, you don’t need to.

We have literally hundreds of years of sharemarket data, across many different markets around the world. And history tells us that shares, in the long term and on average, tend to be the best performing asset class.

Those that buy quality companies at sensible prices, and have the temperament and patience to see that value recognised by the market, have always done very well in the fullness of time.

Others, participating in the same market at the same time, but whose approach is to speculate on prices by trading in and out of positions, will almost certainly end up worse off. There will be exceptions, occasionally, but they will belong to a small minority — and to a large extent can be explained by dumb luck alone.

Foolish takeaway

Reference bias is the psychological flaw that leads us to assume that our own experience is representative of the wider one (e.g. my uncle smoked until he was 90 and was as fit as a bull, so smoking can’t be bad for you!). But it can lead you to make some terrible mistakes.

When you buy some shares it’s a near 50-50 chance you will see them drop lower in the days and weeks ahead — sometimes by a lot — but it says nothing about the merits of long term sharemarket investing. And that’s equally trueif your shares quickly and substantially gain in value!

But, if you apply a sensible approach, can keep focused on the bigger picture, and stay the course, you’ll likely do well — despite the inevitable bump along the way.

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