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Sunday, 4 October 2009

The Case of the Delusional Investor

In which Sherlock Holmes demonstrates that closely following markets is bad for your health and your investments, derides the popular press and other tipsters and argues that market values in the short-term are determined by unpredictable psychological forces rather than foreseeable trends. And Dr. Watson discovers that following others is rarely a successful strategy and that his wife is unexpectedly loquacious in the morning.

"Ah Watson,” said Sherlock Holmes, “I see your stocks have declined in value once more”.

“Good heavens, Holmes,” I expostulated, “However did you know that? I don’t believe I’ve ever discussed my investments with you? To be honest I never thought you would be interested. Although I do have this interesting tip about the 4.3% Consols ...”

Holmes waved my best intentions away impatiently.

“You, I deduce, prefer to engage in risky stratagems for increasing your savings with no regard for the possible downside,” he said, gravely. “As a newly married man I’m surprised that you have so little regard for your wife. Or the child she carries that you have hurried here to inform me of”.

I admit that I dropped my copy of the financial paper in shock.

Holmes crossed the room with two strides of those long legs and folded himself into the armchair by the roaring fire. He gazed at me with amusement, his dark eyes twinkling at me from the deep recesses behind that aquiline nose; as they often did when he was musing over some personal triumph at my expense.

“Unlike you, Watson, I have no time for financial speculation. My savings are safely invested for the long-term on the best modern principles. With each fee I simply add a little more to my fund, at the lowest cost possible, without regard for the market's undulations and I shall not call upon it until I retire to a little cottage on the South Downs".

"Through the simple act of companies compounding their retained earnings and reinvesting dividends I will acquire sufficient savings to see me through my retirement," he added, carelessly, "regardless of whether markets outperform or not".

“But how ...,” I started.

“How do I know your investment habits?” Holmes shrugged. “Consider the copy of that paper you habitually carry. No one with regard for the long-term nature of investment bothers with the financial news. It should have as little effect on one’s investment behaviour as the migration pattern of the swallow”.

“By Jove,” I exclaimed, “Selling on the sight of the first swallow and buying on the departure of the last is the very latest technique. I was reading about it in the Bow Street Tipsheet just the other month. Although it doesn’t seem to have worked very well this year”, I added, sadly, thinking of the remarkable boom in stocks since I had sold most of my holdings earlier in the year, on the best advice of many of the country's most prominent financial experts.

Oddly enough most of these distinguished gentlemen now seemed to have forgotten their earlier recommendations and were discussing the great market recovery as though it had always been the most obvious thing in the world. It was extremely puzzling, but I was eagerly following their latest words of wisdom in order to determine the next best steps.

Holmes rolled his eyes and drew hard on his pipe. Swathed in smoke he waved a monograph on railway timetables at me, angrily. I thought gloomily about how badly my investments during the great Railway Mania had turned out despite the great hopes and claims of the promoters.

“Tipsheets, Watson, tipsheets. Do you mean your family to live in penury?" he scowled, "The people who can outperform the markets, if these mythical creatures exist, are not offering penny tipsheets to unwary souls such as yourself. They are investing silently, using other people's money to accrue great fortunes. The last thing they will do is reveal their secrets to the great masses who will destroy them in their haste to take advantage".

"Why aren’t these tipsters investing themselves if their investment knowledge is of any worth? Mark my words, Watson, these people are no better than travelling fortunetellers. Pah!”

“Gosh, Holmes", I said brightly, "apparently there’s this stock tipping soothsayer over on Grays Inn Road that everyone says is remarkably good.”

Holmes threw his timetable extravagantly in my direction. I ducked with difficulty and turned to face Holmes who was now pointing a red-hot poker at me. On one hand I remembered the disappointments with my investments in the new Bessemer Steel processes. On the other he did have my full attention.

“Your risky strategies are easily implied from the way in which the price pages of your newspaper are always well thumbed. Only someone unable to fully apprehend the value of their investments and therefore constantly in need of reassurance about their prices would bother checking so regularly. It is a mercy that there is no way for you to get constant price updates since I fear you would spend all day following the random twitches of the markets instead of tending to the malformed flock who grace your surgery”.

“Well now you mention it I’ve just ordered one of those new stock ticker machines for the office. I thought it would give me an advantage over the majority of investors”.

Holmes had dropped the poker and was busily preparing his morning fix as I said this. He now turned and thrust his wad of Chinese opium at me angrily. My mood darkened, as I recalled the hope with which I had invested in the promise of the East. More pounds turned to pennies.

“If you install that machine”, he hissed, “I shall visit you and break it myself like a modern day Luddite. You have duties – to your patients, your wife and your unborn infant.”

“Yes,” I said, remembering, “About the baby ...”

“Yes Watson, you need to develop a different approach to investing now that you are a man of responsibility. Mark my words, one of these days the modern approach to risky investment will lead to the ruin of the world. Put not your trust in the probity of your fellow man or the trustworthiness of governments.”

He put his arm around me, a gesture I found strangely touching, tinged only with concern about the blood flowing from his puncture wounds staining my suit and the tip of his syringe alarmingly waving around under my nose. He gestured at the bookshelves that constituted the walls of his study, floor to ceiling full of learned tomes on all the subjects he deemed important to his calling.

“Look here. How many books do you see on investing?”

I peered around me, daunted by the sheer volume of volumes. I shrugged.

“Precisely none. I need none because I know that the prices of stocks and consols are driven not by any of the endless changes generated by the ceaselessly restless and ingenuous financial business in its search to extract every last fee from the pockets of people like yourself. No, Watson, the key to successful investment is psychology, not finance”.

“Psychology? I’m sorry, Holmes, I’m not sure what that is. Do you mean the strange writings of the Viennese professor, Freud?”

“Poppycock!” exclaimed Holmes, whirling his arms in animated exasperation, “No I talk of the inestimable writings of the mentalist Dr. William James and the naturalist Mr. Charles Darwin, who between them have offered us an insight into the truth of human nature”.

“Darwin tells us that we are descended from apes, does he not?”, I said, trying hard not to picture the baboons we had seen at London Zoo the previous weekend, engaging in acts that I felt were not suitable for the eyes of my good lady whom I’d hurried away to an exhibition of the latest in communications technology given by the inestimable Italian inventor, Guglielmo Marconi, in whose company I had unhesitatingly invested on the Monday morning. In hindsight the lack of earnings or actual products was slightly concerning, but his telegraph was surely a world beating technology destined to dominate global communications for centuries.

“We are cousins, certainly. But we share many biases which are in-built and from which we can escape with only the greatest of difficulty. We run from danger and flock with the crowd for safety, actions which are of the greatest benefit to us in the course of our normal lives. Yet these are traits of the utmost danger in investment, where the beliefs of the masses are close to delusional. And Dr James explains that our world is constantly in flux and our emotions in flux with it, lessons most stock speculators should heed”.

“Gosh Holmes”, I frowned, “It sounds rather difficult.”

“Difficult!” exploded Holmes, “Have you learned nothing from your years as my faithful assistant? What could be simpler – we are all habitually controlled by inner urges we understand nothing of and influenced unconsciously by the people we spend our time with? These are the fundamentals of my trade, Watson, and you of all people should know this”.

“Well, I suppose so”, I mumbled, “but I still don’t understand ...”

“If you invest on the basis of short term tips and hints, if you spend your time watching your investments instead of earning an income through your skills, if you spend your money on whims and fanciful speculations and if you persist in acting upon your investments on the basis of the words of people whom you know not then you will end up in the gutter. Is that so hard to understand?” Holmes pointed a long finger at me, “Trust me on this, as a friend”.

“No, no”, I said, “I trust you implicitly old man. It’s just I still don’t know how you knew my good lady was with child. That’s astonishing”.

“Oh that”, said the Great Detective carelessly, “Well, your beloved met my housekeeper at the bakers this morning and she couldn’t keep a secret I’m afraid”.

Holmes suddenly smiled and offered me his hand. “Congratulations. Come, a new day beckons”.

And so saying, he threw my paper upon the fire and stood there, warming his hands upon the bonfire of my vanities.

Related Articles: Darwin's Stockmarkets, Contrarianism, Panic!


  1. “Unlike you, Watson, I have no time for financial speculation. My savings are safely invested for the long-term on the best modern principles. With each fee I simply add a little more to my fund, at the lowest cost possible, without regard for the market's undulations and I shall not call upon it until I retire to a little cottage on the South Downs".

    By taking the "best modern principles" on faith, Holmes has learned just enough about investing to be truly dangerous. He has convinced himself that he is not engaged in speculation, but he is recklessly ignoring the price at which he is buying stocks if he makes purchases "without regard for the market's undulations."

    Say that Holmes began buying stocks in January 2000. Going with those "best modern principles," he invested heavily in an asset class likely to pay an annualized return of 1 percent real for the next 20 years and took a pass on an asset class with a government guaranty attached that was offering 4 percent real (Treasury Inflation-Protected Securities). That's a 3 percent differential every year for 20 years running.

    Had Holmes never heard about the "best modern principles" for investing, he might have paid heed to his common-sense understanding that stocks are not the place to be after the most insane bull market in history had been raging for 25 years. He could have invested more prudently and had a much larger portfolio to invest in stocks when prices returned to reasonable levels. And the miracle of compounding returns would have applied to that huge differential for decades to come, making the payoff for going with common sense bigger and bigger and bigger.

    A true detective would have wondered why our earlier attempts to persuade ourselves that price doesn't matter all ended in mass financial ruin. The reality, of course, is that there is nothing "modern" about this idea. It is the oldest Get Rich Quick scheme in the book. The tipoff is that the marketing slogans have been repeated so many times that everyone who has heard the "wisdom" that "timing doesn't work" or that "stocks are always best for the long run" has come to fancy himself a Sherlock Holmes.

    When everybody who knows how to turn on the television set or buy a magazine thinks he is Sherlock Holmes, there's a good chance that nobody really qualifies. When large numbers of people open themselves to the idea of checking whether the marketing slogans stand up to scrutiny, it will be safe again to invest in stocks.


  2. Lovely post Timmar. Deserves to be super widely read!

  3. i'd be interested (by jove) to hear what you think of this: giving ichmoku clouds, elliot waves, tipsters etc the bird is a fine rule, but you, and holmes (of all people), seem to have no interest in the positive virtues of balance sheet reading, or in thinking about the general political/economic climate and timing investments accordingly.
    you ought to remember that holmes was notorious for long bouts of violin playing if he'd done his research & had no immediate lead to chase, while watson paced and fretted. i'll bet he timed his buys like the best of them...
    and the other thing is: you don't have to beat all the people, only the thick ones. behavioural finance is about controlling your own fear and greed, and exploiting other people's.

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  5. In rough order:

    1. I think balance sheets are very important but invariably fail to tell the whole truth. But I believe that value investing does work over the longer term, if you have the patience and courage to stick with it, and I write about it occasionally.

    2. I think worrying about the general political/economic climate will usually lead people into making horrible mistakes. The future can't be predicted from the past and a good job too. In such a context timing is usually a fairly hopeless activity. I write about this too, rather too often I suspect.

    3. I agree that behavioural finance is about controlling your own fear and greed but research generally suggests that this is very difficult for most people most of the time. And if you only do as well as the market you'll be beating most of the thick people to start with.

    And I do write for thick people too, you know ...

  6. ouch, by jingo.

    i like this blog very much, but mayyybe you tend to say 'know thyself' without saying 'test thyself'. you have to take the action in order to know; & so humility and humour should be advanced parallel to balance sheet analysis. otherwise maybe the fear and greed are lurking unexposed. the Psy is for Psychoanalysis, right?

    i'll read the value-investing posts again....