Financial advice
Let's analyze the biggest mistakes investors can make. In this article, we'll see how pride and anger can cause us to lose a lot of money, as happened to Blockbuster and Long-Term Capital Management.
Since the Middle Ages, the Catholic Church has grouped the most common human faults, calling them "deadly sins," as they were practices contrary to Christian teachings. Similarly, investors can also fall into these types of sins, or faults. Of course, they are not exactly the same, but they can cause us to lose a lot of money. And we must be cautious, because, as we will see, these are not mistakes typical of novices. Often, highly qualified and respected people can commit them. Let's see what they are.
First deadly sin: pride
Arrogance is defined as an excessive self-esteem, believing oneself to be better than others. It's closely related to pride, but even worse, as its purpose is to satisfy one's vanity. In general, successful people tend to be very arrogant, although there are notable exceptions. And in the world of investment, arrogance can be fueled by success after success, but when a mistake is made, the market quickly accommodates it.
This is what happened about 20 years ago. For those born in this millennium, I'm going to tell you things you might not know. When you got together with friends or family and wanted to entertain yourself at home, you went to the nearest video store and rented a movie. Aside from the local video stores, there were larger chains with an incredible collection of movies for all tastes. The great example in this regard was Blockbuster. By 2004, it had more than 9,000 stores worldwide.
But before that, some rather curious events occurred. A regular customer named Reed Hastings forgot to return his VHS.[1] and had to pay a $40 penalty. This seemed absurd to him... and he planned to launch a new business model similar to Blockbuster, but based on a monthly fee. By 1997, a company that will be quite familiar to us was born: Netflix.
Blockbuster's reign is threatened
By early 2000, in the midst of the transition from VHS to DVD, Blockbuster was the undisputed star. Warner Bros. had even offered it an exclusive deal for its films that meant the rental company would keep 60% of the profits.
On the other hand, Netflix, which had started as a DVD rental service mailed to every home, devised a new business: becoming an online video store, with the advantage of not having many employees or physical stores. To counter this, Blockbuster created the Total Access platform, which allowed customers to rent movies both in physical stores and online. New customers clearly preferred it: a 70% went to Blockbuster, and only a 30% to Netflix.
The incredible rejection
By 2000, Hastings met with John Antiochus, CEO of Blockbuster, and proposed a partnership so the two companies could work together. He offered to sell his company for $50 million. Antiochus found the offer ridiculous, dismissing it as a capitulation and a bit of a joke. He reportedly died laughing after leaving the meeting.
Back then, and especially until 2004, things seemed to be going well for Blockbuster. However, the company had several weaknesses that began to come to light: they relied heavily on penalties from people who delivered their movies late, and their online platform was loss-making.
By 2007, due to a conflict with one of the majority shareholders, Antiochus left his position and was replaced by James Keyes, another key executive at the company. He pursued a different strategy, seeking to diversify the movie offerings with candy, fast food, and snacks. He even went so far as to say that "Netflix is not on the radar screen in terms of competition."
We know the end of the story well: by 2013, Blockbuster had folded and disappeared[2]. Today, Netflix's stock market valuation is over $300 billion… that opportunity wasted by hubris prevented them from multiplying their investment no less than 4,000 times!
Second deadly sin: anger
Anger is a fairly common feeling for investors. You do research, analysis, and calculations, hoping the market will go in your favor. But often, this doesn't happen. Time passes, and the market continues to go against you. This generates in many investors an intense hatred for a stock, even leading them to believe that the stock knows we own it and that's why it's not going up.
Believe me, it's happened to me and many other investors. But remember, stocks don't have feelings: they don't suffer because they're cheap, nor do they gloat over others when they rise. If you want to have a laugh by calling stocks names, like "it's a mummy," "it's a POT," "we're POT-ed," go for it, but only for a laugh.
Selling stocks simply because you're angry with them isn't wise advice. It's best to conduct a cold, rational analysis of your target price and stick to it. Otherwise, anger may lead you to double down.
Long-Term Capital Management: the Dream Team
By 1994, a new giant had formed in the world of hedge funds. We're talking about Long-Term Capital Management. And when we say giant, it's because it was formed by some of the biggest names in finance. The founder was John Meriwether, former vice president and head of bond sales at Salomon Brothers. The board of directors included people like Myron Scholes and Robert C. Merton, who shared the 1997 Nobel Prize in economics for their method for valuing financial derivatives.[4]
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The business was quite unique and narrow-margin. They looked for correlated bonds that had differences in valuation, so they built long positions in the cheapest and short positions in the most expensive. The goal was to narrow that difference. Of course, the margin wasn't high, so they used a lot of leverage, or debt, to maximize profits. This reached 100 to 1 at times.
For 1995 and 1996, the fund's performance was excellent: a 401% return on investment. The following year, it fell slightly, but was still very good: a 271% return on investment. Since they weren't finding any business opportunities, they returned more than a third of the fund. However, they were still a giant fund: they managed a 51% return on investment in global fixed income.
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Things are not going as expected.
But 1998 was a difficult year. In May and June, mortgage debt problems caused some bonds to fall, resulting in losses for the 161st quarter. But by August, things had gotten worse, as the crisis in Russia prompted many investors to "flight to quality."[5]
The spreads between the bonds they arbitraged used to move 2 or 3 points in a few days, but on August 21, 1998, they moved 21 points. That meant a loss of 550 million for the fund. According to their arithmetic calculations, it was a 1 in 1 billion event... yet it happened!
As things got complicated and fresh funds were scarce (probably angry at the market), investors went back to the market to borrow money to cover their losing positions. However, fear began to take hold among investors as they realized there was a good chance they wouldn't be able to recover their money, since leverage had reached extremely high levels. Finally, the United States Federal Reserve intervened by bailing out 14 banks. The fund that had made so much money ended up losing $4.6 billion in just four months.[6] They undoubtedly had reasons to be angry, but the stock market doesn't know who's buying and selling, and it doesn't hold grudges against its owners.
[1] For the younger ones, think of a flash drive with a movie on it. It was a cassette with a tape that allowed you to watch movies. If you finished watching it, you had to rewind it, that is, move the entire tape back to the beginning. It took a few minutes.
[3] All nicknames given to Central Puerto, a company that started trading on Wall Street in a range of 16 to 21 dollars but recently reached 2 dollars.
[4] Yes, they are from the Black-Scholes method, which allows the value of call and put options to be calculated. I continue to insist that these are topics I do not wish to go into in depth, as it would be a source of confusion for both you and I.
[5] “Flight to quality” is a movement that occurs when a crisis is expected. Almost all funds sell positions in bonds or stocks that they consider risky and buy US bonds, as they consider them safer. This causes price falls. Argentina, for example, suffered greatly from this movement worldwide in 2018, and it was one of the causes of the significant devaluation of its currency.
This article is part of Chapter 4 of the book "The Pocket Investor Three: Investing for Life." You can purchase it in our store.
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