Losing money in a bull market! How do retail investors manage to do that?

This is a comprehensive analysis by Xue Hongyan.

It is recommended that novice investors consider investing in index funds. Get on board at the beginning of a bull market, quickly increase your position, heavily invest to embrace the bull market, and lightly invest to deal with a bear market.

Considering the weakness of human nature, most people cannot resist the temptation: buying index funds is not exciting, and faced with a soaring market, few can control the desire to "do something."

Here, let's pour some cold water on everyone and analyze together how your actions are causing you to lose money in a bull market.

Trading Annual Fee Rate of 8.2% (Note: A-shares)

Recently, some have joked that a bull market is a meat grinder for retail investors. Many seasoned investors also lament that it is easier to make money in a bear market than in a bull market.

Why can you make money in a bear market but easily lose money in a bull market? Charlie Munger answered this way,

"It's not bad ideas that usually bring you trouble, but good ideas. If something is a bad idea, you won't overdo it. But if something is a good idea, you can't ignore it, and then you are very likely to overdo it."

In a bear market, many retail investors do not participate at all, and those who do participate maintain light positions and do not frequently buy or sell. In a bull market, we often get too enthusiastic, over-participate, either frequently buy and sell, incurring transaction fees on profits, or easily go all-in or use leverage, which is excessive.

The year 2015 buried many painful memories for retail investors: leveraged bull to bear, consecutive index limit downs, fund B share conversions, margin calls, circuit breakers, one after another, reportedly ruining many middle-class families. However, as sellers of liquidity, securities firms made a fortune, with trading commission income reaching 269 billion yuan that year.

Retail investors lose their pants in buying and selling, while securities firms make steady profits. Therefore, every time a bull market starts, securities stocks lead the way because securities firms are the biggest beneficiaries of a bull market.

In a comprehensive bull market cycle, as long as the stock selection is not too bad and can be held, making money is not difficult. The problem for many people is that they cannot hold on, frequently change stocks, not only often missing out (selling stocks that keep hitting limit up, buying stocks that go nowhere), but also contributing a large amount of transaction fees to the market.

Buffett and Munger both attach great importance to the power of compounding. In their view, transaction fees are the biggest killer of compounding effects. During the buying and selling process, investors not only have to pay trading commissions but also bear costs such as transfer fees, handling fees, stamp duty, and other expenses. Individually, they may seem insignificant, but accumulated over time, they can be quite daunting.

Calculating with a stock trading capital of 100,000 yuan, if there are 100 trades within a year (buying and selling once a week), the total trading costs to be borne are approximately 8,200 yuan (trading commission of 0.025% charged both ways, transfer fee of 0.002% charged both ways, stamp duty of 0.1% charged to the seller, handling fee of 0.00487% charged both ways), resulting in an annual fee rate of about 8.2%.

In a bull market, restraining yourself, significantly reducing the number of trades, and earning an 8% profit in over a year, isn't that appealing?

Always Wanting to Do Something

It's challenging to restrain yourself in a bull market. Even Buffett couldn't help but feel the desire to always want to do something, just like ordinary investors.

Regarding how to cultivate patience in holding stocks, Munger frankly admitted that relying solely on character is not enough. He suggested curiosity as a solution. If you have a strong curiosity, "your ability to focus on reality will gradually improve." In other words, you will be too engrossed in exploring knowledge and truth to be concerned about stock fluctuations.

Munger's perhaps ultimate solution is to use desire to counter desire. Once you experience the wonders of seeking knowledge, the joy of watching the stock market will fade away. Unfortunately, 99% of people cannot achieve this. How can seeking knowledge be so wonderful?

The method of diverting attention does not work. Once in the market, we are driven by instinct to "do something," constantly trading without patience. Behind this lies a profound psychological mechanism.

Many people have experienced addiction, whether to games or a TV series. You are completely absorbed in addiction, led by one "hook" after another, eagerly following progress and waiting for mysteries to unfold. You can't move, can't take your eyes off, and even resist getting up to go to the bathroom. Your rational mind tells you it's time to sleep, but you let rationality sleep instead.

Well-designed games often include many levels and uncertainties because psychologists agree that intermittent rewards are more effective than continuous ones. As long as there is a possibility of joy, the failures and pains in between will only make you more determined and addicted. Similar to buying lottery tickets, the process of anticipating winning is more fascinating than the actual result.

In terms of intermittent rewards, the stock market is more powerful than any game. Being in it, occasionally making money or losing money, regardless of ups and downs, will bring you intense biochemical pleasure. Immersed in it for the long term, stock traders' mentality will gradually transform. They may appear increasingly crazy and irrational in the eyes of family and friends, yet they are deeply immersed, chasing biochemical pleasure through continuous buying and selling until the bear market arrives, the music stops, and they can finally rest their exhausted bodies.

What plays a role is not only the reward mechanism but also psychological responses such as consistency psychology, social identity effect, comparison psychology, and loss aversion psychology. Under numerous psychological mechanisms, you simply cannot stop.

Loss Aversion Psychology

Munger pointed out that bankrupt individuals share a common problem - they cannot handle "loss aversion psychology" correctly. Once they have invested time and money into something, they will deep down deny the possibility of failure, believing, "It must succeed. If I invest a little more, it will definitely succeed."

This psychology is widespread in stock trading. Once the stocks held start to incur losses, the loss aversion psychology kicks in, leading to typical reactions of increasing investment, buying more as the prices drop.

In a bull market, temporary losses are not a problem. However, under loss aversion psychology, stockholders tend to sell off their stocks as soon as they reach a profit, lacking the patience to hold on during losses but being impatient to make money during the rise.

The reason for selling off the stocks that have turned losses around immediately is to quickly erase the memory of the losses. Investors are tired of the torment of losses, so when the account turns profitable, they breathe a sigh of relief and sell off the stocks, ready for a fresh start. In a bearish market, investors' core expectation is to break free from the trap. After all, compared to a floating profit of 10,000 yuan, recovering a 10,000 yuan paper loss feels more like a moment of self-affirmation.

If the stocks you happen to hold keep rising and breaking new highs, most investors will develop "fear of heights," afraid of losing paper profits. They sell as soon as the car starts, then watch it leave them in the dust, too scared to get back in.

Enduring losses is one thing, but not being able to handle profits? What happened to "let profits run"?

In a bull market like a rising tide, all you need to do is learn from the ducks in the pond - do nothing, and the rising water will lift all boats. Yet, most people get lost in circles, missing out on opportunities and losing out on trading fees.

Busy as a bee, but not making money, while the index has already soared to the sky.

The Myth of Getting On Board

The best strategy in a bull market is to get on board quickly, increase your position, and wait for the rising tide. However, many people's first reaction is, how do you know it's a bull market? What if it's just a large-scale rebound?

Therefore, many people hesitate to get on board, hesitating and watching.

If you keep watching, that's fine, you won't lose anything. The problem is that watching comes with torment, especially under the stimulation of comparison. Seeing friends around you continue to make money, the pressure to get on board will only grow. At that point, to escape the torment, many people will enter the market at any cost, getting on board in the latter half of the bull market, often ending up as bag holders.

There is a saying, "If a company needs to update its equipment, even if it hasn't bought it yet, it is already spending money on it." Procrastination does not really save expenses; instead, it incurs significant hidden costs due to low production efficiency. Since you will eventually buy it, the sooner you do, the sooner you can start production, which is true prudence and thrift.

The same goes for stock trading - once you start watching, you will definitely get on board. If that's the case, then get on board early.

In reality, if you advise someone to get on board, you are likely to be disappointed.

Faced with a soaring stock market, investors who haven't gotten on board will experience cognitive dissonance. To eliminate this dissonance, they will find reasons not to get on board (or to have a light position), such as economic downturn, pandemic impact, trade disputes, etc.

"A person will believe what they want." At this point, investors see only risks and will not admit mistakes.

In this mindset, in the early stages of a bull market, investors are skeptical, tending to interpret the market as a false bull market, with any drop or adjustment seen as evidence. By the mid to late stages of the bull market, they can't resist the torment and finally get in, becoming stubborn and turning a blind eye to many risk signals, believing the bull market will last forever.

Getting on board or not, light or heavy positions, it's a psychological issue, not a logical one.

Turning Psychological Traps into Leverage

After all this talk, the biggest risk of losing money in a bull market comes from oneself, not from greed, but from various psychological traps: incentives, loss aversion, herd mentality, cognitive dissonance...

Faced with these instinctual psychological mechanisms, words like "patience," "discipline," and "contentment" seem pale. Smart investors will never confront them head-on but will try to avoid these traps as much as possible. An effective trading system will even turn resistance into leverage, using various psychological mechanisms for self-reinforcement. For example, Buffett's value investment emphasizes finding high-quality companies, buying at low points, and holding for the long term. In the search for high-quality companies, investors are required to invest a significant amount of effort in preliminary work. It is precisely because of the substantial upfront effort that, to avoid cognitive dissonance, once a selection is made, it will be easier to hold steadfastly.

Psychologists believe that significant sacrifices made by individuals in the process of acquiring a new identity greatly increase their loyalty to that new identity. For example, German officers were more loyal to Hitler because of their "blood oath," and members of the Mafia were more loyal to the organization because of their "omerta."

The greater the upfront cost, the higher the loyalty. Otherwise, it would be a betrayal of oneself first, leading to significant psychological pressure. The value investment philosophy emphasizes leveraging efforts, focusing on selecting good stocks in the early stages, making it easier to resist various temptations later on, and remain loyal to the chosen companies.

Furthermore, why emphasize buying at a low price? Buying at a low price is more likely to result in paper profits, effectively avoiding the "loss aversion psychology" that leads to a series of irrational behaviors. In the early stages of a bull market, emphasizing getting on board early follows the same principle - the earlier you get in, the thicker the profit cushion, allowing for a more composed approach.

In addition, value investing emphasizes operating only within one's circle of competence. Buffett said, "Charlie (Charlie Munger) and I like stable businesses like chewing gum, striving to leave more unpredictable things in life to others." Munger also said,

"We (Munger and Buffett) don't jump over seven-foot bars; we look for one-foot bars that we can step over with a significant return on the other side. So our trick is to do simple things, not to solve difficult problems."

By focusing on what one can handle, it not only helps strengthen confidence but also actively avoids uncertainties, sidestepping a series of pressures and potential irrational behaviors arising from uncertainty.

The Inescapable Cycle of Losing Money

A friend once asked me if she could invest in stocks. Her good friend recommended several stocks to her, all of which had performed well. My advice to her was to use some idle money that she wouldn't need within a year to buy index funds and earn some extra money.

Making money from stocks is a challenging task that requires not only knowledge but also patience, discipline, and the ability to overcome various psychological traps.

Everyone tends to have an overestimation of themselves, thinking they are different. Think about it, are you disciplined enough in your daily life? Have you achieved all the goals you set for yourself each year according to plan? How many pounds have you lost in your three-month weight loss plan?

If you haven't achieved these, don't fantasize about "what if I can." Don't underestimate the instinctual psychological mechanisms that have evolved over thousands of years.

Honestly, just buy some index funds steadily and earn some extra money.

However, I believe very few people can do it, including myself. These psychological mechanisms are so powerful that, under their resonance effect, many people still rush in.

Based on this, losing money in a bull market will continue to happen.

Reference:

1. Peter Kaufman, "Poor Charlie's Almanack: The Wit and Wisdom of Charlie Munger," CITIC Publishing House, 2016.