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FIGURE 20-2

Breaking Even Is Hard to Do

If you had bought JDS Uniphase at its peak price of $153.421 on March 7, 2000, and still held it at year-end 2002 (when it closed at $2.47), how long would it take you to get back to your purchase price at various annual average rates of return?

Even at a robust 10% annual rate of return, it will take more than 43 years to break even on this overpriced purchase!

The Risk is Not in Our Stocks, But in Ourselves

Risk exists in another dimension: inside you. If you overestimate how well you really understand an investment, or overstate your ability to ride out a temporary plunge in prices, it doesn’t matter what you own or how the market does. Ultimately, financial risk resides not in what kinds of investments you have, but in what kind of investor you are. If you want to know what risk really is, go to the nearest bathroom and step up to the mirror. That’s risk, gazing back at you from the glass.

As you look at yourself in the mirror, what should you watch for? The Nobel-prize–winning psychologist Daniel Kahneman explains two factors that characterize good decisions:

“well-calibrated confidence” (do I understand this investment as well as I think I do?)

“correctly-anticipated regret” (how will I react if my analysis turns out to be wrong?).

To find out whether your confidence is well-calibrated, look in the mirror and ask yourself: “What is the likelihood that my analysis is right?” Think carefully through these questions:

How much experience do I have? What is my track record with similar decisions in the past?

What is the typical track record of other people who have tried this in the past?3

If I am buying, someone else is selling. How likely is it that I know something that this other person (or company) does not know?

If I am selling, someone else is buying. How likely is it that I know something that this other person (or company) does not know?

Have I calculated how much this investment needs to go up for me to break even after my taxes and costs of trading?

Next, look in the mirror to find out whether you are the kind of person who correctly anticipates your regret. Start by asking: “Do I fully understand the consequences if my analysis turns out to be wrong?” Answer that question by considering these points:

If I’m right, I could make a lot of money. But what if I’m wrong? Based on the historical performance of similar investments, how much could I lose?

Do I have other investments that will tide me over if this decision turns out to be wrong? Do I already hold stocks, bonds, or funds with a proven record of going up when the kind of investment I’m considering goes down? Am I putting too much of my capital at risk with this new investment?

When I tell myself, “You have a high tolerance for risk,” how do I know? Have I ever lost a lot of money on an investment? How did it feel? Did I buy more, or did I bail out?

Am I relying on my willpower alone to prevent me from panicking at the wrong time? Or have I controlled my own behavior in advance by diversifying, signing an investment contract, and dollar-cost averaging?

You should always remember, in the words of the psychologist Paul Slovic, that “risk is brewed from an equal dose of two ingredients—probabilities and consequences.”4 Before you invest, you must ensure that you have realistically assessed your probability of being right and how you will react to the consequences of being wrong.

Pascal’s Wager

The investment philosopher Peter Bernstein has another way of summing this up. He reaches back to Blaise Pascal, the great French mathematician and theologian (1623–1662), who created a thought experiment in which an agnostic must gamble on whether or not God exists. The ante this person must put up for the wager is his conduct in this life; the ultimate payoff in the gamble is the fate of his soul in the afterlife. In this wager, Pascal asserts, “reason cannot decide” the probability of God’s existence.