Pitfalls to Avoid in Inefficient Markets

In the days before computers were ubiquitous, people would receive phone calls from “brokers” who would offer free advice on stock picks. These “brokers” were in fact salespeople (boiler room operators). They would tout quick fantastic returns, with stories of instant riches on penny stocks. Because trades were not computerized, many stocks will be low float stocks. Therefore, if there were increased sales, opportunities exist where the price moves dramatically. One way operators will gain credibility from gullible investors, i.e. speculators, is by referring to a stock that has gone up as their previous recommendation. The investor will look at that stock and be impressed by “that recommendation.” The operator will then give out a “free” recommendation. The operator will call 100 people. The operator will then say the stock will go up to 50 people and the stock will go down to 50 people. It’s a numbers game. If the stock went up the following day, then the operator will call back the 50 people with the “right” call. Now, the operator can sell a target stock to those investors. The boiler room may have acquired at a very low price that needs to offload shares. These investors will then become suckers.

The Sheep of Wall Street

If you have ever seen or read “The Wolf of Wall Street,” you know that the only ones who became rich were the salespeople. Although Jordan Belfort went to jail, he left behind probably thousands of victims who did not get their money back. I don’t recommend buying the book, because who wants to read about a swindler who stole money to have a never-ending drug-fueled party, and then pay the price by going to jail for a 22 months. Also, I am surprised why anyone would pay $2000 for his persuasion course. With Leonardo DiCaprio playing the role, it may be easy to confuse the person who stole millions with the likable character on screen. Personally, I could not even finish watching the movie. Ironically, the film has a controversial investment from 1MDB (Malaysian sovereign wealth fund). This may have come from embezzlement of the fund. I will speculate that maybe DiCaprio will act in a movie as Bernie Madoff, producing a likable role which gives “valid reasons” why he stole billions.

It is interesting that the financial markets are self regulated and these types of operations still exist today that target unwitting investors. When I was in the financial advisory industry 8 years ago, I too have received this type of call. Although it is not common to get these calls, there are many phishers who will call for “official business.”

Wolves Using Technology

Today, there are different forms of boiler rooms. These marketers, copywriters, and salespeople use emails, websites, and print mailers. Promotional newsletters are required by law to disclose the compensation they are receiving for marketing companies and their stock. However, like many legal notices, it is written at the end with very tiny print. With copywriting, these newsletters are very persuasive. Similar to boiler room calls, the newsletters may offer their services for free or a small subscription fee. They will entice your greed by promising incredible returns and quick riches. Many will tout penny stocks that recently went up. Similar to fake news of recent focus, many of these newsletters will set up multiple websites to spread their “recommendations.”

With the use of technology, websites and emails can reach millions of people. For some to take action on these free “recommendations,” which drives up the penny stocks’ price with above-average volume. Eventually, the emails stop going out and the volume drops, along with the price back to worthlessness. Those who bought as the price went up, now hold onto shares that are most likely at a loss. Only now they can hope that the price goes up, but the newsletters have moved onto the next stock pick.

Lately, some are offering “education” on how to trade penny stocks. Some are legitimate and offer many opportunities to gain through trading and community in chatrooms.  But caution is needed when joining those communities. Chatroom chatter can cause a penny stock to spike during trading hours. Enough traders will jump in, based on chatroom rumor. Also, Twitter and Stocktwits are prone to many accounts promoting penny stocks. Fake news is not new in wall street. Even an ‘objective’ article in Seeking Alpha may cause a stock to move based on ‘research’ of the company. Technology is beneficial is many cases, but it can be abused to detriment of many investors.

Avoiding the Pitfalls

As the saying goes, “There is no such thing as a free lunch.” Many times, I’ve tried to follow a hot stock pick from a friend, online, or even on CNBC. Majority of the times, I lost money following those “recommendations.” So here my suggestions to protect your hen house.

Invest in your own education. Get to know yourself, and your own psychological bias when it comes to trading/investing. I highly recommend Dr. Van Tharp’s books and training courses.

Focus on one type of investment at a time. There are many ways to invest besides stocks. There are forex, futures, mutual funds, options, ETFs, private placements, IPOs, bonds, warrants, etc.

Focus on developing one or two systems of investment before expanding. It is better to be an expert with one system that will consistently make you money. Develop a system that fits your style and does not hinder you from sleeping at night. Investment should add to the stress you face daily.

If you are still losing consistently, reevaluate. The system may not have positive expectancy. Bias may be a bigger factor on the system and profits. Maybe more back-testing is needed. Or maybe the system is not optimal in present market conditions. You are running uphill if you are implementing a short strategy in a prolonged bull market. Draw-downs are inevitable, but understand if this is normal within the system, or if this exceeds the system’s expectation.

If you are winning consistently, reevaluate. Consider the overall market. If the market is on a bull run, you may think you are a genius trader, but “a rising tide lifts all boats.” Look for market changes that may affect the winning system, turning it into a losing system.

Keep a trading journal. This will allow you to review your trades. You can take notes of where mistakes were made, and identify improvements to your system. Also, the journal will keep tabs on your exit strategies. Writing it down will help you with sticking to your rules. I recently learned about the Bullet Journal by Ryder Carroll. I have been modifying it to keep track of my trades. It is a vast improvement over keeping mental notes.

Avoid free advice, cheap advice, and expensive advice. Eventually, they all become expensive. Online, there are investment advice that cost nothing to thousands of dollars. However, there are many tools you can use for free that will help while you are in your learning stage. Follow your developed system and strategy. With time and experience, you will be able to discern and filter out bad advice.

Failure Is Guaranteed

How long will you simple ones love your simple ways?

~ Proverbs 1:22

We hear the words “risk free” or “lower risk” frequently in finance, especially from financial advisers. Does risk free, or low risk, actually exist, or is this an arbitrary sales pitch that people use to lie to us? I will state before writing this article that most people – especially Americans – will not be able to grasp anything in this post and should not read further. This topic is neither easy to understand, nor is comfortable to hear. I have quickly learned in my life that most people simply want to follow orders – they don’t want to create their own orders. Therefore, to rationalize why they’re following other people’s arbitrary rules, they use and create terms like “low risk” or “risk free” when reality offers neither of those.

Risk is ubiquitous. You will never escape risk. Suppose that I told you, “You need to get a college degree because it’s a guaranteed path to success in life” and you followed my instruction. Most of you would think I offered good advice. However, whether that’s good advice or not is completely relative to the time which I told you that advice. If I told you that advice when everyone also received that advice and followed it, the value of a degree would be significantly less because everyone else would also have a degree. At a conference I spoke at a few years ago, I asked a room of banking executives how many of them would be proud if their son became a plumber; none raised their hand. I then pointed out that I knew many plumbers who made four to five times what they all made and retired within five years of working because many of them could do weekly jobs for 5-10 hours total, earning $2000. That didn’t change their view and it highlighted my point that when people believe something is low risk, no amount of evidence to the contrary will change their mind.

Let’s look at a financial example: you’re earning 5% APR in a bank account and your financial adviser describes it as risk free. What you don’t realize is that inflation is about 4.5% that year, meaning that your real return is 0.5%. When your financial adviser says “risk free” what he means is that it is nominal risk free, or you will feel that you are taking no risk because you will see no nominal losses. In reality, you are barely breaking even because the price of goods is rising. Another financial example on the flip side of the coin is a financial adviser tells you to buy stocks to keep pace with inflation, as inflation is roaring 5-6%. You dump 80% of your money into stocks and you see it rising, but then the market drops 60% and inflation grinds to a halt. You suddenly feel the pain of loss (imagine $100,000 becoming $40,000) in addition to inflation staying next to 0. What you thought would prevent you from losing actually made you lose more. Finally, some of your friends buy stocks for pennies on the dollar and you watch as their cash that was “not keeping up with inflation” suddenly experiences multiples of 40 and 50. All decisions carry risk.

“The survival rate for everything eventually drops to zero.” You will die. I will die. Everyone will die. The end. Often, this sentiment is used to justify absolutely stupid decisions, and this is not what I mean when I write this. You should consider this when contemplating whether to take big vs. small actions in your life. When I write that “you should only trade with money that you’re willing to lose because losses are guaranteed” this is exactly what I mean. If you can’t handle losing $100, how are you going to handle dying? You will die and so will I. That’s reality. Loss is guaranteed.

Opportunity costs say that you failed anyway. Every choice you make inherently means you cannot make another choice at that given moment. If you invest all your money in US stocks for one year, that means you didn’t invest in Chinese stocks for that year. What this means is that loss is guaranteed in every action you make; success is not. If your idea failed, it didn’t only fail, but many of the other ideas you could have pursued in that same time also failed. Simply put: you’ve already lost. Now some people may find this depressing, but in reality it’s not depressing at all. Most of our best decisions happen because we failed in the same area or other similar areas, and it was those failures which strengthened us. This means that big wins will more than likely result from many losses, and we’re still guaranteed to lose the other areas of opportunity costs.

Consider same famous losers:

  1. John D. Rockefeller tried getting his first job ever for over three months and was rejected at every place he visited. He was such a loser and failure that he went back to the same places that had rejected him and tried again. And failed. He later became the wealthiest man in mankind’s history.
  2. Genghis Khan’s first major battle resulted in a loss. And it wasn’t just a minor loss, he was obliterated. Genghis Khan later built the largest empire in human history within a 40 year period, conquering people of many different cultures.
  3. In the battle of Shiloh, the Confederacy shocked the Union under General Grant with a surprise attack in the morning and pushed the Union army back toward the river. The Union suffered heavy losses in the first day of fighting and the battle looked like an absolute win for the Confederacy. The second day, however, General Grant assaulted the Confederacy with his back against the river – an unthinkable military decision, especially after facing massive losses – and forced the Confederacy to retreat. The lessons Grant learned in this battle later set the stage for the battle that changed the Civil War, the battle of Vicksburg – a battle which split the Confederacy in two.

Probability cannot be controlled or reduced. I fall over laughing when I hear the phrase, “We can reduce our risk by” as if you can reduce probability or manipulate it in anyway. Take any example on Earth that involves manipulating the probability of an event – such as using solar energy over petroleum for increase the probability of energy independence, but then consider that if the sun went all supernova on us, would it matter? We still lost. What we think you can control, we can’t. There is no “reduce risk” or “lower risk” – we are simply hoping that other probabilities remain in our favor (meaning there are too many variables beyond our control even if we isolate on probability to reduce the risk of). Everyone who says, “I can reduce the probability of [A] event by” completely assumes ceteris paribus, which doesn’t exist in reality.

Why bother then? Some readers may feel like “why bother then” if every decision carries risk and it can’t be avoided. Risk reminds us that we can only focus on what we can control in every situation, while accepting the humility that everything we do is not as significant as we’d like to believe. We can control:

  1. Whether we exercise due diligence when taking one opportunity over another opportunity.
  2. Whether we learn from our failure and loss and take full responsibility for it, even if some if it may be beyond our control.
  3. Whether we appreciate and value the choices that we do make.

You will fail, you might succeed, and you should learn.

The Truth About Coinbase and the IRS

What was the first chapter of my book, The Decentralized Retirement Plan? It covered paying your taxes; if you took my advice, you have nothing to worry about and can skip this post. If not, continue reading.

Coinbase provides a report that does not get sent to the IRS and only shows the transactions by purchases, incoming bitcoins and outgoing bitcoins. This is all they provide; this means that if you accept that all outgoing bitcoins are sells, then you would report those as sells. The same is true with incoming bitcoins; if that’s income, you need to report it as income.

Some of you may be like me and transfer bitcoin to a Trezor or another wallet, which is not a sale. You know this, so you will need to clarify this on your report of information to the IRS. Whether you want to provide a spreadsheet with amounts and notes is up to you; however, what you sold, you need to report on taxes based on the cost basis of what you purchased or received. For an example, if you bought 1 bitcoin at $500 and purchased many items at the cost basis of $700 per bitcoin, then you received a $200 gain and would need to report those transactions as such.

Reminder: since I like buying gold with bitcoin as I get a deep discount on gold, the best practice for this is to purchase the bitcoin then buy the gold so there’s no increased value of the bitcoin sold when you buy the gold. This would be like buying $10,000 worth of bitcoin and buying $10,000 worth of gold using bitcoin immediately.

If you sent 1 bitcoin to your Trezor wallet, then that’s not a sale. You could either include that on your report to the IRS as a transfer to “my other wallet” (I personally recommend this as I prefer to be upfront with the IRS), or you could simply not include it – but if you do the latter, you may be asked about this. If you transfer bitcoins to other exchanges and sell bitcoins on those exchanges, you will need to report these at their cost basis when you sell them based on the cost of purchase and the total made (or lost) when sold.

I don’t feel sorry for anyone who wasn’t doing this in 2013 and 2014 as you should have been complying with tax laws this entire time. Some of you have chosen to circumvent the tax system and you’ve learned that won’t work.

As for people who claim they’ll find another exchange to hide their bitcoins – in the long run, you won’t. The IRS is motivated by profits and is one of the few departments of the government that actually works because of incentives (basic economics); Coinbase is only the beginning. Pay your taxes. As for helping other exchanges, I’ve offered, but they don’t really seem to think they need to comply, meaning they are making your life hard. Complain to them.

Again, pay your taxes. And stop misleading new people: Coinbase never said that a transfer out was a sale, they made it clear that you will have to report what that transfer out is.