Mind Over Money or Money Over Mind?
By Steve Gillman - January, 2013
People naturally hope they can think their way to wealth.
In stock investing this can be seen in efforts to use the power
of the mind to gain an advantage over the market. Investors think
that if they can gather enough information and develop a system
they can predict where prices will go. But just as often we are
mislead by the things going on in our heads.
Let's look at an example of how easy it is to think we know
more than we do, and how our minds can limit our access to more
information that we need. The following description (including
all the stock quotes) comes from a piece I wrote a few years
ago when I was actively investing in the stock market (I am not
now). I had begun to think I had a great strategy using covered
calls, which are options that I would sell on stocks that I own.
A call option gives the buyer the right, but not the obligation,
to buy the underlying stock at a given price by a certain date.
This should become clearer as we continue...
Sunoco (symbol SUN) is selling at $23.42 per share. It's a
solid company that analyst say is selling for about 8 times next
years projected earnings. It's relatively cheap, in other words.
If I buy 200 shares I'll invest a total of $4,689 ($23.42 times
200 shares plus a $5 commission).
As soon as I buy I can sell 2 options contracts (each one
covers 100 shares) giving someone else the right to buy the stock
from me at $24 on or before the third Friday of next month (32
days from now). The options buyer is gambling on the stock going
higher, and the market price is $85 for each option right now.
After the $7 commission for selling the options I would get $163
deposited into my account (2 options sold for $85 each minus
the commission). In other words, I will really only have invested
$4,526 total as of today ($4,689 for the stock minus the $163
I was paid for the options).
Now, suppose the stock rises to $26 by the time the options
expire. The option holder, who has the right to buy my stock
for $24 per share, will certainly exercise those options, and
so give me $4,800 ($24 times 200 shares). He can immediately
sell the stock for $5,200 (the current price of $26 times 200
shares), for a gross gain of $400. After commissions he has more
than doubled the money he invested in the options, and in about
As for myself, after the $10 assignment commission I get $4,790.
That's a profit of $264, or a return of 5.8% in 32 days ($264
divided by $4,526). What if the stock doesn't go above $24 by
the expiration date of the options? I'll still own my shares,
and at a net cost of only $22.63 per share because of the option
Think about this for a moment. It's a company I like and I
either make 5.8% in a month or I get it for .79 per share less
than the current price. If I wasn't "called out" I
could also sell 2 more options to make more money while I hold
the stock for another month. It is possible to make 30% or 40%
in year by repeatedly selling options, and so be ahead even if
the underlying stock drops in value. By the way, these kind of
opportunities are available all the time in many different stocks.
I've been making money doing this, but the market has been
up recently, making it easy for almost any strategy to show a
profit. Now, I like to think I'm careful in how I think about
these things, so I asked the question "What if the high
option price means there is a greater probability that the price
will rise?" If that's the case, is it a better strategy
to just buy the stock when the options selling for a high price?
After all, in the example given I would have done better holding
the stock as it went to $26 per share.
But there is no evidence that anyone can consistently predict
what the price of a stock will be a month from now. And since
they can go down, I like the protection of that .79 per-share
discount (the net premium I received for the options lowered
my cost). Sunoco could lose 3% of it's value (70 cents) and I
would still have a small profit.
My theory then, was that if stock prices in the near term
are no more predictable using option prices than by any other
means, and I can either get a better than average return for
the month or get the stock cheaper than the current price, this
has to improve my odds. I figure that most option buyers are
essentially gambling and pushing the prices of some options beyond
any value based on the true odds. If the odds are then bad for
the buyer (and most options do expire worthless) they must be
good for the seller; so I want to be on that side of the deal.
And if the price of the stock drops a lot, I can wait for a rebound
that usually occurs with solid companies.
Now to get back to how the mind works, what tried to enter
my mind unsuccessfully for weeks was the nature of the way the
stock market delivers returns. My mind told me that it has an
upward bias, of course, to the tune of about 7% annually. So
making 3% in month (or 36% annually) on stocks that nobody can
predict with any certainty will go down seems like a good bet.
Even though there are bound to be losses, the gains should outweigh
Stocks may average 7% returns annually, but they can rise
and fall that much in a week (in fact the market was up 7% last
week). And by using those options I am limiting the upside. The
most I can make on Sunoco in the example is $264. This is true
even if the stock went to $40 per share, making thousands of
dollars for those who didn't sell options on their shares! Meanwhile
my losses are limited only slightly. Even a good company can
have its stock price drop in half in a month for a variety of
reasons. If that happened in the example above, and the price
did not rebound over time, I would lose a couple thousand dollars,
which wipes out a lot of $264 gains!
I hope that my strategy continues to work. I have experienced
some losses, but the gains have outweighed them so far. But then
there is another factor which I did not anticipate. When a stock
drops in price and the options I can sell on it are no longer
high-priced, it is very difficult to generate much option income
as I hold and wait for a rebound (which may not come). But I
don't want to bore you with more details of stock trading.
The point is that I thought I knew more than I did, and my
mind in its infatuation with that investing idea didn't easily
allow contradictory information to enter for quite a while. In
fact, I clearly recall a moment as I was shaving when the idea
of the potentially large losses versus limited gains started
to present itself to me, and I recall that I quickly moved on
to other thoughts! Only later did I make it a point to think
about this possible flaw in my theory.
Mind and Money Lessons
We don't know that we don't know, which is a very difficult
concept to really integrate into our thinking. Our unacknowledged
ignorance allows for some big mistakes. Of course we have to
make decisions at some point even with incomplete information.
But we should keep in mind that no matter how certain we feel
about what we know, our knowledge is always incomplete. If we
do not understand this, the money we might make might temporarily
boost our confidence and so encourage us to do more of the same.
But the confidence is largely false, and the success somewhat
random, so confidence can simply increase the risks we take without
increasing our investing skill or business acumen. The money
affects the mind, in other words, possibly pushing us to make
even worse decisions.
To counteract this we should make it a habit to look for the
flaws in our own thinking. The mind wants to hold up an image
of itself as more than it really is -- our ego at work. The result
is an unconscious screening of inputs so that only evidence which
confirms our thinking is allowed in easily. Facts and ideas that
suggest we might be wrong are easily ignored, leaving us very
vulnerable to making big money mistakes. To combat this universally
human problem, we need to become more aware of how our minds
are working, and we need to habitually look for the biases that
are there and where those may be leading. In other words, we
need to constantly challenge and doubt our own minds to use them
Still, decisions need to be made. Should you buy that stock,
start that business, or take that job? We can never have all
the relevant information in any situation, and we can endlessly
analyze our own thinking processes. We face what has been called
"decision paralysis." What's worse, some research shows
that decisions get worse when we gather too much information
-- even when it is all accurate. So if you want to exercise the
power of your mind in the pursuit of money, try this formula:
1. Set a deadline for making a decision.
2. Gather a limited amount of the most important information.
3. Do your analysis.
4. Watch for and adjust for any selective evidence gathering
and biases in your thinking (and analyze everything all over
again if necessary).
5. Make a decision and act. Don't move that deadline too easily
either; you will never have all the relevant information and
your fears will remind you of this causing procrastination or
outright inability to do anything (decision paralysis).
6. Adjust course as you learn more.
This is about the mind and money, but of course it might be
applicable in other areas of your life as well.