The Tycoon Report

The Unseen Danger of Too Many Options

Thursday, September 17, 2009 | Bob De Dea

This isn't an article about holding too many options contracts in your account, though that can be a real concern, and though that does parallel our topic.

But if you have a tendency to hold on to your losers and believe too strongly in your winners, or if you haven't yet developed habits that limit your potential loss (and sometimes your potential gain), then read on.


Fear and Loathing on Wall Street

As I've written before, fear can be an excellent, if misguided, motivator. We do things all the time because we're afraid that something bad could happen, often preventing ourselves from experiencing our lives to the fullest, thinking we can control every element so as to avoid pain and loss.

But we can't. Bad things happen to the good and the bad alike. Fate is not fair.


I'm not talking about sensible precautions like fastening your seatbelt or taking an aspirin a day when you've reached the ripe young age of 50 or saving up for retirement. I'm talking about those things that cause knee-jerk reactions in our psyches.

For investors and traders, fear can keep us from entering the market, from exiting the market, from considering options, from learning about futures, from expanding our portfolios to include Exchange-Traded Funds, and so on and so forth.

The flipside of fear, though, is equally debilitating, and we Americans are especially prone to succumb to its lure. This is, after all, "the land of opportunity," so it's always a good idea to keep our options open, right?

Wrong.


I Can't Do Anything Better Than You Can

Why are we so consumed with the latest and the greatest? Why do we have to upgrade to a newer, faster computer when the one we own now is perfectly fine since all we use it for is word processing, opening spreadsheets, sending e-mails and watching YouTube videos?

We don't know if we'll ever use the extra bells and whistles of a new toy, but we're afraid that someday we might, so we convince ourselves that we can't live without 'em.

So we buy an SUV just in case we happen to get pushed off a country road. And we purchase that extended warranty on the DVD player, even though most never fail within the first five to seven years.

We want insurance.


But leaving ourselves with too many options can have unintended consequences.

For example, I have many friends who want their kids to be well-rounded individuals, so they enroll them in gymnastics, teach them piano and violin, register them for drama camp, make sure they practice their Spanish, and expect them to be committed students.

Sure, kids need to have many experiences, but expanding their possibilities to an unmanageable degree can deprive them of the chance to become really good at one thing. Not to mention, the time that they could instead be spending with their parents is drastically reduced.

When we aren't sure what's important -- or, more exactly, when we think something may be important -- we can act like chickens without heads, running to and fro among things we hope will prove to be worthwhile. As Dan Ariely writes, in his book "Predictably Irrational," "It's a fool's game, and one that we are remarkably adept at playing."


I Don't Know if I Want it, But I'll Take it Anyway

When we're afraid of running out of options, we'll sometimes do anything to make sure we don't close the door to any opportunity.

This can backfire by preventing us from making any choice that excludes the other possibilities, so that we try to master each possibility (any of you ever tempted to learn everything you can about ETFs, options, futures and commodities trading?), thereby losing the chance to gain the expertise to do any one thing to the best of our ability.

In fact, we're likely to hold on tightly to our "doors of opportunity" as long as possible, sacrificing certain benefits merely for the privilege of keeping those doors open. This is, frankly, irrational.

We can't afford to forget that there are consequences for our indecision.



Hocus-Pocus to Learn to Focus

Once again, it's the idea of loss that enters our mental framework and allows fear to take us in its grip. It's the idea of loss that makes us hold on to stocks long after we should have cashed in on them.

Recognizing that we are predisposed toward such behavior, we should always use precautions, such as stop-losses and good cash management (e.g., not risking more than 3% of total holdings on any one trade), and refrain from buying things just because they're on sale.

(I'm referring to the price of stocks in the current market here; what if the recent correction downward isn't temporary but is a return to normal after a long dance with excess?)

We have to come terms with our preconceptions. Ariely points out that "previously held impressions can cloud our point of view," whether in religion or politics or sports, and whether we realize it or not.

To test this, he set up an experiment wherein he offered hundreds of students at MIT the choice between two beers, one a standard commercial beer (Budweiser in one instance, Sam Adams in another) and the other was the same brew laced with balsamic vinegar.

A majority of those who didn't know beforehand about the tainted brew chose the one with the balsamic. But when they were told upfront about the addition, most people wrinkled their noses and chose the plain suds.


It's All About Expectations

The important part is that they did so, not because their experience told them so but because of their expectations. When the students were informed, after they had already downed the beer, that the drink was adulterated with vinegar, these continued to prefer the balsamic beer as much as those who were told nothing.

So if we believe something will be good beforehand, our expectations generally make it good. The same holds true for the bad.

It also holds true when something is described in greater detail. (Think about a "lemon pepper, pine-nut-encrusted grilled King Salmon fillet on a bed of wild brown rice laced with jasmine and lemon juice," or those penny-ante stock offerings that go into great detail as to why now is supposedly a good time to invest in "SunRay Technologies.")

Or, if something has been propagated as a fact for a long time, we tend to buy it without question.

(Did you know that double-blind studies have shown that the shape of the glass doesn't have any effect whatsoever on the taste of the wine poured into it? Yet people insist they perceive a difference when drinking from the "properly shaped" glass.)

On the other hand, how many of us would ever crave Jello if we thought about the fact that it comes from cow hooves?




Won't Get Fooled Again!

Marketing experts know how prone we are to trying the latest craze, and how afraid we are to miss out on a great deal. And the sharks online in the investing biz also know how to whet the appetite for another "door of opportunity."

Focusing on what's important in the long run and where our current strengths lie is what will inform us as to which doors we must let close.

In our personal lives, good relationships must be fostered; relationships that are going nowhere can be hard to end, but it's often necessary to do so.

It's often so in our financial lives.

Just can't grasp the whole futures thing? Options more your bag? Specialize if you need to. Stay focused on what you do understand and learn all you can to improve your investing.

You'll stay on the mark and find your nest egg growing. And that's the most we can ask from our financial education, isn't it?






Bob De Dea
Guest Contributor
The Tycoon Report