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Accounting Fiction

Jesse Livermore, a trader in Wall Street, once said, "There are only two emotions in the market - hope and fear." However the list includes doubt, suspicion, caution, confidence, fear, panic despair etc

Jesse Livermore, a trader in Wall Street's early days who made and lost several separate fortunes in the stock market, once said, “There are only two emotions in the market - hope and fear. The problem is you hope when you should fear, and you fear when you should hope.” Sounds a little too smug, doesn't it? What exactly does this mean? Loosely, it means that when a stock you are holding goes down, you keep holding it hoping it will rise whereas actually you should fear that it will fall more. And when an investment goes up in value, you do the opposite.

This is true for many of us. But fear and hope aren't the only two emotions at play in stock investing, there are many more. Here's the full list: doubt, suspicion, caution, confidence, enthusiasm, greed, indifference, denial, concern, fear, panic and finally, despair. This, according to many is the canonical list of emotions, in the proper order that investors go through when the markets go through a full cycle up and down. Naturally, greed comes when markets are at the top. In the list above, the emotions before greed are the ones that are felt on the way up and the ones after greed are felt on the way down.

Of course, the problem nowadays is that we don't know whether the greed point at the top is past or not. For months now, investors have been oscillating from greed down to panic and then back up to greed with occasional excursions to confidence and enthusiasm on the other side. But while these are the emotions that most investors do go through, the most useful emotional response - the one that can actually help - missing from practically all of us. We never admit mistakes. We hardly ever say to ourselves, "I made a mistake; I shouldn't have bought this stock. I'm going to sell it right away.” Instead, our normal response is to dig out the original rationale for making an investment and then going on pretending to ourselves that we were correct and that events would eventually bear us out and one day the investment would do well again.” As Jesse Livermore would point, we hope when we should fear.

The practical upshot of this is confusion between accounting entries and reality. We keep hearing advise about 'booking profits' and 'booking losses'. Professional investors understand exactly what these phrases mean but many others do not. This results in investments that have lost a huge part of their value but investors think that unless they 'book losses', they do not have to admit the mistake and can therefore go on pretending that no losses have actually been made. Booking losses is accounting fiction that has relevance to taxation and related matters. In real life, a loss is a loss when the market says it's a loss, regardless of whether you've 'booked' it or not.

Curiously, 'booking profits' is also an equal source of mistakes if one confuses accounting with reality. Recently, I came across someone who had invested a very large sum in dividend paying mutual funds. The logic was that the continuous dividend payouts enabled profits to be booked. However, because this investor doesn't actually need the money, the dividends were all reinvested back into the funds. This is the opposite problem - the profits are just accounting fiction - because the money has gone back to the same investments, there are no real profits.

From not admitting losses that have actually been made to recognising profits that are not actually there, the unwillingness to recognise reality can be a problem in investing.