Editor's note: You won't win all the time as an investor. But you can avoid taking catastrophic losses. Today, we're revisiting a classic 2013 essay from Extreme Value editor Dan Ferris. As he explains, with a few simple steps, you can ensure that you're taking smart risks in the markets – and that your mistakes won't destroy your portfolio...
Tubs of Fun is a simple carnival game.
You throw a softball into a plastic tub from a few feet away. The object is to make the ball stay in the tub.
It sounds easy, but it's not. The ball is too bouncy and the tub is too hard. It's difficult to keep the ball from bouncing out of the tub. The player has the illusion he's throwing a ball into a container. But he's really just throwing it at a solid wall.
To make it worse, the worker running the game lets you take a practice throw.
First, he drops a softball in the tub... And it stays, because he's standing right next to the tub. Then, you throw a softball... And the ball he dropped in absorbs the energy from the one you threw, so your ball stays, too. But when you play for real money, you can only throw the ball into an empty tub.
If you're not the sharpest tool in the shed, you won't figure this trick out. But hey, it's a carnival game. Everybody knows you're not supposed to win, right?
Well, no. Not everybody...
Enter Henry Gribbohm, a tough-looking, tattooed young man with a toddler to care for and $300 in cash burning holes in the pockets of his dusty work pants.
On a spring day several years ago, Gribbohm walked into the Fiesta Shows traveling carnival in Epsom, New Hampshire. He walked out shortly after, his pockets empty and a large stuffed banana toy with a smiley face and dreadlocks draped across the top of his toddler's stroller. A news reporter said the funky banana toy was worth $149.
Gribbohm watched the worker do his little practice throw routine and didn't figure out the ruse. So Gribbohm played and played... He lost $300 within minutes, all he had in his pockets. He went home and fetched another $2,300 – all that remained of his life savings. He returned to the game and lost all that, too.
He admitted on camera, "You get caught up in the whole double-or-nothing-I've-got-to-win-my-money-back..."
The thing is, many investors are walking in Gribbohm's shoes every day. They're making exactly the same mistakes...
Now, you might think the first mistake I'll point out is that Gribbohm was gambling.
It won't be.
Plenty of people gamble without devastating losses. Gambling doesn't guarantee devastating losses – nor does it indicate a grand character flaw. It's fine, as long as you limit losses and understand it's pure entertainment spending, not a legitimate attempt to increase your net worth.
In other words, it's fine – as long as you know the game you're playing...
Gribbohm's first mistake was ignorance of the game he was playing.
Gribbohm was on a financial mission. He started playing Tubs of Fun to win an Xbox Kinect video-game device (valued at about $100 at the time). When his first attempts were unsuccessful, he ran home, got more money, and kept at it.
Gribbohm later filed charges against the game owner, alleging fraud.
Yes, Gribbohm thought alleging a carnival game was fixed was a plausible defense for being clueless enough to give $2,600 away voluntarily. He kept plowing money into a carnival game... while being totally ignorant of the fact that carnival games are rigged.
You might think Gribbohm is uniquely naïve. But millions of investors are just as bad as he is. They have no idea that Wall Street is often about the same as a carnival.
Wall Street is in the business of selling stocks and bonds. This business generates billions of dollars in fees. It's a business that allows bankers to drive around in $300,000 cars... afford $10 million homes in the Hamptons... and collect absurd bonuses. That money comes from customers who are encouraged to buy every piece-of-crap security the bankers can come up with.
Think about the brokers, lawyers, accountants, and other people you do business with. Always ask what they get out of it. Ask what has to happen for them to make money. When you buy stocks, ask who's selling them, or who has sold you on the idea of buying them. Know the business you're in, and know the businesses you deal with.
Gribbohm's second mistake was pursuing easy financial gain.
Most people don't understand that easy financial gain is one of the worst things that can happen to them. Ask a lottery winner. According to author Don McNay's book, Life Lessons From the Lottery, the lives of lottery winners are usually a wreck within about five years of winning.
Lottery winners get a ton of money they didn't earn without any practice at hanging onto large sums of money. It's really, really hard to handle that. It's like ordering a drink at your favorite watering hole and being dropped into a giant vat of beer.
Technically speaking, you got what you asked for... just more. More is bad when you're not prepared for it... when you didn't do more to earn it.
Aspiring to easy financial gain might be normal, but it's also self-destructive. Gribbohm was trying to win a $100 prize by playing a $2 carnival game. His results speak for themselves.
Investors make this same mistake as well. They buy risky options and hot tips from friends in the pursuit of fast, easy gains. They see the stock market as a lottery... rather than a place where people can buy pieces of world-class businesses that they can hold for decades.
Gribbohm's next big mistake was giving in to a bias toward action.
Nobody likes to sit still. And that's too bad.
Famous 17th-century French mathematician and scientist Blaise Pascal said, "All men's miseries derive from not being able to sit in a quiet room alone."
If you search for Gribbohm's picture on Google, you'll see that he's a tough-looking guy. You can imagine him giving in to pressure to "act like a man." Men don't refrain from action. Men act. They take dramatic and constant action. When the going gets tough, the tough get – you get the picture.
People think "doing something" is always the answer. Nobody thinks doing nothing is the answer.
On the flip side, the actions that keep you from losing your life savings at the carnival and in the market will certainly not impress other tough guys, nor attract women looking for tough guys.
Taking big risks is more likely to make you feel like a swaggering gambler, someone who's "not afraid to risk it all on a roll of the dice." It'll at least attract a fair amount of attention. Gribbohm got plenty of that!
Fear is the dominant emotion in the market at all times. When it appears greed has taken over, it's really just the fear of being left out. That fear drives people to constantly seek action.
The final mistake Gribbohm made was not knowing how far he was going to go.
Gribbohm's story shows you how crazy financial decisions can get, especially when speculating on great financial gain. He lost because he couldn't trust himself. He didn't decide beforehand how he would behave if presented with a game like Tubs of Fun.
What will you do if the stock market falls? What are your goals? I can't really answer any of those questions for you, but I can tell you what I'll do... I'm a dedicated lifetime buyer of equities. I do what I believe is enough homework to know which stocks to buy and which ones to avoid.
Other things being equal, when the market falls, I buy more of what I like, same as I do when chocolate-chip cookies go on sale at the grocery store. I want more cookies, so I like it when my money buys more of them. I like equity returns, too, so I really like it when my dollar buys bigger ones.
Every stock investor faces a huge list of unknowns. You're not in control of stock prices or interest rates or tomorrow's headlines. You must make your own behavior in the stock market the most solid, reliable of known entities. You must be in control of yourself.
At any point during his incredible losing streak, Gribbohm could have wised up and walked away... but he didn't.
Many investors are making the same mistakes he did. If you're one of them, wise up and walk away. And before you come back, make sure you learn the game you're playing.
It's a huge mistake to walk away from your losers too late. But you can also sell winners too early. That's why picking stocks is only a small part of how to succeed in the markets... Learn more here: The Expensive Education of Investing.
You need to know how to navigate risk... whether you're looking to boost your returns or limit your downside. But most investors don't understand this idea as well as they think. Find out if you're using risk correctly here and here.