The beauty scheme is one of the best known of the 36 strategies, but many do not recognise it as a strategy of disadvantage. It is used to distract opponents who may use overwhelming force. Its crude interpretation bears little relationship to the more sophisticated applications of this strategy in business and the markets.
Sometimes the real deception comes because people think they understand the strategy and so fail to recognise it when it is applied.
Trader’s translation: Greed makes the ugly appear beautiful.
In the market, beauty has a single characteristic – the opportunity to make considerable amounts of money. This beauty appeals to our greed, and greed clouds judgement, erodes discipline and encourages stupidity. These reactions form the beauty trap. This is a strategy the market uses most frequently and most successfully against traders.
The heart of this strategy is to charm the enemy so his judgement is impaired. Decisions are ruled by the heart and not the head. In this situation the enemy is ourself and our heart drives our emotions, clouding our judgement and assessment of the situation. We must recognise the situation where we are most likely to succumb to this strategy, falling in love with a stock. If we recognise this beauty trap, we can also use it to our advantage. Others fall into the same trap set by the market and their reactions are consistent. Emotionally attached to a stock, they provide us with the opportunity to sell them more of what they desire, and in the process deliver a profit, or a victory, to ourselves.
Those who use fundamental analysis methods based on company performance and operating metrics, sometimes called magic numbers, are most vulnerable to this form of the trap. This aspect of the beauty trap usually starts with the idea that an unloved stock can learn to fly.
The beauty trap is the way our analysis of a clear situation is influenced by our greed, which hampers our judgement. Applying the analysis steps, the investor “discovers” an unloved, fundamentally sound stock trading below his estimate of “correct” market value. The hidden gem is not necessarily beautiful, but his calculations make it so. The investor compares current market price with his calculation of fair value. The gap between the two adds a glow of beauty to his candidate. The larger the gap, the more beautiful the opportunity and the more difficult it becomes to make an objective rational judgement.
The trap is sometimes extended to include a selection of beauties, gathered together in a hot market sector. The trap starts with the hot sector because greed makes all these stocks attractive. They offer us a better opportunity for exceptional profits than other sectors of the markets. There are many genuine opportunities in a hot sector, but the beauty trap works when we let the emotions associated with this sector overrule our judgement in selecting a stock to trade.
The victim of the beauty trap does not select a strongly performing stock. He prefers the underperforming stock because he is influenced by greed. He believes this stock will catch up with the rest of the market sector, matching or even exceeding the performance of its peers. Traders who use charting and technical analysis are the most frequent victims of this beauty trap. A technical scan to locate underperforming stocks in strong sectors is just as dangerous as the search for stocks with magic fundamental numbers. The searches themselves are valid, but when we allow greed to influence the way we use the results, we are easy victims for the beauty trap. These searches always expose us to temptation.
The beauty trap is also found in losing trades and winning trades. One of the most intriguing questions in the market is this: “Why do so many people hang on to losing stocks?” They purchase a stock at US$1.50 ($1 approx US$0.63) and still have it in their portfolios when it is trading at 50 US cents. The victims of the first aspect of this beauty trap have ridden a steady downtrend from US$1.50 to 50 US cents.
Fall deeply in love and it becomes difficult to see the sometimes significant imperfections in your chosen partner. In the market, this is called falling in love with your stock, although it is a narcissistic love because you really fall in love with your analysis of the stock. The beauty trap corrupts judgement.
Greed is at the heart of the beauty trap, eating away at our sound judgement. A beautiful stock becomes more radiant and attractive as returns grow from 10%, to 30%, to 50%, to 100% or more. Those who hold the stock fall deeply in love with this beauty. Then prices decline as the trend comes to an end. The return slips back to 90%, and clear exit signals are given with a close below the trend line. They do not take action to close the trade because their judgement is deflected by the beauty of the existing returns and the allure of the trend rebounding to regain its previous highs.
The beauty trap influences our judgement and compromises our ability to trade effectively. Successful trading requires us to appreciate the beauty of the market and its opportunities without allowing this to become a distraction that stays our hand when the time comes for action to capture our profits.
This is the ninth part of a serialisation of Daryl Guppy’s book, The 36 Strategies of the Chinese for Financial Traders. Guppy is the founder and director of Guppytraders.com. He has written other financial market books and conducts regular financial training seminars in Beijing, Shanghai, Nanjing and other Chinese cities.
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