To save for your retirement, you need to find a suitable investment vehicle.

Index funds are often touted as the best way of saving for retirement because they charge very low fees and they outperform most managed stock funds.

BUT: Even over long time spans, index investing will not necessarily turn a profit.

Here’s a chart of the Dow Jones from Yahoo Finance:

Dow Jones Industrial Average 1940 - 2007

There’s no doubt that, over long periods of time, tracking the DJI has delivered a decent return. BUT, there’s an awkward looking 20 year period between the early 1960s and early 1980s. During this period, you would have earned close to nothing in an index fund. Imagine putting away your money every month for twenty years for zero capital return. A grim prospect indeed! And there’s no guarantee that this kind of performance won’t happen again.

Don’t worry though – the obvious solution to this grim prospect is not to put all of your eggs in one basket.

My Tips for the Future

• If you’ve started putting money into index funds for your retirement, keep doing it.
• Add a little self-reliance and knowledge to the situation. Learn more about trading and investing to better understand the risks involved in saving for retirement.
• I personally don’t think it’s smart for anyone to put all of his or her retirement savings into localized index funds. Think about investing in three dimensions – time, space and asset-type.
  • Time: Use dollar cost averaging to your advantage – but be prepared to put larger amounts of money in when you think the risk-reward ratio of the investment is highly favorable.
  • Space: Diversify your assets geographically. It’s likely that for the next few years, economic growth will continue to be higher in Asia than in the West.
  • Asset Type: Consider stocks, currencies, commodities, real estate, and bonds. Whether you’re a fundamental investor or a trader, each of these asset classes will continue to offer opportunities in mispricing and in trending.

Learning to be masterfully inactive doesn’t come easily, but it pays.

The master himself said:

“The desire for constant action irrespective of underlying conditions is responsible for many losses in Wall Street even among the professionals, who feel that they must take home some money every day, as though they were working for regular wages.”

The Difference between
“Masterful Inactivity” and “Inactivity”

Inactivity means putting your feet up on some tropical island and wondering how the ocean got to be that beautiful shade of green-blue.

Masterful inactivity means that you’re not acting like a headless chicken, wasting your time and energy on dozens of trades. (Not unless you’ve got a computer program executing them.) If you take on too many trades, there’s a danger that you won’t see the forest for the trees.

Masterfully inactive traders listen, read, research and learn. As an M.I.T., you should be on the look out for the sort of trades I mentioned last time – trades where a trend is getting underway and where there’s a story that can help drive a significant price change. Masterful inactivity used to be easier than it is today. The Internet has made it all too easy to enter a big trade with as much thought as you’d give to choosing a pair of socks.

Above all, masterful inactivity means only taking trades where the risk-reward ratio is strongly in your favor.

Long term investors - Warren Buffett is the best-known example - prefer to leave their money in the markets to reap the rewards of compounding.

Jesse Livermore - a trader - thought this was unwise. His opinion was that, after a successful trade, traders “should make it a rule to take one-half of the profits and lock this sum up in a safe deposit box.”

In How To Trade In Stocks Jesse Livermore describes how he was staying in Palm Beach after a highly successful trade. He requested the telegraph operator to tell his broker in New York to deposit one million dollars from the trade into his bank account. After sending the message, the operator asked if he could keep the slip. Why? Livermore asked. The operator replied:

“I’ve been an operator here in Palm Beach for twenty years and that was the first message I’ve ever sent asking a broker to deposit money in a bank account of a customer.

“I’ve seen thousands and thousands of messages passing over the wire from brokers demanding margins from customers. But never before one like yours.”

What Wall Street Giveth, It Taketh Back

Edwin Lefèvre, near the end of Reminiscences of a Stock Operator, said prophetically:

“My study of the history of Wall Street justifies a belief that the same ticker which giveth also taketh away. The only kings that were not ignominiously dethroned were those who abdicated in time and ran away from the danger of destitution.

“And then I thought of other kings for a day. Men who were the leaders of the market after beating the game for millions were eventually beaten by the game in the end.”

Too Negative?

I’m not trying to be negative here - just realistic. If you’ve been taking big profits out of the market, put some of them aside occasionally to build tangible assets, like real estate.

Although cold, mathematical logic dictates that a successful trader should usually keep as much money as possible in the market, history gives another perspective - the perspective of traders who were once successful bankrupting themselves. Who’s to say we won’t suffer this fate? Turning some of our trading profits into tangible assets might not help us become kings of Wall Street - but we might make the grade as princes - and it should stop us sinking to the status of paupers.

Jesse Livermore wrote:

“Analyze in your own mind the effect, marketwise, that a certain piece of news may have… Try to anticipate the psychological effect of this particular item on the market. If you believe it’s likely to have a definite bullish or bearish effect, don’t back your judgement UNTIL THE ACTION OF THE MARKET ITSELF CONFIRMS YOUR OPINION.”

How can we apply Jesse’s thoughts in today’s markets?

When I’m looking for trades, two questions I always ask are:

• Is there a good underlying story to engage the interest of other investors or traders?
• Can I see the potential for a big price move?

The two issues are, more often than not, related.

After I’ve waited until the market has “given its approval” for a trade, and I buy into the early stages of a trend, I’m hoping that the trend will be solid enough to last for months – or even years. I’m also hoping the slope of the trend will be rewarding. If the slope is too shallow, I might ride the trend successfully, but make less money than if I’d picked a better trend.

The “story” behind the trade is an important one – because if the story is good enough, it can carry a trend for longer and take it to greater heights than is financially logical. In this context, probably the biggest story in recent years was the dotcom boom of the late 1990s.

The tech industry had a good story to tell and people bought into the story - that the internet was going to take over the world within a few years and bricks and mortar businesses were finished. You can see the impact of this “story” in the first half of graph I’ve pulled from Yahoo Finance comparing the NASDAQ with the S&P 500 at the time.

Performance NASDAQ v S&P 500 November 1998 - June 2001

What about the “Story”?
Buying into the dotcom/NASDAQ story and trend in 1998, or even 1999, and getting out when the trend broke, made a lot more money than buying the S&P 500 - whose “story” was weaker.

Of course, after the NASDAQ uptrend had broken, the big “story” was that the dotcoms were nearly all losing money - and even the ones making money had p/e ratios in the hundreds. The uptrend was over. The story was negative. The dotcoms’ fundamentals were appalling - it was time to sell short and double the profit you’d made on the way up.

Summing Up
When you’re trading, the “story” can be more important than the fundamentals.

Jesse Livermore made $100 million in 1929. By 1934 he had given it all back to the market. How could an experienced trader lose his entire fortune? Why didn’t Jesse Livermore follow his own trading rules? - rules that should quickly have closed his losing positions.

In 1917 Jesse Livermore had bought $800,000 worth of annuities to ensure his family had an income in case he lost everything in the markets. He knew from experience how strongly the market could pull on every last cent a trader had. He said:

“The reason I did this was not alone the fear that the stock market might take it away from me, but because I knew that a man will spend anything he can lay his hands on. By doing what I did my wife and child are safe from me.

“More than one man I know has done the same thing, but has coaxed his wife to sign off when he needed the money, and he has lost it. But I have fixed it up so that no matter what I want or what my wife wants … it is absolutely safe from all attacks by either of us; safe from my market needs; safe even from a devoted wife’s love. I’m taking no chances!”

So how could Livermore, who had explained the importance of his trading rules at length in Reminiscences Of A Stock Operator, fall into the trap that he had taken such pains to avoid - and taken such pains to protect his family from?

The answer is likely to be found in Jesse Livermore’s mental state. Jesse Livermore was prone to depression.

Winston Churchill was one of the world’s most famous depressives – he called it the black dog. When people suffer a serious bout of depression they can become completely disinterested in their normal lives and feel incredibly fatigued. Their energy is sapped and often they just want to sleep. They can behave in ways they would normally describe as abnormal.

It may have been Jesse Livermore’s misfortune to enter highly leveraged trades just prior to suffering a debilitating black dog. The trades could have turned sour while Livermore’s mind was elsewhere. Livermore was notorious as a loner. The losing trades could not be closed except with his authority, yet he was not in a fit state to give that authority – or perhaps in his depressed mental state he did not care that he was losing money – perhaps he even welcomed it.

I can’t believe Jesse Livermore, the man I came to know through reading Reminiscences Of A Stock Operator, would have permitted himself to betray his own trading principles to the extent that he would lose $100 million. It seems plausible to me that the man who lost the money was an alter ego – a Mr. Hyde who tore apart the achievements of Livermore’s more usual Dr. Jekyll persona. Six years later, Jesse’s Mr. Hyde won the final battle. Jesse, suffering another deep depression, took his own life.