As you can see, I’ve spent some time upgrading the site in the last couple of days. I hope you’ll find the new Most Popular Posts and Tagging features helpful.

Since we’ve reached the end of the year (I’ll add a belated Happy Christmas to everyone) I’ve looked over this year’s posts and picked out the five I liked best. These range from the comic (well, I tried my best…!) to trading methods to biographical. In no particular order, I’ve picked:

You know you’re under Jesse Livermore’s spell when…
You know you’re under Jesse Livermore’s spell when you tell anyone who’ll listen that “there is nothing new in Wall Street”. You start talking about the size of the line you’re swinging. You often begin sentences with the words “There I was…” […]

Investing Books - A Lesson from History
In 1998 the investor announces that, having read Mr. Fisher’s book, he has decided to invest all of his money!!! in Coca-Cola. Here’s Coca-Cola’s stock price chart since 1997 (with all of the reviewer’s money invested in it!).

Accurate Stock Picks vs Precise Stock Picks
For example, the oil sands that I mentioned in Alberta were marginal or unprofitable at $20 - $30 oil. A big increase in oil prices would almost certainly give a bigger boost to oil-sand company’s profits than to Exxon’s. […]

Pyramiding, Locking in Profits, or enjoying the Ride
If you’ve never done much trading, the problem of how to deal with trades that move nicely in the right direction won’t seem like a problem – but it is. When a trade moves in the right direction you need to make as much money out of it as you can; remember that quote from George Soros I mentioned earlier this month, “It doesn’t matter how often you are right or wrong - it only matters how much you make when you are right versus how much you lose when you are wrong.”[…]

Jesse Livermore in 1907
February 1907 - exactly one century ago - was an exciting year for Jesse Livermore. In 1906, he had hit the big time - profiting by over a quarter million dollars - by shorting the market just before the San Francisco earthquake. It was at about this time that Livermore consciously began changing his trading style. He decided that the key to success lay in […]

I also loved the two guest posts in November from

Chuck Gray - Pretty Girls - You are Bad Trades

and David Wallace - Mathematicians and Physicists Emerge From Geekiness To Dominate Hedge Fund Trading

By the way, high quality guest posts that would be of interest to Jesse Livermore readers are still very welcome - you’ll get full credit for the post – attribution to your name (or pen name) and, if you have your own stock related blog or site, you can add a link to it.

Click on Contact near the bottom of the navigation links on the left-hand side if you want to send in a post.

And that’s it for 2007.

All I have to do now is to wish each and every one of you a stimulating, successful and – above all – a HAPPY 2008!

Morgan Stanley’s fourth quarter results are the most remarkable I’ve ever seen.

Last time, I talked about John Paulson’s mega profit from shorting subprime. While Paulson’s team was putting together a series of trades that gained $12 billion, their competitors at Morgan Stanley were putting together trades that have lost over $9 billion.

What’s remarkable is that Morgan Stanley’s record breaking loss came from a trading desk that took the same view of subprime as Paulson – they looked at the sector and saw a dog with fleas that was crying out to be shorted. Having seen this, they then constructed a trade that, in three months, lost them over $9 billion.

In this context, it’s easier to see the truth of Arpad Busson’s comment that the great merit of Paulson’s trade lay in its execution.

So how did Morgan Stanley’s traders manage to make record losses out of a correct prediction of subprime’s downfall?

The losses stemmed from the fact that they did not fully understand the debt market they traded.

Morgan Stanley’s team shorted subprime but hedged by going long supposedly solid AAA debt. The theory was that, if their short went against them, their long position in AAA debt would rise and cover the losses. They put approximately $2 billion into their short position and $14 billion into their long position.

The mistake the traders made – and they were not alone – was that although their long position was in supposedly AAA debt, this debt had been constructed from BBB debt using credit default swaps – known to those in the business as mezzanine.

According to Portfolio.com – who give a simple, animated explanation of how lower quality debt was transmuted into high quality AAA debt – financial professionals thought that BBB debt could be elevated to AAA through “diversity”: If borrowers were defaulting in Florida, they could still count on payments from California. But over the last year, different kinds of mortgages defaulted at the same time – leaving no money even for the supersenior AAA tranche, which was meant to be completely safe.

In fact, the AAA debt Morgan Stanley bought as a “hedge” is now worth only about 30c for each dollar they paid.

Although they’re putting a brave face on it – trying to spin it as improving their links with China - in order to remain sufficiently capitalized, Morgan Stanley has been forced to borrow $5 billion from the China Investment Corporation. The $5 billion comes at a high price – the Chinese are charging 9 percent interest. In a couple of years’ time, this debt will convert into CIC owning 10 percent of Morgan Stanley.

John Mack, Morgan’s chairman, says he is embarrassed by the results and Morgan will be reigning in its risk taking in future trading.

You can listen to Morgan Stanley’s webcast and Q&A session. (Until late January).

Further to my thoughts on Jesse Livermore and the subprime fiasco, I thought I’d make a near-end-of-year post looking at the biggest winning trade of the year.

The trade I’m talking about is John Paulson’s shorting the subprime credit markets.

Paulson’s NY based hedge funds have made a profit of $12 billion to date on these positions. If Paulson were to take a 25 percent personal cut of the profit, his year’s trading will have netted him a personal fortune of close to $3 billion – the largest personal sum anyone has ever made from a bet on the markets.

In comparison with Paulson’s profit, Jesse Livermore’s $100 million profit from 1929 is no mean feat - worth somewhere between $1 billion and $12 billion when adjusted for inflation.

In fact, Paulson’s personal cut is likely to be lowered as he is believed to share (an unknown) proportion of his earnings with the teams of analysts and traders who help run his funds.

Even in mid-year, before his position had been fully rewarded, Paulson had joined Forbes Rich list – the list of America’s 400 wealthiest people - shooting from nowhere to No. 165, equal with Oprah Winfrey. Paulson’s current position in the Rich List is unknown but it’s certain now to be considerably higher than the more famous Winfrey’s.

In addition to making vast amounts of money, Paulson also seems to share Jesse Livermore’s passion for the good things in life. Like Livermore, Paulson enjoys sailing and – according to Bloomberg - he lives in a 28,000-square-foot, or 2,600-square-meter, $14.7 million home off Fifth Avenue

When Paulson was raising money last summer, he claimed that “in his entire career he’s never seen such a big opportunity.”

Kyle Bass, who runs Hayman Capital, a Texas hedge fund, is quoted by the Financial Times saying the short credit trade is “by far the best risk/reward position I have ever seen”. One of Paulson’s investors told the FT: “He’s really made a lot of money out of what has in essence been quite a conservative bet. There’s no doubt it’s been one of the greatest trades of all time.”

At the end of September Paulson told investors he saw “only” a further 30 to 40 percent in the trade – and it made almost 22 per cent in October.

Paulson took positions based on buying credit default swaps on mortgages. The value of these instruments increases as the risk of default increases.

Arpad Busson is another hedge fund manager with a taste for the high life. He is one of Elle Macpherson’s former partners and has been romantically linked with actress Uma Thurman. Busson’s EIM group has money with Paulson.

According to Busson the great merit of Paulson’s trade was not merely the prediction of the crisis, but also the execution of the trades. Paulson – and several other managers – constructed complex portfolios of the instruments they believed would be worst-hit, rather than just shorting an index.

Portfolio managers talk about risk not in terms of loss but in terms of variability of their returns. This way of looking at risk can also be valuable to stock traders.

Jesse Livermore, one of the world’s most famous speculators, was known for plunging - risking all of his available assets plus a large margin from his brokers in single trades. In addition to making fortunes, he lost them too. Although Livermore’s trading tactics are as relevant today as when he used them, his management of risk often left much to be desired.

Risk

You take a risk every time you drive to work or cross the street. You take a risk when you dine out. You take a risk when you trade shares hoping to get rich.

What Does Risk Mean?

Each example above describes an action you take to get something you want. However, there is also the possibility of an outcome you don’t want - be that serious injury in a car accident, food poisoning in a restaurant or losing money in your stock-trading activities.

To trade stocks successfully, you need to understand risk.

To professional portfolio managers, a high-risk portfolio is one in which the returns are highly variable.

For example, here are the five-year track records of two stock portfolios:

Portfolio A Performance Summary

• Average Annual Return +39%
• Annual Compounding Rate +31%

Portfolio B Performance Summary

• Average Annual Return +6%
• Annual Compounding Rate +6%

Portfolio A, compounding at an average rate of +39% per annum, would be described as high risk, because the annual rate of return is highly variable.

Portfolio B, compounding at an average rate of +6% per annum would be described as low risk, because the annual rate of return changes little from year to year.

The portfolio manager’s definition of risk seems to be lacking because it fails to see the ‘risk’ that your rate of return is lower than you expected. There is a high ‘risk’ that you will not grow wealthy with Portfolio B.

On the other hand, how many of us would have the nerve stick with a portfolio (or a trading method) like A, that lost 20% of our funds in its first year? To that extent, we can sympathize with the portfolio manager’s definition of risk.

To further examine this definition of risk, which trading strategy would you rather follow from the two below? Which of the two would you be most likely to stick with after sitting down after the first year and reviewing your performance? Be honest now!

Results: $100,000 allocated to A will grow into $380,160 while $100,000 allocated to B will grow into $381,164.

Traders following strategy B would sleep more easily at night than those following A. Furthermore, many beginning traders using Strategy A would give up after their first year, believing their trading skills to be poor, even though Strategy A would reward them handsomely over a longer period of time.

For this reason, when you are choosing your first trading strategy, it’s important to consider variability of return. When you are testing strategies, you should select those which offer good profits AND have low variability in yield. This will allow you to build confidence in your methods. Later, you may be happy to accept higher volatility in pursuit of higher returns.