John Wheeler is a theoretical physicist with a talent for memorable communication. In the nineteen-sixties he came up with the term “black hole” to describe the phenomenon we now know as…….. a black hole.

On scientific laws he offered: “There is no law except the law that there is no law.”

More generally, for anyone chasing knowledge, he said: “In any field, find the strangest thing and then explore it.”

So, in stock trading – or speculation – what is the strangest thing?

Surely it must be the large number of people willing to be losers so that others might gain.

Ours is a zero (or negative) sum game. On every stock index, one half of all shares traded must, on average, be traded for a loss, relative to the movement of the index itself. When trading fees and costs are taken into account, it’s plain to see that compared with buying the index there’s a net average loss associated with trading.

The winners must be a minority. So why on earth would anyone want to start trading?

Funnily enough, an answer comes from another theoretical physicist – the iconoclastic Richard Feynman.

In Surely You’re Joking Mr. Feynman, a collection of anecdotes about his life, he talks about his times in Las Vegas. Feynman, like Jesse Livermore, was a womanizer. He knew gambling was a sucker’s game but he liked visiting Vegas for the female company.

Here’s what he had to say about a visit to a casino:

….and she said “See that man over there, walking across the lawn? That’s Nick the Greek. He’s a professional gambler.”

Now I knew damn well what all the odds were in Las Vegas, so I said, “How can he be a professional gambler?”

“I’ll call him over.”

Nick came over and she introduced us. “Marilyn tells me that you’re a professional gambler.”

“That’s correct.”

“Well, I’d like to know how it’s possible to make your living gambling, because at the table, the odds are 0.493.”

“You’re right,” he said, “and I’ll explain it to you. I don’t bet on the table, or things like that. I only bet when the odds are in my favor.”

“Huh? When are the odds ever in your favor?” I asked incredulously.

“It’s really quite easy,” he said. “I’m standing around a table, when some guy says, ‘It’s comin’ out nine! It’s gotta be a nine!’

The guy’s excited; he thinks it’s going to be a nine, and he wants to bet. Now I know the odds for all the numbers inside out, so I say to him, ‘I’ll bet you four to three it’s not a nine,’ and I win in the long run. I don’t bet on the table; instead, I bet with people around the table who have prejudices – superstitious ideas about lucky numbers.”

Nick continued: “Now that I’ve got a reputation, it’s even easier, because people will bet with me even when they know the odds aren’t very good, just to have the chance of telling the story, if they win, of how they beat Nick the Greek. So I really do make a living gambling, and it’s wonderful!”

So Nick the Greek was really an educated character. He was a very nice and engaging man. I thanked him for the explanation; now I understood it. I have to understand the world, you see.

So, what’s the moral I take from this story?

Given the sheer number of suckers who make their way to Las Vegas hoping to win, but deep down knowing they’ll lose, and the numbers who lose money trading, it has to be that more people have an instinct for gambling than have an instinct for winning. They also like to experience the thrill of the game – whether it’s chasing the big win on the one armed bandits or on the trading screen. They like to talk about their experiences – “I beat Nick the Greek” or “I made 30% on the breakout.” Occasionally they’ll be lucky and have a big victory they can brag about. Losses are often kept quiet.

In addition to and tied in with the gambling behavior is the “I’m better than he is” attitude often seen in car drivers. Survey after survey shows the vast majority of drivers believe their driving is above average. Clearly it’s impossible for the majority to be above average at anything. People are systematically overestimating their own ability.

The trouble with trading is that a lot of books actually tell beginning suckers that, by following the advice of the book, they will become better than average traders. This reinforces their in-built car-driving/I’m better than he is attitude. Only bitter experiences and, sometimes, large losses change that.

For me, the willingness of traders to repeatedly lose money was the strangest thing in trading. What do you think?

A couple of my recent articles have been about ‘gut feel‘.

I’m writing about gut feel for the last time today – about how our gut feel for numbers – probability/chance in particular – is inaccurate. This is important because trading is a game of chance. We should trade when we have the highest expectation of success.

Most of this post is taken up with the Monty Hall game. If you’re not already familiar with it, Monty Hall can be a surprising introduction to how we misjudge our chances of winning. I’ll begin, though, with a quick look at birthdays.

Gut Feel Misjudges Birthday Probabilities

How many people do you think would need to occupy a room for a 50/50 chance that two of them share the same birthday? The answer is 23.

For a 99%+ chance that two people share a birthday, only 57 people are needed.

These results are counterintuitive. Our gut feel is that more people should be needed.

Gut Feel Misjudges Chances of Winning a Game

Another well-known example of how our gut feel gets confused about probability is the Monty Hall Game – named after the host of the 1960s television quiz show Let’s Make a Deal.

Each week, Monty Hall would offer the contestant three doors. Behind one door was a big prize and behind the other two doors was nothing. Obviously, the contestant had a 1 in 3 chance of choosing the winning door.

Let’s imagine that you are a contestant.

You pick a door – the blue one – hoping to win the prize.

Then Monty has a bit of fun with you. Monty knows which door the prize lies behind. After you tell Monty your choice, he opens one of the doors to show you that the prize isn’t there.

Monty then asks you if you want to change your mind.

So what do you do? Stick with your first choice or change?

I’ll give you a moment to make your choice – try to choose without reading ahead.

Made your mind up? Good.

The correct answer is that you should accept Monty’s offer and change your selection to the yellow door. Doing so increases your chances of winning the prize.

Now, I must admit when I first heard this puzzle, my initial instinct was to stick with my original choice – I didn’t think it would make any difference switching doors. Surely, after Monty had shown me one empty door, I would have a 50/50 chance of winning the prize whether or not I switched my choice of doors. But, no, that’s not the case. In fact, after Monty has shown you one empty door, there’s a two-thirds likelihood that the prize lies behind the door you did not originally pick. Let’s see why.

First, you are presented with a choice.

You have a one in three chance of choosing the right door.

Second, you choose a door.

There is a one in three chance the prize is behind this door. There is a two in three chance that it lies behind another door.

Now Monty opens a door.

In doing so, he changes your chances, if only you realized it. There must still be a two in three chance that the prize lies behind one of the doors you haven’t chosen. You have now been shown which of these doors doesn’t have the prize behind it. This means that choosing the final door – the yellow door on the right – has a two-thirds chance of winning the prize.

Summing Up

If we rely on gut feel in activities involving probabilities we are likely to make big mistakes.

There’s a stock market saying that bulls can make money, bears can make money but the pigs get slaughtered. Make sure you leave gut feel to the pigs and write your trading plans using predefined, objective criteria.

I want to talk a little more about how conditioned minds can prosper in trading. You’ll be relieved to know that I’m going to use a trader rather than a scientist as the example this time.

Jim Leitner runs Falcon Management in New Jersey. He has taken $2 billion profit out of the market in his career. Jim gave an interview to Steven Drobny for his book The House of Money. Jim’s mind has been conditioned by a huge amount of experience in trading, as follows:

• While studying international finance and Russian at graduate school, Jim worked half days as a “monkey” – a money broker trainee adding data from around the world to the big board for the brokers to see.
• While still working as a monkey, he started broking – calling small banks in the Midwest. He did this for two years.
• He then took a big salary cut to get more experience, working at J.P. Morgan, trading the Eurodollar market. Jim became an expert on euroswiss francs, eurodeutsche marks and europesetas.
• He then became an FX trainee with J.P. Morgan and then a currency forward trader.
• After a few years, Jim was hired by the Bank of America to run forwards, exotics and all currency trading outside the major currencies.
• He moved to Shearson Lehman as a proprietary trader.
• He moved to Banker’s Trust and spent five years trading currencies.

With all this experience behind him, Jim was asked whether he has an innate trading skill and can “just tell” when prices are out of line. He answered:

“I don’t have an innate skill. It comes from being extremely interested in markets and looking at everything all the time. After doing it for years I’ve developed a mental database of where things should be, such that when something makes an irregular move, it shows up on my radar screen. I used to have so much fun playing around in the market and knowing that I knew my markets better than other people.”

So here again, is an example of a conditioned mind prospering where others fail. Where others might claim an innate skill or a gut feel for trading, Jim Leitner attributes his success to conditioning of the mind – a mental database – built up from many years’ trading.

Jim Leitner’s hedge fund, Falcon Management, has a website. You can find out their address and their phone number but nothing else.

I’m off now to condition my own mind.

I’ve heard experienced traders talk about trading on “gut feel.” Inexperienced traders need to be cautious about this sort of trading – if they don’t want to see their trading accounts clobbered.

What exactly is gut feel? I see it as the way our previous experiences have stacked up to guide our decision taking.

You’ll need to forgive me for bringing science in here, but scientists and traders have quite a few things in common – one of which is that we’re constantly trying to analyze data to construct the most accurate or financially beneficial models of our worlds. The astronomer James Christy’s discovery of Charon – Pluto’s moon – is a great example of using previous experiences to see the true picture.

After Christy discovered Charon he looked back at other people’s work and he realized that Charon had already appeared on many other images of Pluto – but people hadn’t seen it.

So why hadn’t the people who had analyzed the images before – and we’re talking about professional astronomers here – realized Pluto had a moon? It turns out that Pluto and Charon were closer together than anyone had ever expected a planet and its moon to be. The astronomers who had seen images of Pluto and its moon together had discarded them, believing the images were distorted because Pluto appeared to be “elongated.” The “elongation” was, of course, Charon.

The astronomers’ minds had been conditioned to interpret the images incorrectly. Here’s what Christy said about the discovery (from Planets Beyond by Mark Littman):

“When I first saw these exposures on June 22, 1978, I was looking with the mind and eyes of an astronomer who had examined roughly 50,000 images in recent years. Many of these images had been of double stars exposed in the course of the U.S. Naval Observatory’s extensive double-star program. I had seen dual images blended together in all possible circumstances by all combinations of image distortions. My mind was now attuned to two celestial bodies disguised as one. Now I could think: Pluto has a moon.”

Christy’s mind had been conditioned by years of experience to see the possibility that the elongation in images of Pluto was actually its moon.

In our day-to-day lives, our minds are conditioned and tuned – just as Christy’s was – on the basis of our previous experiences. When we use these accumulated experiences sub-consciously we call it gut feel.

The better the mind has been conditioned, the better the prospects of gut feel actions having a successful outcome.

When we’re trading, if our minds have been conditioned by years of observations and experiences during different phases of market behavior they can reach better conclusions than if they’re less experienced. The sort of gut feel that can sweep across stocks, commodity and FX markets and pick up more than its fair share of good trades doesn’t come quick and it doesn’t come cheap. It takes years of experience with plenty of costly mistakes along the way.

I recall a discussion I had around 5 years ago with a semi-sucker.

This particular semi-sucker had misunderstood a trading book. He believed it should be possible using money management techniques to beat the casino at roulette. Provided he could cut his losses (by leaving the casino when he was losing) and let his profits run (by continuing to play when he was winning) he was “bound to make money.”

Now, I know this gambling strategy sounds superficially similar to Livermore’s strategy of quickly closing losing trades and allowing winning trades to run: but there’s one crucial difference. Livermore’s strategy – through his tape reading and trend following – had positive mathematical expectation. ^*

The suckers who play roulette in casinos do so under the handicap of negative expectation. It’s the casino owners who enjoy positive expectation – why else would they be in the business? The direction of money flow is from a casino’s customers to its owners.

Money management can’t turn a game with negative expectation into one you can win – it can only keep you playing longer. All that our semi-sucker friend could hope to achieve was more nights at the casino. Eventually, the casino would take all of his money.

The same outcome awaits the sucker who begins trading when his mathematical expectation is negative. Unless he is lucky, money will flow from him to people who have better trading strategies than he does. If he wins through good luck, the more often he plays, the likelier it is that his luck will run out.

The good news is that some markets are more forgiving than others. Given the long-term uptrend of the major stock indices, it’s often possible to turn a profit on long stock trades, even if you have poorer than average trading skills. Your profit will, of course, be lower than if you had simply put your money into an index-fund. And, with below average skills/knowledge/strategy, you’re more likely to end up with a big loss than a small profit – especially if you trade frequently.

^* Mathematical Expectation: Your chances are 50/50 when you bet on the toss of a fair coin. If the coin is loaded, however, and it landed heads more often than tails, then betting on heads has positive expectation and betting on tails has negative expectation.

1. Market commentators say money’s going to be made by anyone who goes long volatility. You decide it’s time to:

2. Tomorrow is your birthday and you’re feeling good. To celebrate your birthday, you’re going to:

3. It’s vacation time. You’re on a tropical island and a street vendor offers you a bag of peanuts for 50c. You:

4. Selling short is inherently riskier than going long because:

5. The 3-6-3 rule is:

Check out what sort of trader you are on Spot the Sucker.

In his 1987 letter to shareholders, the masterfully quotable Warren Buffett said, “If you’ve been in the [poker] game 30 minutes and you don’t know who the patsy is, you’re the patsy.”

In the same letter, he said, “If you aren’t certain that you understand and can value your business far better than Mr. Market, you don’t belong in the game.”

Four Grades of Sucker

The equally masterful quote-smith, Jesse Livermore, categorized four grades of sucker:

The Beginning Sucker: has read little and knows little.

The Semi-Sucker: has read books about trading – usually written by higher-grade suckers. He can recite wise stock market sayings. He does not realize that reading books is not the same as trading experience. He loses money more slowly than the beginning sucker because he has learned some basic trading rules.

The Wall Street Fool: knows enough to make a profit if he sticks faithfully to his trading rules. The excitement of the market overpowers the fool; he trades more often than he should and loses his advantage over the market.

The Higher Grade Sucker: makes his money from selling trading books because he can’t make money in the markets.

Although Buffett and Livermore are at opposite ends of the financial spectrum in terms of buy and sell criteria, they wholeheartedly agree that if you don’t have some advantage over average market participants, you’ll lose money.

There are a lot of intelligent players in the markets and plenty of fools too. Unfortunately, too many stock market books try to persuade their readers that fools predominate, lulling the semi-sucker into a false sense of security. If only you will do what it says in the book (often with too little detail to put together a truly effective trading strategy) you’ll be successful.

Before you trade, you should have some idea of where your advantage is coming from. You should paper trade to verify your advantage.

Then you need to trade for real – this is hardest of all because once you have your own money in the markets, your emotional involvement increases. The emotions – greed and fear start kicking in – cause difficulties for many traders. Some find the advantage they thought they had evaporates.

So, do you call yourself a beginning sucker, a semi-sucker, a Wall Street fool, a higher-grade sucker or a successful trader? The best test is the direction of your trading account balance over several years. As an alternative, though, you could try passing the Stock Market Sucker Test.

I’ll begin with an apology to economists. If an untrained economist were to write an article about physics or chemistry, it’s likely he or she would be given short shrift. So don’t take what I’ve got to say seriously. My opinions don’t matter – all that matters is my ability to take a steady flow of income from the markets.

And now for a little history…

On March 10 1988, an opposition MP goaded British Prime Minister Margaret Thatcher at “Question Time” about the way her Treasury (run by Nigel Lawson) was using interest rate policy and intervention in the foreign exchange markets to keep sterling trading in a tight band with the deutschemark. Mrs. Thatcher actually deeply disapproved of Lawson’s exchange rate policy and she replied – famously:

“Adjustments are needed, as we learnt when we had a Bretton Woods system, as those in the EMS have learnt that they must have revaluation and devaluation from time to time. There is no way in which one can buck the market.”

Unfortunately for United Kingdom taxpayers, Mrs. Thatcher’s successor, John Major, did not subscribe to her views. Under his government the UK joined the European Exchange Rate Mechanism at an unrealistic level. George Soros and others pounced on sterling, shorting it at considerable cost to taxpayers – whose money was recklessly wasted as the government sought to prop up sterling on FX markets.

Soros told the Times: “Our total position by Black Wednesday had to be worth almost $10 billion. We planned to sell more than that. In fact, when Norman Lamont [Treasury Chief] said just before the devaluation that he would borrow nearly $15 billion to defend sterling, we were amused because that was about how much we wanted to sell.”

Moving on a few years came the Greenspan Put. Following the collapse of Long-Term Capital Management, Federal Reserve Chairman Alan Greenspan – who had previously offered an opinion that stocks were overvalued – cut interest rates. Traders called Greenspan’s position “The Greenspan Put” because a put option gives investors the right to sell their stocks at a set price. Greenspan’s actions were seen as a guarantee to the market that he would keep cutting interest rates to prop up the stock market.

We can see the damage low interest rates and reckless loans have done to the economy. US consumers are expected to be the engine of world economic growth – even if they have to get into serious debt to do so. Every time consumers stop to get their breath back, they’re told to wake up and get out spending their money again (or more likely someone else’s money).

Today Ben Bernanke has talked about stimulating the economy again – through cutting interest rates and cutting taxes. This despite the fact that both inflation and government debt are already higher than anyone thinks is prudent.

It now seems all the more credible that the Fed. Chairman is trying to write the Bernanke Put. With the steep falls in stock prices today it seems the markets are telling him that – even with all the intervention in the world – they’ve realized that American consumers and taxpayers cannot go on borrowing forever to fund the expansion of their own and overseas economies.

Perhaps Ben Bernanke should pay heed to those famous words I’ve quoted from Margaret Thatcher?

Today, here’s another fine example – from Germany – of a company and analysts telling investors that everything was fine when its chart told an entirely different story.

Hypo Real Estate Holding AG had been insisting that it wasn’t exposed to the subprime crisis.

Analysts, as of 12.11.2007 were still recommending “BUY.”

Just last week ratings agencies S&P and Moody’s had the outlook for Hypo marked “STABLE.”

Meanwhile the chart was saying “SELL” and had been doing so for some time.

Finally, today, Hypo admitted a writedown of $580m (390 million euros) on debt it had bought. Given that Hypo’s total profit last year was 429 million euros, there’ll be little if any profit this year. In today’s trading, Hypo’s shares promptly lost one third of their value.

Somewhat incredibly, Hypo’s CEO, Georg Funke commented that Hypo’s management had “not made any mistakes.” In fact he said they had done a “fantastic job.”

Sounds like another good year for bonuses then.

Here’s Hypo’s 12 months “SELL” chart with today’s 30%+ fall at the end. Below the chart are recent analyst recommendations from Hypo’s website.

Chart Recommends “SELL”

12.11.2007 Analysts Recommend “BUY”

In case the image on the left makes you think I’m quietly going insane, I am not going to talk about using sunspots as trading signals.

(Although, now that I think about it, sunspot activity does influence climate and climate does influence the economy and the economy does influence the stock market – hey maybe I should be using sunspot activity!)

Let’s get back to the point – and the point is how to avoid unreliable trading methods.

The Spots are Wrong
I remember reading about a researcher a long time ago who took a huge amount – many, many years’ worth – of sunspot data. He used the data to build a new model of sunspot activity. The model seemed to perform brilliantly. When asked to predict sunspot activity at any time in the past, it did so perfectly. But its predictions of future activity were woeful.

The Fools are fools
In similar vein, the Motley Fool’s much hyped Foolish Four technique attempted to beat the stock market. Apparently, by spending just 15 minutes a year, you could crush other investing strategies. The method had worked for 25 years, beating the Dow by 10 percent per annum.

The 15 minutes work consisted of:

1. Find the five stocks out of the 30 stocks in the Dow Jones that have the lowest price and highest dividend yield. (Divide the yield by the square root of stock price.)
2. From the five selected stocks, buy equal dollar amounts of the stocks ranking the second, third, fourth and fifth highest. Discard the highest-ranked stock.
3. Repeat annually until rich beyond the dreams of avarice.

Methods Need to Work in “The Now”
Naturally enough, as soon as this nonsensical method was faced with “the now” instead of “the past” it failed – totally.

All that the sunspot researcher and the Fools showed, in my opinion, was that they didn’t understand numbers.

If you take a large amount of data – as the Fools did – it will contain number patterns. Often these patterns have occurred through mere chance. Sometimes they have a real cause. The Foolish Four latched onto a chance pattern and confused it with reality. Here’s what they said:

“With a Spartan commitment of just minutes a year for research (entailing not much more than clicking into our Today’s Stock List page once a year, figuring out the amount you need to put in each stock, and placing your trades), you can use a strategy that has thrashed the Wall Street professionals for decades. How very Foolish!”

Well, at least they got one thing right.

In How to Trade in Stocks, Jesse Livermore discussed “the folly of trying to find out a good reason why you should buy or sell a given stock.”

He wrote in the context of the behavior of U.S. stocks, whose four major sectors – including steel makers – had risen after World War 2 began. While other sectors continued to advance, U.S. steel stocks stopped rising.

Livermore wrote that there must have been a good reason why the steel stocks had stopped rising but he didn’t know what it was.

It was not until four months later that the public was given the facts and the action of the steel stocks – which had by now fallen 26 to 29 points – was finally explained. The British and Canadian governments had been selling large volumes of shares in U.S. steel makers. (Presumably to fund their war efforts.)

“If you wait until you have the reason given, you will have missed the opportunity of acting at the proper time!

“The only reason an investor or speculator should ever want to have pointed out to him is the action of the market itself.

“Whenever the market does not act right or in the way it should – that is reason enough for you to change your opinion and change it immediately.

“Remember: there is always a reason for a stock acting the way it does.

“But also remember: the chances are that you will not become acquainted with that reason until some time in the future, when it is too late to act on it profitably.”

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.

Here’s a guest post from Jim Wallace. Jim noticed in one of my former blog posts that I used to teach physics. He thought I’d be interested in this summary of a BBC Radio item about mathematics in finance.

London has become an international centre for the world’s most talented mathematicians, who try to make fortunes writing financial models and trading algorithms for hedge funds and investment banks.

These mathematicians are employed as quants (Quantitative Analysts).

William Hooper says he fell in love with mathematics at university. He then came up with an idea to apply his skills to foreign exchange deals.

He analyses forex data from the previous 12 months and writes computer models to identify and quantify relationships in the data. He then writes an algorithm to make profitable forex trades based on the relationships.

Provided the algorithm is running profitably, William spends his time attempting to make it more profitable. In practice he says he has plenty of time for vacations and visits the gym – it’s a nice way to trade.

Although he would not directly say how much he was paid, William said that the general rule is that quants are paid about 20 percent of the profit they make. Typical algorithmic traders make annual profits for their banks/funds of $10 to $20 million.

William said his own model doesn’t make astronomical amounts of money – some can make sums of the order of a billion dollars per annum. These, however, are riskier models than can lose two billion the year after they have made a billion.

David Harding – who runs the hedge fund Winton Capital Management – studied theoretical physics at Cambridge. Winton trades world wide futures markets using a proprietary model based on a statistical model of market behaviour.

David Harding entered the financial sector in the early nineteen eighties, when few people thought there was any special place for mathematics in trading. That soon began to change and by the mid-nineteen eighties, increasing numbers of mathematicians and scientists were moving into trading and investing.

He says Winton Capital employs some very “improbable” types of people – people who are lacking in social skills but are very focussed researchers. Winton requires that people are clever and obsessively interested in researching areas of interest to the firm.

The lack of social skills will not suit all firms however. Many banks need mathematicians who are able to communicate their ideas to less numerate colleagues.

You can listen to the interview here:

http://news.bbc.co.uk/player/nol/newsid_7090000/newsid_7099200/7099200.stm?bw=nb&mp=wm&news=1&ms3=6&ms_javascript=true&bbcws=2

Jim Wallace

Jesse Livermore, one of the greatest stock traders in history, made his biggest market killings when he shorted stocks. In particular, he made $100 million (worth more than $1 billion in today’s money) when he shorted the market in 1929.

Non-expert traders should be reluctant to short stocks though, without very great cause. Here are some reasons why short trades are riskier than long trades:

Why you should think Twice Before Shorting

1. When a long goes against you, your position size falls. When a short goes against you, your position size rises, increasing your risk.
2. A rising stock market serves the interests of society’s most influential people – business owners and governments. They will lobby and legislate for conditions in which businesses and wealth creation can prosper. Notice how central banks cut interest rates when economic conditions take a downward turn.
3. Business owners and managers work hard to make their businesses succeed. Their desire to increase their profits usually results in rising stock prices.
4. The long-term charts of the Dow, S&P500 and the NASDAQ reflect points 2. and 3. The long-term direction is upward. When you short, you go against the natural, long-term market trend.
5. Long positions can result in 100% loss of your stake. Short positions can lose you an unlimited amount.

Every serious trader should have shorting as a stock trading tactic – but it’s a tactic that requires greater caution than going long.

Napoleon, when hearing good things about potential senior officers liked to ask, “but is he lucky”?

I’ve known people who have traded the markets for years with only red ink to show for it. From a technical standpoint they seem to know what they’re doing, but they are just unlucky. Or are they?

Napoleon’s question was astute because it’s possible for someone to apparently know what they’re doing but, in the heat of the battle (or in the middle of a trade) deficiencies emerge resulting in defeat. Someone who in battle or trading seems to be consistently lucky is either very good at what they do or is enjoying improbably good fortune.

On a similar theme, when someone commented on how lucky he’d been with a shot he’d played, Arnold Palmer replied:

“It’s a funny thing, the more I practice the luckier I get.”

Unfortunately, this doesn’t seem to work for would-be traders who lose money without fail. No matter how much they practice, they can’t seem to trade consistently profitably.

Clearly the consistently lucky battlefield commander or trader enjoys an edge on his less fortunate colleagues.

Jesse Livermore – in contrast to many self-made men – was happy to put some of his successes down to luck.

Of his 1915/16 comeback from bankruptcy, and his $3 million profit, he said:

“I was very lucky. I was rampantly bullish in a wild bull market. Things were certainly coming my way so that there wasn’t anything to do but to make money.”

And

“As you may remember, I was busy ‘coming back’ in 1915. The boom in stocks was there and it was my duty to utilize it. My safest, easiest and quickest big play was in the stock market, and I was lucky, as you know.”

Speaking of luck in more general terms, he said:

“Of course, if a man is both wise and lucky, he will not make the same mistake twice. But he will make any one of the ten thousand brothers or cousins of the original. The mistake family is so large that there is always one of them around when you want to see what you can do in the fool-play line.”

Avoiding Mistakes

Jesse is pointing out that successful traders need to minimize mistakes. It’s the same in war, or in sports contests. Most battles and sports games are not won by moments of genius – these are few and far between. The contestants who make fewest errors win most contests.

The “lucky” trader is one who minimizes mistakes AND, if they do make a mistake, acts to minimize the damage by exiting from the situation quickly. In practice this means having a written plan for each trade you enter, the most important element of which is the stop-loss.

Quick Thinking

Christian Siva-Jothy was Head of Proprietary Trading with Goldman Sachs. (Prop trading is when firms trade for themselves rather than on behalf of customers for fees.)

Siva-Jothy made his name on seemingly high-risk trades he made in the immediate wake of the first airliner crash into the World Trade Center in 2001.

“The first thing I noticed on the TV was that it was a perfectly clear blue sky day. I’m a helicopter pilot and I’ve been flying for 14 years. I know that when you’ve got a plane that’s going down, you don’t aim for the tallest building to fly into.

“I immediately thought, ‘terrorist act’. I figured this was going to whack consumer sentiment… I bought Eurodollars…

Markets can be Unbelievably Slow to React

“Strangely, I think they rallied no more than 13 basis points on the day. Markets can be unbelievably slow to figure out the consequences of big events.”

The capacity of markets to react slowly to events was also noted by Jesse Livermore, who said:

“The Street paid no attention to the earthquake the first day or two. They’ll tell you that it was because the first dispatches were not so alarming, but I think it was because it took so long to change the point of view of the public toward the securities markets. Even the professional traders for the most part were slow and shortsighted.”

Christian Siva-Jothy’s Favorite Book – Reminiscences of a Stock Operator

Interestingly enough, it turns out that Christian Siva-Jothy is well acquainted with Jesse Livermore. When asked – by Steven Drobny, in The House of Money – “Are there any books that you recommend to your traders,” Siva-Jothy responded:

“My favorite book in relation to markets is Reminiscences of a Stock Operator, by Edwin Lefèvre. I’ve probably read it four or five times, and I love it every time I read it. He talks about everything, about risk, about hubris, about passion, everything.”

“Prices rise because there are more buyers than sellers.”

This is a hoary old saying that needs to be put to bed once and for all. It’s absolutely incorrect, yet it’s everywhere.

Just type “more Buyers than Sellers stock market” or “buyers outnumber sellers stock market” into a search engine for plenty of examples.

In reality, prices rise when buyers are keener than sellers, not because buyers outnumber sellers.

Example

For example, imagine a case in which Livermore Inc. shares have been trading at $100. The situation is that:

• There are two sell orders at $101 for a total of 35,000 shares.
• There are ten buy orders at $99 for a total of 95,000 shares.
• There are more buyers and sellers – so our hoary old saying tells us that the price will rise.

In fact, the situation unfolds with the price falling to $98 because one individual comes along and sells 100,000 shares at market – taking out the 95,000 shares bid at $99 and eating into the shares bid at $98.

Our seller who dumped $100,000 shares at market was the keenest market participant.

Repeat, after me ……

The keenest participants determine the market direction.

Prices rise when buyers are keener than sellers.

Prices fall when sellers are keener than buyers.

When I wrote last month about trades that are worth taking, I was careful to say we should be looking for trades that engage the interest of other investors or traders.

I wasn’t, of course, saying anything original. We face the same situation as generations of traders before us.

A couple of days ago, I was fighting my way through a couple of chapters of Maynard Keynes’s General Theory of Employment, Interest and Money. I found Keynes had written entertainingly about the subtle art of picking winning trades. In 1936 he wrote (and I paraphrase):

You Think She’s Pretty – But Will Other People Agree?

Professional investment may be likened to those newspaper competitions in which you have to pick out the six prettiest faces from a hundred photographs. The prize will be awarded to the reader whose choice most closely matches the average preferences of all the other readers.

This means you have to pick, not those faces you find prettiest, but those you think other readers will pick as the prettiest. Of course, all of the other readers are also going to look at the problem from the same point of view. So, to win the prize:

1. You shouldn’t pick the faces you think are really the prettiest.
2. You shouldn’t even try picking the faces you think average opinion will find the prettiest.
3. You have reached the third stage where you try to figure out what average opinion expects the average opinion to be.

And there are some who practice the fourth, fifth and higher degrees.

Jesse Livermore concluded, through trial and error, that the biggest profits are made through being fully invested while markets are trending strongly.

Others have learned to profit from trendless markets – trading ripples in the market.

In Staying Ahead of the Curve, George Soros describes how Victor Niederhoffer had a system for trading these ripples and how, eventually, it failed.

“He was well grounded in random walk theory. He looked at markets as a casino where people act as gamblers and where their behavior can be understood by studying gamblers. For instance, gamblers behave differently on Mondays than on Fridays, differently in the morning than in the afternoon, and so on. He regularly made small amounts of money trading on that theory. I gave him money to manage and he made a good return on it.

“There was a flaw in his theory however. It is valid only in a trendless market. If there is a historical trend, a tide, it can overwhelm these little waves that are caused by gambling behavior and he can be very seriously hurt because he doesn’t have a proper fail-safe mechanism.

“He made very good money while the markets were sloshing around aimlessly. Then he started losing money, and he had the integrity to close out the account. We came out ahead. Very few commodity traders would have done that.”

Get Your Trading Strategy Right

• Some traders trade a single market (or just two or three) – changing their tactics depending on whether the market is trending, trendless, or showing a reliable chart pattern.
• Others trade a single tactic – such as only trading head and shoulders chart patterns – and scan the markets for indices, stocks and commodities, in search of these opportunites.
• Still others take a more à la carte approach, mixing and matching tactics and markets wherever they think they can make a profit.

In his earliest years, Jesse Livermore day traded successfully using price/volume correlations.

Later he acted on – and then ruled out – using tips and inside information.

Finally, he used macroeconomic data as a guide where the market ought to be moving and then looked for pivotal-point trades in stocks and markets which had begun to trend.

A Quick, Easy Physics Lesson

Once upon a time, I taught physics. Among hundreds of other topics I covered, I taught students the difference between accuracy and precision. Although a lot of people use the words interchangeably, accuracy and precision are actually different things.

If you aim bullets at a target they might hit it with high precision – a tightly grouped bunch of hits – but low accuracy – your hits are far from the bulls-eye.

Precision AND accuracy are achieved when you get a tight grouping of hits on the bulls-eye.

Working Hard NOT to make Money

When you’re trading, or investing, it’s more important to be accurate than precise. If you have a big idea that’s wrong, you can analyze it to the nth degree, but it’s still not going to make money. Since the first rule of trading and investing is to avoid losing money, you’ve got to be accurate with your big ideas. If your big idea is right, you’ll have to work hard at it not to make money.

Accurate Investing – the Big Idea

A big idea that I caught onto a few years ago was the idea of peak oil. I could write pages and pages about this, but I won’t. Suffice to say that oil is a finite resource. The US has already passed its peak of production, as has the UK. Oil is being consumed faster than it’s being discovered. There are huge reserves of “alternative oil” around the world but the large-scale viability of these resources – such as Alberta’s oil sands – demanded much higher oil prices than the $20 – $30 per barrel that crude oil was trading at five years ago.

So a good “big idea” was to invest in oil stocks.

Some stocks have done better than others, but provided you caught the big idea, you were almost bound to avoid loss and make a decent return. If you did something obvious, like buying Exxon (XOM) you’d have made 100% in the last five years, or Royal Dutch Shell (RDS-B) 60%. If you did the opposite and invested in GM or Ford, who were busily building a new generation of gas-guzzlers, you’d be down 29% and 41% respectively. You see the value of getting your big ideas – your accuracy – right?

Precision Investing – making the most of a Big Idea

If you’d thought a bit deeper, you might have been able to make more money from your oil trade – this time by improving your precision and identifying a nice tight grouping of the highest profitability trades to express your big idea. You don’t need to put money into all of these – but at least you’ve identified a tight group of stocks that should deliver you the highest rewards.

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. In fact, the Canadian Oil Sands Trust (COS-UN.TO) has quadrupled in price over the last five years while Suncor (SU) has quintupled and UTS Energy (UTS.TO) has sextupled.

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.

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 looking for trades, two questions to 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 the market has “given its approval” for a trade, you may buy into the early stages of a trend, hoping that the trend will be solid enough to last for months – or even years. You can also hope the slope of the trend will be rewarding. If the slope is too shallow, you might ride the trend successfully, but make less money than if you’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.

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.”

Let’s say you’ve bought shares in Livermore Financial Services Inc. and the price has been rising in a satisfactory way – there’s a solid uptrend and it’s showing no signs of weakening. There are three ways of managing your trade:

Lock in Profits – sell some shares now so if the price falls suddenly, you’ll have locked in a good profit on the ones you’ve sold.

Pyramid – buy more shares hoping to further increase your profit.

Enjoy the Ride – neither increase nor decrease your position.

Which is best?

Academia Says:
I’ll begin by recalling the old joke that if you need three different opinions, put your question to two economists. Much the same can be said of theoreticians in finance. Joking aside, however, most finance theoreticians accept that price trends do develop and that stock prices are not always moving in a random walk.

If we assume that trending is real, then it would be illogical to sell during an uptrend. You would be selling at a time when prices are likely to continue rising. The correct time to sell is after the uptrend has broken.

So, on this basis, I will rule out the “sell some shares to lock in profits” option. The best way of locking in profits is to move your stop-loss higher as your trade moves in the right direction.

Jesse Livermore Says:
If you were a gung-ho speculator like Jesse Livermore, you would pyramid. Strictly speaking – and as practiced by Livermore – pyramiding is a form of margin trading where you borrow against paper profits in a trade to increase your position in the same trade. (Later I’ll use the word pyramiding more loosely to include the practice of increasing your position in a trade using your own, unborrowed, money.)

Provided the trade continues to move in your desired direction, you will certainly increase your profits by pyramiding. In the unlikely event that, like Jesse Livermore, you were allowed to pyramid stocks using very high margin, and the trend suffered a sharp break, you would be in great danger of losing all of your profits, and more.

Managing Pyramiding Risk
Loss-minimization is crucial in trading. Your trading account can only survive long-term if, without fail, you get out of trades when their stop-loss is hit. Panic sell-offs are the trader’s nightmare because, under these conditions, you might not be able to sell your shares at your stop-loss price – you could get much less. Continually adding to a position in a single stock means that your losses during a panic sell-off could be catastrophic.

Trading trending stocks in several different sectors is helpful because if any one stock suffers a severe reversal and a stop-loss is missed, you won’t suffer a catastrophic loss.

There are more sophisticated ways of reducing trading risks and I’ll write about these another day – I don’t want to put too much into one post.

Conclusion
Pyramiding can be a useful way of increasing trading profits, but continually adding to your position in a single stock increases your risk of catastrophic loss.

I liked the quote from George Soros I used earlier this month, so I thought I’d dig out a few more words of wisdom.

In doing so, I’m well aware that this is precisely the kind of activity a sucker loves to engage in. Jesse Livermore said:

“The semi-sucker had read books about trading – usually written by yet higher grade suckers – but he did not realize that reading books was not the same as trading experience. This type of sucker could quote all sorts of wise sayings about the operations of the stock market. He did not lose money as quickly as the beginning sucker because he had learned some of the most rudimentary trading rules.”

Despite the fact that it might make me look like a sucker in Jesse Livermore’s eyes, here are a few quotes I’ve enjoyed – quotes I think even Jesse might have liked and approved of:

A banker: the person who lends you his umbrella when the sun is shining and wants it back the minute it rains.
Mark Twain

Remember your goal is to trade well, not to trade often.
Alexander Elder

The conduct of successful business merely consists in doing things in a very simple way, doing them regularly and never neglecting to do them.
William Hesketh Lever

There is a great difference between the best company and the best stock.
Ralph Wanger

Never risk more than 1% of your total equity in any one trade. By risking 1%, I am indifferent to any individual trade. Keeping your risk small and constant is absolutely critical.
Larry Hite

If you bet on a horse, that’s gambling. If you bet you can make three spades, that’s entertainment. If you bet cotton will go up three points, that’s business. See the difference?
Blackie Sherrod

I see the SEC is prosecuting a married couple for allegedly making $600,000 through insider trading. In Jesse Livermore’s day, ripping off the public through insider trading was legal but that, thankfully, changed a long time ago. The greed that attracts people to insider trading will never change though.

In an emergency civil action filed in the US District Court for the Southern District of New York, the Commission charged Ruben Chen and his wife Jennifer Xujia Wang with using online brokerage accounts in Wang’s mother’s name, Zhiling Feng, to purchase securities of three companies on the verge of announcing they would be acquired. Wang and Chen used non-public information from Wang’s employer, Morgan Stanley, which was providing services in connection with the acquisitions.

The Commission’s complaint alleges that Chen and Wang funded and exercised control over Feng’s online brokerage accounts. When Feng’s first brokerage account was opened, it was funded with money from a checking account in Wang and Chen’s name. In addition, Feng, who lives in Beijing, China, did not access the two online brokerage accounts that were opened in her name on the days of the relevant trading. Rather, most of the logins to the brokerage accounts were from Internet Protocol addresses at ING and from Chen and Wang’s home in New Jersey.

The Court has issued a temporary restraining order which, among other things, freezes the defendants’ assets and orders repatriation of funds taken out of the United States.

The Commission’s complaint alleges that Wang and Chen obtained illegal profits of more than $600,000 by trading on the basis of material non-public information before the public announcements of three acquisitions:

• Morgan Stanley Real Estate’s (MSRE) December 19, 2005 announcement of its acquisition of Town & Country Trust;
• MSRE’s August 21, 2006 announcement of its acquisition of Glenborough Realty Trust; and
• Formation Capital, LLC and JER Partners’ January 16, 2007 announcement of its agreement to acquire Genesis HealthCare Corporation.

Since August 29, 2005, Wang has been employed as a Vice President of Morgan Stanley in a group that supported the Principal Transaction Group, which provides financing for MSRE potential acquisitions. Wang received documents via e-mail and had access to documents on a shared network drive, which demonstrated that the firm was providing financing on certain acquisitions before they were publicly announced.

Danger, Danger
Too many first time investors / traders read a few books and, having absorbed the authors’ wisdom, launch themselves (and their savings) into market activity. They then learn that there’s no substitute for losing money in the markets to complete a stock market education. Some – like the investor this post is about – then wish they had committed less money to their initial foray.

I found this investor while I was looking at reviews of Phil Fisher’s book – Common Stocks and Uncommon Profits – on Amazon.com. 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 what he says:

Phillip Fisher is the father of qualitative analysis. This book changed my life like no other. It has made me settle down as an investor and think as a businessman, and put all notions of trading aside. From reading Fisher, I now understand that one should only invest in a small number of stocks, but these stocks must be perfect in all aspects. He shows one what signs to look for in a company and how to analyze it. From reading Mr. Fisher’s book I have put all my money in Coca-Cola, and have been well rewarded. Mr. Warren Buffett who read this book in the 1960′s found it to be one of the best investment books ever written. I myself consider it my family bible. Life as an investor was pure hell until I read this book, and after reading it I feel that nothing can stop me from becoming very wealthy. All I have to do is follow the steps that are in this book. Thank You Mr. Fisher.

April 25, 1998

Here’s Coca-Cola’s stock price chart since 1997 (with all of the reviewer’s money invested in it!):

Coca-Cola (KO) chart 1997 to 2007

Result:
If he has stuck doggedly with his original strategy, our intrepid investor will have spent nine fruitless years in Coca-Cola. I sincerely hope he got out soon after his review and invested his money more profitably elsewhere.

Putting too many eggs in one basket after reading a book or two is not smart. Occasionally you might get lucky but I’d strongly advise market newcomers against being too bold. Edge your way into the markets carefully. Give yourself time to learn while putting a little of your money on the line. You learn faster and better when your money’s in the market than when you’re just reading books.

A Pivotal Point – Get Ready to Buy Coca-Cola?
Interestingly, Coca-Cola has been in an uptrend since the beginning of 2006. It’s now approaching a pivotal point. Jesse Livermore, if he were alive, would be watching this one carefully.

Lemon Stocks
One of the tenets of fundamental analysis is that you should buy stocks when they are undervalued and sell them when they are overvalued.

When I began investing in the stock market, this is the method I chose. I didn’t do very well because I wasn’t very good at judging the value of companies.

I bought companies that looked undervalued only to read an announcement within weeks or months showing why the stock had been trading so “cheaply.” I realized I’d developed a talent for finding “lemon” stocks.

Ben Graham’s Voting Maching – The Lemons’ Enemy
I’m keen on Jesse Livermore’s methods because they’ve helped me make better decisions. For several years now, I’ve enjoyed much more success based on trend-following than I did using fundamental analysis on its own. I think one of the reasons for this is that I’m no longer dependent on reading out-of-date and occasionally downright mendacious company reports in order to decide which stocks to buy and sell. Several years on, I’ve learned enough to avoid lemons and my fundamental analysis has improved. I NEVER rely on fundamental analysis alone though. I ALWAYS allow the market to confirm my choices.

After all, who am I to assign a true price to any stock? In the real world it’s supply and demand that determine price. In saying this I’m aware of Ben Graham’s famous dictum that markets, in the short term, act like voting machines while in the longer term they act like weighing machines. I’ve discovered I’m perfectly happy to take profits on short term or (preferably) medium term trades using the results from the “voting machine” (trend) to guide me.

Stocks and Childish Fads
Remember Cabbage Patch Dolls? Or Furbies? – toys worth a few bucks each. A few Christmases ago some parents were paying hundreds of dollars for these toys. Later – once the fad was over – the same toys could be bought in second hand stores for no more than a few cents.

The parallel with stocks is exact. Once the market gets it into its head that a stock is hot, prices reach heights that horrify traditional fundamental analysts. Our job is not to sell these stocks too early. Just because a stock is trading at twice what we think it’s worth, there’s no reason that it won’t reach five times that. Hang in there until the trend is over. Then get out.

In How To Trade In Stocks, Jesse Livermore wrote:

“As long as a stock is acting right, and the market is right, do not be in a hurry to take a profit. You know you are right, because if you were not, you would have no profit at all. Let it ride and ride along with it. It may grow into a very large profit, and as long as the action of the market does not give you any cause to worry, have the courage of your convictions and stay with it.”

Similarly, don’t buy a stock just because it looks cheap on the basis of fundamental analysis. Wait for THE MARKET to recognize that it’s cheap. Let other people take the risk of buying too early. Jesse Livermore always said that the most profitable trades resulted when he entered a trade soon AFTER the market had confirmed his belief that prices were going to move in a particular direction. That’s been my experience too.