Stock Market Wizards

by Jack D. Schwager

  30. Beware of Ego

  Walton warns, “The odd thing about this industry is that no matter how successful you become, if you let your ego get involved, one bad phone call can put you out of business.”

  31. The Need for Self-Awareness

  Each trader must be aware of personal weaknesses that may impede trading success and make the appropriate adjustments. For example, Walton ultimately realized his weakness was listening to other people’s opinions. His awareness of this personal flaw compelled him to make sure that he worked alone, even when the level of assets under management would seem to dictate the need for a staff. In addition, to safely vent his tip-following, gambling urges, he set aside a small amount of capital—too small to do any damage—to be used for such trades.

  Dr. Kiev describes his work with traders as “a dialogue process to find out what [personal flaws are] impeding a person’s performance.” Some examples of these personal flaws he helped traders identify included:

  a trader whose bargain-hunting predisposition caused him to miss many good trades because he was always trying to get a slightly better entry price;

  a trader whose scale-down entry approach was in conflict with his experiencing these trades as a loss, even though they were entered in accordance with his plan;

  a trader who, to his detriment, always kept a partial position after he made the decision to get out because of his anxiety that the stock would go higher after he liquidated.

  Awareness alone is not enough; a trader must also be willing to make the necessary changes. Cook, who also works with traders, has seen people with good trading skills fail because they wouldn’t deal with their personal weaknesses. One example he offered was a client who was addicted to the excitement of trading on expiration Fridays. Although the trader did well across all other market sessions, these far more numerous small gains were more than swamped by his large losses on the four-per-year expiration Fridays. Despite being made aware of his weakness, the trader refused to change and ultimately wiped out.

  32. Don’t Get Emotionally Involved

  Ironically, although many people are drawn to the markets for excitement, the market wizards frequently cite keeping emotion out of trading as essential advice to investors. Watson says, “You have to invest without emotions. If you let emotions get involved, you will make bad decisions.”

  33. View Personal Problems as a Major Cautionary Flag to Your Trading

  Health problems or emotional stress can sometimes decimate a trader’s performance. For example, all of Cook’s losing periods (after he became a consistent winning trader) coincided with times of personal difficulties (e.g., a painful injury, his father’s heart attack). It is a sign of Walton’s maturity as a trader that he decided to take a trading hiatus when an impending divorce coincided with a rare losing period. The morale is: Be extremely vigilant to signs of deteriorating trading performance if you are experiencing health problems or other personal difficulties. During such times, it is probably a good idea to cut trading size and to be prepared to stop trading altogether at the first sign of trouble.

  34. Analyze Your Past Trades for Possible Insights

  Analyzing your past trades might reveal patterns that could be used to improve future performance. For example, in analyzing his past trades, Minervini found that his returns would have been substantially higher if he had capped his losses to a fixed maximum level. This discovery prompted a change in his trading rules that dramatically improved his performance.

  35. Don’t Worry About Looking Stupid

  Never let your market decisions be restricted or influenced by concern over what others might think. As a perfect example of the danger of worrying about other people’s opinions, early in his career, Minervini held on to many losing positions long after he decided they should be liquidated because of concern about being teased by his broker.

  36. The Danger of Leverage

  Ironically, even though Mark Cook won on most of his trades in his initial market endeavor, he wiped out because of excessive leverage. If you are too heavily leveraged, all it takes is one mistake to knock you out of the game.

  37. The Importance of Position Size

  Superior performance requires not only picking the right stock, but also having the conviction to implement major potential trades in meaningful size. Dr. Kiev, who sees Cohen’s trading statistics, said that nearly 100 percent of Cohen’s very substantial gains come from 5 percent of his trades. Cohen himself estimates that perhaps only about 55 percent of his trades are winners. Implicit in these statements is that when Cohen bets big, he is usually right. Indeed, his uncanny skill in determining which trades warrant stepping on the accelerator is an essential element in his success.

  As another example, even though Lescarbeau is a systematic trader, he will occasionally increase the leverage on trades that he perceives have a particularly high likelihood of winning. Interestingly, he has never lost money on one of these trades.

  The point is that all trades are not the same. Trades that are perceived to have particularly favorable potential relative to risk or a particularly high probability of success should be implemented in a larger size than other trades. Of course, what constitutes “larger size” is relative to each individual, but the concept is as applicable to the trader whose average position size is one hundred shares as the fund manager whose average position size is one million shares.

  38. Complexity Is Not a Necessary Ingredient for Success

  Some of the patterns and indicators that Cook uses to signal trades are actually quite simple, but it is his skill in their application that accounts for his success.

  39. View Trading as a Vocation, Not a Hobby

  As both Cook and Minervini said, “Hobbies cost money.” Walton offered similar advice, “Either go at it full force or don’t go at it at all. Don’t dabble.”

  40. Trading, Like Any Other Business Endeavor, Requires a Sound Business Plan

  Cook advises that every trader should develop a business plan that answers all the following essential questions:

  What markets will be traded?

  What is the capitalization?

  How will orders be entered?

  What type of drawdown will cause trading cessation and reevaluation?

  What are the profit goals?

  What procedure will be used for analyzing trades?

  How will trading procedures change if personal problems arise?

  How will the working environment be set up?

  What rewards will the trader take for successful trading?

  What will the trader do to continue to improve market skills?

  41. Define High-Probability Trades

  Although the methodologies of the traders interviewed differ greatly, in their own style, they have all found ways of identifying high-probability trades.

  42. Find Low-Risk Opportunities

  Many of the traders interviewed have developed methods that focus on identifying low-risk trades. The merit of a low-risk trade is that it combines two essential elements: patience (because only a small portion of ideas will qualify) and risk control (inherent in the definition).

  43. Be Sure You Have a Good Reason for Any Trade You Make

  As Cohen explains, buying a stock because it is “too low” or selling it because it is “too high” is not a good reason. Watson paraphrases Peter Lynch’s principle: “If you can’t summarize the reasons why you own a stock in four sentences, you probably shouldn’t own it.”

  44. Use Common Sense in Investing

  Taking a cue from his role model, Peter Lynch, Watson is a strong proponent of commonsense research. As he illustrated through numerous examples, frequently, the most important research one can do is simply trying a company’s product or visiting its mall outlets in the case of retailers.

  45. Buy Stocks That Are Difficult to Buy

  Walton says, “One of the things I like to see when I’m trying to buy stocks is that they become very difficult to bu
y. I put an order in to buy Dell at 42, and I got a fill back at 45. I love that.” Minervini says, “Stocks that are ready to blast off are usually very difficult to buy without pushing the market higher.” He says that one of the mistakes “less skilled traders” make is “wait[ing] to buy these stocks on a pullback, which never comes.”

  46. Don’t Let a Prior Lower-Priced Liquidation Keep You from Purchasing a Stock That You Would Have Bought Otherwise

  Walton considers his willingness to buy back good stocks, even when they are trading higher than where he got out, as one of the changes that helped him succeed as a trader. Minervini stresses the need for having a plan to get back into a trade if you’re stopped out. “Otherwise,” he says, “you’ll often find yourself…watching the position go up 50 percent or 100 percent while you’re on the sidelines.”

  47. Holding on to a Losing Stock Can Be a Mistake, Even If It Bounces Back, If the Money Could Have Been Utilized More Effectively Elsewhere

  When a stock is down a lot from where it was purchased, it is very easy for the investor to rationalize, “How can I get out now? I can’t lose much more anyway.” Even if this is true, this type of thinking can keep money tied up in stocks that are going nowhere, causing the trader to miss other opportunities. Talking about why he dumped some stocks after their prices had already declined as much as 70 percent from where he got in, Walton said: “By cleaning out my portfolio and reinvesting in solid stocks, I made back much more money than I would have if I had kept [these] stocks and waited for a dead cat bounce.”

  48. You Don’t Have to Make All-or-Nothing Trading Decisions

  As an illustration of this advice offered by Minervini, if you can’t decide whether to take profits on a position, there’s nothing wrong with taking profits on part of it.

  49. Pay Attention to How a Stock Responds to News

  Walton looks for stocks that move higher on good news but don’t give much ground on negative news. If a stock responds poorly to negative news, then in Walton’s words, “[it] hasn’t been blessed [by the market].”

  50. Insider Buying Is an Important Confirming Condition

  The willingness of management or the company to buy its own stock may not be a sufficient condition to buy a stock, but it does provide strong confirmation that the stock is a good investment. A number of traders cited insider buying as a critical element in their stock selection process(e.g., Okumus and Watson).

  Okumus stresses that insider buying statistics need to be viewed in relative terms. “I compare the amount of stock someone buys with his net worth and salary. For example, if the amount he buys is more than his annual salary, I consider that significant.” Okumus also points out the necessity of making sure that insider buying actually represents the purchase of new shares, not the exercise of options.

  51. Hope Is a Four-Letter Word

  Cook advises that if you ever find yourself saying, “I hope this position comes back,” get out or reduce your size.

  52. The Argument Against Diversification

  Diversification is often extolled as a virtue because it is an instrumental tool in reducing risk. This argument is valid insofar as it generally unwise to risk all your assets on one or two equities, as opposed to spreading the investment across a broader number of diversified stocks. Beyond a certain minimum level, however, diversification may sometimes have negative consequences. Okumus, for example, explains why he limits his portfolio to approximately ten holdings as follows: “Simple logic: My top ten ideas will always perform better than my top hundred.”

  The foregoing is not intended as an argument against diversification. Indeed, some minimal diversification is almost always desirable. The point is that although some diversification is beneficial, more diversification may sometimes be detrimental. Each trader needs to consider the appropriate level of diversification as an individual decision.

  53. Caution Against Data Mining

  If enough data is tested, patterns will arise simply by chance—even in random data. Data mining—letting the computer cycle through data, testing thousands or millions of input combinations in search of profitable patterns—will tend to generate trading models (systems) that look great, but have no predictive power. Such hindsight analysis can entice the researcher to trade a worthless system. Shaw avoids this trap by first developing a hypothesis of market behavior to be tested rather than blindly searching the data for patterns.

  54. Synergy and Marginal Indicators

  Shaw mentioned that although the individual market inefficiencies his firm has identified cannot be traded profitably on their own, they can be combined to identify profit opportunities. The general implication is that it is possible for technical or fundamental indicators that are marginal on their own to provide the basis for a much more reliable indicator when combined.

  55. Past Superior Performance Is Relevant Only If the Same Conditions Are Expected to Prevail

  It is important to understand why an investment (stock or fund) outperformed in the past. For example, in the late 1990s a number of the better performing funds owed their superior results to a strategy of buying the most highly capitalized stocks. As a result, the high-cap stocks were bid up to extremely high price/earnings ratios relative to the rest of the market. A new investor expecting these funds to continue to outperform in the future would, in effect, be making an investment bet that was dependent on high-cap stocks becoming even more overpriced relative to the rest of the market.

  As columnist George J. Church once wrote, “Every generation has its characteristic folly, but the basic cause is the same: people persist in believing that what has happened in the recent past will go on happening into the indefinite future, even while the ground is shifting under their feet.”

  56. Popularity Can Destroy a Sound Approach

  A classic example of this principle was provided by the 1980s experience with portfolio insurance (the systematic sale of stock index futures as the value of a stock portfolio declines in order to reduce risk exposure). In the early years of its implementation, portfolio insurance provided a reasonable strategy for investors to limit losses in the event of market declines. As the strategy became more popular, however, it set the stage for its own destruction. By the time of the October 1987 crash, portfolio insurance was in wide usage, which contributed to the domino effect of price declines triggering portfolio insurance selling, which pushed prices still lower, causing more portfolio selling, and so on. It can even be argued that the mere knowledge of the existence of large portfolio insurance sell orders below the market was one of the reasons for the enormous magnitude of the October 19, 1987, decline.

  57. Like a Coin, the Market Has Two Sides—But the Coin Is Unfair

  Just as you can bet heads or tails on a coin, you can go long or short a stock. Unlike a normal coin, however, the odds for each side are not equal: The long-term uptrend in stock prices results in a strong negative bias in short selling trades. As Lescarbeau says, “Shorting stocks is dumb because the odds are stacked against you. The stock market has been rising by over 10 percent a year for many decades. Why would you want to go against that trend?” (Actually, there is a good reason why, which we will get to shortly.)

  Another disadvantage to the short side is that the upside is capped. Whereas a well-chosen buy could result in hundreds or even thousands of percent profit on the trade, the most perfect short position is limited to a profit of 100 percent (if the stock goes to zero). Conversely, whereas a long position can’t lose more than 100 percent (assuming no use of margin), the loss on a short position is theoretically unlimited.

  Finally, with the exception of index products, the system is stacked against short selling. The short seller has to borrow the stock to sell it, an action that introduces the risk of the borrowed stock being called in at a future date, forcing the trader to cover (buy in) the position. Frequently, deliberate attempts to force shorts to cover their positions (short squeezes) can cause overvalued, and even worthless, stocks to
rally sharply before collapsing. Thus, the short seller faces the real risk of being right on the trade and still losing money because of an artificially forced liquidation. Another obstacle faced by shorts is that positions can be implemented only on an uptick (when the stock trades up from its last sale price)—a rule that can cause a trade to be executed at a much worse price than the prevailing market price when the order was entered.

  58. The Why of Short Selling

  With all the disadvantages of short selling, it would appear reasonable to conclude that it is foolhardy ever to go short. Reasonable, but wrong. As proof, consider this amazing fact: fourteen of the fifteen traders interviewed in this book incorporate short selling! (The only exception is Lescarbeau.) Obviously, there must be some very compelling reason for short selling.

  The key to understanding the raison d’être for short selling is to view these trades within the context of the total portfolio rather than as stand-alone transactions. With all their inherent disadvantages, short positions have one powerful attribute: they are inversely correlated to the rest of the portfolio (they will tend to make money when long holdings are losing and vice versa). This property makes short selling one of the most useful tools for reducing risk.

  To understand how short selling can reduce risk, we will compare two hypothetical portfolios. Portfolio A holds only long positions and makes 20 percent for the year. Portfolio B makes all the same trades as Portfolio A, but also adds a smaller component of short trades. To keep the example simple, assume the short positions in Portfolio B exactly break even for the year. Based on the stated assumptions, Portfolio B will also make 20 percent for the year. There is, however, one critical difference: the magnitude of equity declines will tend to be smaller in Portfolio B. Why? Because the short positions in the portfolio will tend to do best when the rest of the portfolio is declining.