by Jim Paul
Below is some of the advice the pros offered for making money. Appendix A has brief dossier on these pros for those of you not familiar with their names.
Advice and Dissent
“I haven’t met a rich technician.”4
Jim Rogers
“I always laugh at people who say, ‘I’ve never met a rich technician.’ I love that! It is such an arrogant, nonsensical response. I used fundamentals for nine years and then got rich as a technician.”5
Marty Schwartz
Not very encouraging! Okay, so maybe the key to success wasn’t whether you were a fundamentalist or a technician. I mean, I had made a lot of money using both of these methods. While I found technical analysis indispensable, there was nothing like a good fundamental situation to really make a market move. Maybe another topic would begin to reveal the pros’ secret.
“Diversify your investments.”6
John Templeton
All right! Now I was getting somewhere. This was striking a familiar chord. Maybe I had placed too much emphasis on the soybean oil spreads. I had too large a percentage of my capital committed to that market and that trade. Even afterwards, I was trading only one market at a time. This looked like my first lesson from the masters: diversify. Or it looked that way until I read the following:
“Diversification is a hedge for ignorance.”7
William O’Neil
“Concentrate your investments. If you have a harem of 40 women you never get to know any of them very well.”8
Warren Buffett
Buffett has made more than $1 billion in the market. Who was I to disagree with him? But Templeton is also one of the greatest investors alive and he said something totally opposite of Buffett.
Okay, so maybe diversification wasn’t the answer either. Maybe you could put all of your eggs in one basket and still get rich by watching the basket very closely. Perhaps the topics I had selected so far were too broad in their implications. Certainly the pros would agree on the more specific and practical applications of investment and trading mechanics.
Averaging a Loss
“You have to understand the business of a company you have invested in, or you will not know whether to buy more if it goes down.”9
Peter Lynch
“Averaging down is an amateur strategy that can produce serious losses.”10
William O’Neil
Top and Bottom Picking
“Don’t bottom fish.”11
Peter Lynch
“Don’t try to buy at the bottom or sell at the top.”12
Bernard Baruch
“Maybe the trend is your friend for a few minutes in Chicago, but for the most part it is rarely a way to get rich.”13
Jim Rogers
“I believe the very best money is made at the market turns. Everyone says you get killed trying to pick tops and bottoms and you make all the money by catching the trends in the middle. Well, for twelve years I have often been missing the meat in the middle, but I have caught a lot of bottoms and tops.”14
Paul Tudor Jones
Spreading Up
“When you’re not sure what is going to happen in the market it is wise to protect yourself by going short in something you think is overvalued.”15
Roy Neuberger
“Whether I am bullish or bearish, I always try to have both long and short positions — just in case I’m wrong.”16
Jim Rogers
“I have tried being long a stock and short a stock in the same industry but generally found it to be unsuccessful.”17
Michael Steinhardt
“Many traders have the idea that when they are in a commodity (or stock), and it starts to decline, they can hedge and protect themselves, that is, short some other commodity (or stock) and make up the loss. There is no greater mistake than this.”18
W.D. Gann
I had expected there might be some subtle differences among the pros. After all, some were stock market moguls, while others traded options or futures contracts. But didn’t these guys agree on anything? Based on the examples above, they sounded more like members of a debate team trying to score points against each other.
I had to find out how the pros made money in the markets. I had to learn the secret that all of them must know. But if the pros couldn’t agree on how to make money, how was I going to learn their secret? And then it began to occur to me: there was no secret. They didn’t all do the same thing to make money. What one guy said not to do, another guy said you should do. Why didn’t they agree? I mean, here was a group of individuals who had collectively taken billions of dollars out of the markets and kept it. Weren’t they all doing at least a few things the same when they made their money? Think about it this way; if one guy did what another said not to do, how come the first guy didn’t lose his money? And if the first guy hadn’t lost, why didn’t the second guy?
If imitating the pros was supposed to make you rich and not imitating them was supposed to make you poor, then each one of these guys should have lost all his money because none of them imitated each other. They all should be flat broke because they very often did things opposite of each other. It finally occurred to me that maybe studying losses was more important than searching for some Holy Grail to making money. So I started reading through all the material on the pros again and noted what they had to say about losses.
Losses
“My basic advice is don’t lose money.”19
Jim Rogers
‘‘I’m more concerned about controlling the downside. Learn to take the losses. The most important thing in making money is not letting your losses get out of hand.”20
Marty Schwartz
‘‘I’m always thinking about losing money as opposed to making money. Don’t focus on making money; focus on protecting what you have.”21
Paul Tudor Jones
“One investor’s two rules of investing:
1. Never lose money.
2. Never forget rule #1.”22
Warren Buffett
“The majority of unskilled investors stubbornly hold onto their losses when the losses are small and reasonable. They could get out cheaply, but being emotionally involved and human, they keep waiting and hoping until their loss gets much bigger and costs them dearly.”23
William O’Neil
“Learn how to take losses quickly and cleanly. Don’t expect to be right all the time. If you have a mistake, cut your loss as quickly as possible.”24
Bernard Baruch
Now I was getting somewhere. Why was I trying to learn the secret to making money when it could be done in so many different ways? I knew something about how to make money; I had made a million dollars in the market. But I didn’t know anything about how not to lose. The pros could all make money in contradictory ways because they all knew how to control their losses. While one person’s method was making money, another person with an opposite approach would be losing — if the second person was in the market. And that’s just it; the second person wouldn’t be in the market. He’d be on the sidelines with a nominal loss. The pros consider it their primary responsibility not to lose money.
The moral, of course, is that just as there is more than one way to deal blackjack, there is more than one way to make money in the markets. Obviously, there is no secret way to make money because the pros have done it using very different, and often contradictory, approaches. Learning how not to lose money is more important than learning how to make money. Unfortunately, the pros didn’t explain how to go about acquiring this skill. So I decided to study loss in general, and my losses in particular, to see if I could determine the root causes of losing money in the markets. As I said at the beginning of the book, I may not be wise, but I am now very smart. I eventually did learn from my mistakes.
Part II
—
Lessons Learned
“Good judgment is usually the result of experience, and experience
frequently the result of bad judgment.”
Robert Lovett
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What started as a search for the secret to making money had turned into a search for the secret of how not to lose money. Why is it is so important to learn how not to lose? Because when people lose money in the markets, they usually look for a new approach how to make money. Obviously, the previous method was defective; it’s never the investor’s or trader’s fault. Given the myriad of how to methods, you could spend a lifetime trying, and failing, to make money with each one because you don’t know how not to lose. On the other hand, if you learn why people lose and thereby control losses, profits will follow.
Basically, what I found is that there are as many ways to make money in the markets as there are people in the markets, but there are relatively few ways to lose money. When I say lose here, I don’t mean that there won’t be any losses. You don’t win every point in every game in every set in every match in tennis; you win some and you lose some. There will be lots of losses, just as there are losses in any business. Former Citicorp CEO Walter Wriston said that a lender who doesn’t have loan losses isn’t doing his job. And it’s the truth. Trying to avoid taking losses altogether is the loser’s curse. But the losses you are trying to avoid are the ones for which you hadn’t made allowances, the ones which sneak up on you and the ones which ultimately put you out of business.
Losing money in the markets is the result of either: (1) some fault in the analysis, or (2) some fault in its application. As the pros have demonstrated, there is no single sure-fire analytical way to make money in the markets. Therefore, studying the various analytical methods in search of the “best one” is a waste of time. Instead, what should be studied are the factors involved in applying, or failing to apply, any analytical method. Even when equipped with accurate analysis, correct forecasts and profitable recommendations, people still manage to lose money. Why can’t people match the profitable performance records of the market advisory services they subscribe to? They can’t because of psychological factors that prevent them from applying the analysis and following the recommendations.
Psychological factors can be categorized as either: (1) the pathological mental disorders and illnesses which require professional help, or (2) the psychological distortions all of us engage in even though we are basically mentally healthy. We are interested in the latter.
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Market Lore to Ignore?
Most remedies for market losses due to psychological factors are old market saws that are too ambiguous to offer any means of practical application. People recite these catch phrases as if they were self-evident truths. After repeating them so often they become trite clichés used out of unthinking habit. But pearls of trading wisdom are more easily repeated than implemented. Repeating maxims, as if mere verbalization will activate the underlying principles, will not work. For example, simply following the dictum “Don’t discuss market positions because the pros don’t,” won’t automatically make you a pro. You must understand those principles before you can benefit from the maxims. Pros don’t discuss their positions because they understand what triggers discussing positions in the first place, as well as the dangers of doing so. A maxim is a succinct formulation of some fundamental principle or rule of conduct. Memorizing and repeating clichés is easy; grasping their underlying principles is more difficult.
For instance, consider what must be the most quoted maxim in the business: “Cut your losses short.” Sounds great, but what does it mean? Do you get out of a position as soon as it shows a loss? What constitutes a loss? How do you define a market loss? At some point in almost every investment or trade the position is going to show a loss, so how do you know when it is really a loss — something to get rid of — and not a position that is going to come back and be profitable?
Or how about: “Don’t follow the crowd. Go against the herd.” Okay, but how do you measure the crowd’s position in the market? What are the truest bellwethers of public sentiment? Do you determine what the crowd is doing by looking at volume and open interest? Put-call ratios? Put-to-call premiums? Consumer confidence? Odd lot shorts? Sentiment numbers and consensus of investment advisors? Besides, doing the opposite of what everyone else is doing doesn’t guarantee success and there are times when “trading opposite the crowd” can wipe you out.
And then there’s that oldie but goldie: “Don’t trade on hope or fear or make emotional decisions.” Sounds simple enough but as you will see later in the book, emotions in general, and hope and fear specifically, create a unique paradox for the market participant.
This book will not instruct you on the specifics of how to confront your fears or how to “get in touch with your feelings and emotions.” It will not reconcile your ego’s legitimate internal psychological needs with your participation in the markets. I don’t have a battery of tests for you to take to determine your particular psychological profile or your internal conflicts. I don’t have a test to determine if you should be participating in the markets at all. I am not, nor do I pretend to be, a psychologist. But I don’t have to be a psychologist to know that losses caused by psychological factors presupposes your ego’s involvement in the market position in the first place, which means you have personalized the market. Knowing what causes something is the first step in preventing it from going into effect. If we can determine how a market position gets personalized (i.e., how ego gets involved), we will be well on our way to preventing it from happening. Then the losses due to psychological factors can be prevented.
Some of the ideas in the rest of the book may sound like semantic quibbling. However, it is precisely those confused semantics that are largely responsible for the confused thinking, which, in turn, leads to the losses due to psychological factors. To clear up that confusion let’s attach clear, specific meanings to the terms we use. Let’s start at the beginning by defining psychology and seeing how it applies to us when we are in the market.
The American Heritage Dictionary defines psychology as the study of the mental processes, behavioral characteristics and emotions of an individual or group. Since we’re interested in market losses due to psychological factors, we will examine each of the three parts of the definition as they relate to us when we have those types of losses. Therefore, the second part of this book examines the mental processes, behavioral characteristics and emotions of people who lose money in the markets.
1. Mental Processes. Chapter Six explains what happens when a market position, especially a loss, gets personalized. It presents the difference between external, objective losses and internal, subjective losses. Next, it looks at the mental process an individual goes through when experiencing an internal loss: denial, anger, bargaining, depression and acceptance. Most people equate loss with being wrong and, therefore, internalize what should be an external loss. Then they start to experience Five Stages of Internal Loss and the loss gets larger as they progress through the stages. Finally, the chapter makes a distinction between losses from discrete events (e.g., games) and continuous processes (e.g., markets) and shows that only the latter are subject to the Five Stages.
2. Behavioral Characteristics. Chapter Seven discusses the most common way people personalize market positions. The chapter introduces the five types of participants in the markets: investors, traders, speculators, bettors and gamblers. The type of participant a person is, is determined by the behavioral characteristics he displays; not by the activity in which he is engaged. In other words, all stock purchases are not investing just as all card playing isn’t gambling. The chapter also shows that the source of most losses in the markets is people betting or gambling, as defined by the characteristics of their behavior, on a continuous process risk activity.
3. Emotions of an Individual or Group. Chapter Eight explains that emotions are neither good nor bad; they simply are. Emotions per se canno
t be avoided. Emotionalism, on the other hand can, and should, be avoided. Emotionalism is decision-making based on emotions. The entity which best describes emotional decision-making is the crowd. The chapter explains that the crowd is the epitome of emotions in action and discusses the crowd not in the familiar terms of contrary opinion or as a stage of a runaway market, but in terms of a process that can affect a solitary individual. Being a member of the crowd is not a function of quantity of people. Rather, it is a function of the characteristics displayed. We will also look at two models that describe the stages an individual passes through as he becomes a member of a psychological crowd.
6
The Psychological Dynamics of Loss
“I can’t get out here; I’m losing too much.”
Loser’s famous last words
In mid-October 1983, while the bean oil position was blowing up in my face, I got a call from my mom. “Dad is going into the hospital for exploratory cancer surgery. It shouldn’t be a big deal and they don’t expect a problem, but they have to take a look,” she said. She called back the next day after the surgery and the news from the doctors was that the cancer had spread through his whole body, and he had six months to live. They’d given him a full colostomy and he would start going to start chemo-radiation therapy immediately.
Two months later I got a call from my dad. He said, “Mom’s gone. I can’t find her. She left last night and hasn’t come home.” As it turned out, my mom had committed suicide. She had walked into the Ohio River and drowned herself. The only good news was that she didn’t know I was broke, so it wasn’t my situation that made her do it. She did it because my dad was so sick and going to die, and she couldn’t deal with it. I’d really have been in bad shape if I’d thought that she did it because of my situation. But they had no idea that I’d gone under. Things didn’t look any different. We still lived in the house and so on. I just didn’t have the same job. They knew I’d had a job change, but they didn’t know why.
