by Jim Paul
Ordinarily, greed and fear are cited as the two driving emotions of market participants. However, hope and fear are the primary emotions; greed is simply hope run amok. The advice on hope and fear is almost as conflicting as the advice the pros give us on making money. We have all been told not to buy/sell a stock or make trade based on hope or fear: never hope that a position will go our way and never fear that a position won’t go our way. We’ve been told that hope causes us to buy a stock after it has already gone up, and we buy it at the top; fear causes us to sell a stock after it has already gone down a lot, and we wind up selling at the bottom. Or in the words of the father of contrary thinking, Humphrey Neil, “the crowd is most enthusiastic and optimistic when it should be cautious and prudent, and it is most fearful when it should be bold.”36 On the other hand, we read Jesse Livermore’s advice that we should hope when we would fear and fear when we would hope. That is, we should hope our profits will become bigger profits instead of fearing the profits will turn around; and that we should fear our losses will become bigger losses instead of hoping the losses will turn around.
The conflicting advice is explained by the paradox that hope and fear are merely two sides of the same coin. In other words, more often than not you are likely to experience both hope and fear simultaneously.
When you’re long and the market is going up you:
1. hope it will keep going but
2. fear it won’t.
If your fear is great enough, you will get out and hope the market turns down.
When you’re long and the market goes down you:
1. hope it will turn around but
2. fear it won’t.
If your fear is great enough, you’ll get out and hope that it keeps going down.
When you’re not long in the market but want to be and the market goes up you:
1. hope it will temporarily turnaround to let you in, but
2. fear it will keep going.
If your fear is great enough you will buy and hope the market keeps going up.
The point is: focusing on individual emotions can be quite confusing and it is better to focus on emotionalism instead. The best way to do that is by understanding the psychological crowd.
Mania and Panic: Where Hope and Fear Meet the Crowd
As the epigraph to this chapter states: man is extremely uncomfortable with uncertainty, tries to substitute certainty for uncertainty and, in doing so, succumbs to the herd instinct. That uncertainty about the future also elicits two primary emotional responses: hope and fear. We hope the future will turn out well, but we fear it won’t. As members of the crowd we will always take these emotions to extremes. When the herd instinct combines with hope and fear in a market environment, we get panics and manias.
According to The American Heritage Dictionary, a mania is an inordinately intense enthusiasm or hope for something; a craze, a fad or a behavior that enjoys brief popularity and pertains to the common people or people at large. It defines a panic as a sudden, overpowering terror often affecting many people at once. (It also says see synonym, fear.) Notice that the definitions of both mania and panic have direct references to hope and fear and the crowd.
Manias and panics don’t have to be full-scale mass population events like the tulips in Holland; they can occur on the scale of an individual making decisions about entering and exiting the market. Since an isolated individual can be classified as a crowd, then the same individual can get involved in a solitary panic or mania. And the market doesn’t even have to be frothy for this to happen. It can be going sideways and the individual can experience a solitary panic or mania, simply by exhibiting the characteristics of a crowd coupled with hope or fear.
In a solitary panic, crowd behavior combines with an individual’s fear of losing money, or fear of missing an opportunity to profit, and becomes the primary reason for acting or failing to act. In a solitary mania, crowd behavior combines with an individual’s intense hope for profit, or hope that a losing position will turn around, and becomes the primary reason for acting or failing to act.
So, instead of trying to monitor yourself for all the different emotions and what they might mean, simply monitor yourself for the few stages of crowd formation. By avoiding the tell-tale symptoms which accompany becoming part of the crowd, you will automatically avoid emotionalism.
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The day after my $248,000 Thursday in August of 1983, Broderick and I were sitting on the dock at his lake house. He turned to me and said, “What’s the only thing that can keep this market from really going?” I thought a minute and said, “Well . . . if it rains that’ll change things.”
That night we were watching the news, and the weather report called for rain over the weekend. Broderick looked at me and said, “Well? That’s it, right?” I said, “Well . . . no . . . it ain’t . . . it may not be enough rain . . . and it’s not really getting Indiana . . .” It only took me about half-an-hour to decide that the rain didn’t matter. There wasn’t enough rain in the right places, and the market had already shrugged off that little bit of rain by closing higher that day.
Broderick got out of the market on Monday — because it had rained. And I had told him that if it rained the trade was over. So he got out and he made money. But me? No! I had to stick and stay and tell myself it hadn’t rained enough. I was not going to be tricked out of one of the best trades of the decade by “a little rain.” I had my own solitary mania going on.
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To repeat the leitmotiv of the book thus far: people lose (really lose, not just have occasional losing trades) because of psychological factors, not analytical ones (Chapter Five). They personalize the market and their positions (Chapters One through Four), internalizing what should be external losses (Chapter Six), confusing the different types of risk activities (Chapter Seven) and making crowd trades (Chapter Eight). Is there a single, factor common to all of these errors, and can we determine a way to address that factor in order to avoid the errors?
Part III
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Tying It All Together
9
Rules, Tools and Fools
“A fool must now and then be right by chance.”
William Cowper
The final irony of this story is that the bean oil market turned shortly after I blew out in November 1983. If I had been able to stay in the market a little longer, by May 1984 my 540 spreads would have been worth $3,200,000. In hindsight, however, I don’t think it would have made any difference. Sooner or later I was going to lose all of my money and the later it was, the more I was going to lose. If I had ridden through that valley of death and come out the other side with $3,200,000, somewhere along the line, in some other trade, I would have ended up losing $6,000,000 instead of $1,600,000. It just would have postponed the inevitable loss and made it bigger. Is it possible that I might have done some smart things like pay off the house or lock some money away? Maybe. But I still believe that eventually the disaster was going to happen.
Why am I so sure it was inevitable? Because even though I had succeeded in many things in life by treating them like games and simply following the rules (i.e., freshman English, the MSV test, OCS and the honor graduate award), I had also succeeded in many other things by breaking the rules. A lot of things I did worked, but shouldn’t have. For instance, nobody calls a frat house during rush, asks for a pledge pin and gets it. Nobody gets elected to the Board of Governors of the Chicago Mercantile Exchange because he wears $600 suits, $50 ties, and Bally shoes. Once I realized I was breaking the rules but still succeeding, I thought rules were for everybody else, and that I could break them and still succeed.
What this means is that sometimes I was breaking the rules whether I knew it or not, and that one time I was going to be wrong (and we will all be wrong sometimes) but not accept or believe it. That approach ensured t
hat when the loss occurred, it would wipe me out.
If you occasionally break the rules and still have an unbroken string of successes, you are likely to compound the problem because you assume that you are better than other people and above the rules. Your ego inflates and you refuse to recognize the reality of a loss when it comes. You assume that you will be right. You assume that even if the market is against you, it will come back. Well, if I had an ego problem at one million dollars what kind of problem would I have had if I had ridden through the valley of death and cheated death? If I had survived the loss and the market had gone on to make money for me, my ego problem would have been much worse.
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Tying It All Together
In answer the question posed at the end of the last chapter — Yes, there is a common factor which triggers the mental processes, behavioral characteristics and emotions of a net loser: the uncertainty of the future. In a certain world we wouldn’t have to choose or act. Certainty would replace probability. We wouldn’t have the potential for loss (i.e., risk) and, therefore, we wouldn’t have any risk activities, created or inherent. We would neither have losses nor experience the Five Stages of Internal Loss. In the words of financial editor James Grant: “Because the future is always unfathomable, there are always buyers and sellers in every market. If the socialists were right — if the future could be accurately divined — markets would disband because nobody would ever take the losing side of a trade.”37 Since the herd instinct and crowd behavior arise out of our desire to replace uncertainty with certainty, if the future were certain we wouldn’t succumb to emotionalism. Likewise, hope and fear, which are our strongest emotional responses to the uncertain future, wouldn’t subject us to personal panics and manias. As it happens, we don’t live in a certain world so we need a way to deal with the uncertain future.
Dealing with the Uncertainty of the Future
All enterprise, all human activity inextricably involves risk for the simple reason that the future is never certain, never completely revealed to us.38 When dealing with the risk of the uncertainty of the future, you have three choices: engineering, gambling or speculating. The engineer knows everything he needs to know for a technologically satisfactory answer to his problems. He builds safety margins into his calculations to eliminate any fringes of uncertainty. Therefore, the engineer basically operates in a world of certainty since he knows and controls most, if not all, of the variables which affect the outcome of his work.39 The gambler, on the other hand, knows nothing about the event on which the outcome of his gambling depends, because the distinguishing feature of gambling is that it deals with the unknown. The gambler plays for the excitement — the adrenalin rush. He isn’t playing to win — he is just playing.40 The speculator doesn’t have the advantage of the engineer. The rules of natural science will not render the future direction of prices predictable. But the speculator does know more than the gambler because while the gambler is dealing with pure chance, the speculator has at least some knowledge about what determines the outcome of his activity. Speculating is the application of intellectual examination and systematic analysis to the problem of the uncertain future.
Successful investing is the result of successful speculation. If your “investment” is a stock, you are depending on the managers of the firm to accurately foresee the market for the goods it produces. If your investment is a bank savings account, you are depending on the loan officers at the bank to accurately foresee future business conditions and make prudent, profitable loans which generate the interest the bank pays to you. Interest doesn’t just materialize out of thin air simply by putting money in the bank. (This is a reference to banking the way it used to be, ignoring FDIC insurance in order to make a point.) Federal Reserve Chairman Alan Greenspan put it this way: “The historic purpose of banking is to take prudent risks through the extension of loans to risk taking businesses.”41 In other words, the bankers are speculating.
Successful trading is also the result of successful speculation. The trader has a methodical approach to bidding and offering stock (or bonds, futures, currencies, etc.) and monitoring market conditions for any subtle changes in supply and demand. He knows only too well the perils of predicting and doesn’t try to forecast market direction. He operates under strict parameters of “if . . . then . . .” statements which dictate his subsequent buy and sell decisions.
Successful hedging, too, is a function of successful speculation. The hedger examines current and prospective business and market conditions, and he speculates as to how they might change and whether or not he can turn a profit at today’s prices; if so, he hedges his inventory or inventory needs.
Speculation is forethought. And thought before action implies reasoning before a decision is made about what, whether and when to buy or sell. That means the speculator develops several possible scenarios of future events and determines what his actions will be under each scenario. He thinks before he acts. The sequence of thinking before acting is the exact definition of the word plan. Therefore, speculating and planning are the same thing. A plan allows you to speculate with a long time horizon (as an investor), a short time horizon (as a trader) or on a spread relationship (as a basis trader or hedger). Since you can’t really be an engineer in the market (unless you’re a “rocket scientist” on Wall Street) and since we’ve already discussed the dangers of gambling in the markets, then speculating, and therefore having a plan, is the only way to deal with the uncertainty of the future in the markets. Given this definition, for the remainder of the book Speculator (capitalized) will be used to include investors, speculators and traders, all of whom are Speculating.
A plan, the noun, is a detailed scheme, program or method worked out beforehand for the accomplishment of an objective. To plan, the verb, means to think before acting, not to think and act simultaneously nor to act before thinking. Without a plan, you fall into one of two categories: a bettor if your main concern in being right, or a gambler if your main concern is entertainment. If you express an opinion on what the market will do, you’ve gotten your self personally involved with the market. You start to regard what the market does as a personal reflection. You feel vindicated if price moves in the direction you predicted and wrong if it doesn’t. Moreover, when the market moves against you, you feel obligated to say something to justify your opinion or, worse, you feel obligated to do something like show the courage of your conviction by adding to a losing position. Participating to be right is betting, and betting for excitement is gambling. In order to be speculating, by definition you must have a plan.
Decision-Making
As we saw in Chapter Six, participating in the markets is about decision-making. You must decide the conditions under which you will enter the market before developing a plan to implement the decision. Obviously, if you decide not to enter the market there is no need for a plan. Broadly speaking, the decision-making process is as follows: 1) Decide what type of participant you’re going to be, 2) Select a method of analysis, 3) Develop rules, 4) Establish controls, 5) Formulate a plan. Depending on what your goals or objectives are on the continuum of conservative to aggressive, you will decide whether you are an investor or speculator, which in turn will help you decide what markets to participate in, what method of analysis you’ll use, what rules you’ll develop, what controls you’ll have, and how you will implement these things with a plan. We already know that no single analytical method will be successful for everyone. Instead, you are likely to find some type of method that is compatible with your tolerance for exposure. You will fill in the specifics based on your research, and your tolerance for exposure.
The first thing you decide is what type of participant you are going to be (investor or speculator). Then you select what market you are going to participate in (stocks, bonds, currencies, futures). The plan you develop must be consistent with the characteristics and time horizon of the type of participant you choose t
o be. Why? Changing your initial time horizon in the middle of a trade changes the type of participant you are, and is almost as dangerous as betting or gambling in the market. For example, what’s an investment to most people who dabble in the stock market? Ninety percent of the time an “investment” is a “trade” that didn’t work. People start with the idea of making money in a relatively short period of time, but when they start losing money they lengthen their time frame horizon and suddenly the trade becomes an investment. “I really think you ought to buy XYZ here Jim. It’s trading at $20, and it’s going to $30.” We buy and it goes down to $15. “It’s really a good deal here at $15. It’s gonna be fine.” So we buy more. Then it goes to $10. “Okay, we’re taking the long term view. That’s an investment.” How many shares of Penn Central are in trust funds in this country? Lots. Because they invested in the great American railroad. When it went from $86 in 1968 to $6 in 1970, in their minds they couldn’t sell it because they had lost too much. So they lengthened their time frame in order to rationalize hanging on to the losing position. Or how about IBM, the darling of institutional and individual investors alike? Its stock went from $175 in 1987 to $45 in 1993 with buy recommendations from analysts all the way down.
One of the problems most stock players face is that they buy the stock because of a fundamental story. They believe a story just like I believed the bean oil story: “We’re going to run out of bean oil. There’s going to be a shortage and people will pay up.” If I buy a stock because I think earnings are going to be up but then the stock starts down, I’ve got a problem. As a stock player who believed the story, I have to decide: “Either I’m stupid to have believed it in the first place, or the market is wrong.” Which do you think I’m going to pick? The market is wrong, of course. So I fight the market, hold the losing position and turn my trade into an investment.
