The ‘ten commandments’ of trading

By Lewis Borsellino

In the 20 years I’ve been trading, I’ve discovered one truism that is valid whether you’re trading stocks, fixed income or futures: trading is 90% psychological. All the rest – technical analysis, trade execution, etc. – is the other 10%.

That’s not to say that technical analysis of the markets isn’t important. It’s vital. You can’t trade without a plan based on technical analysis that encompasses support and resistance, trend lines, moving averages, momentum, volatility and the like. But you can’t possibly execute that plan consistently if your mental game is off. That’s where the ‘ten commandments’ of trading come in.

1. Trade for success, not for money.

Your motivation should be first and foremost to make a well-executed trade. If money alone is your motivation you will severely limit your chance of success. Why? Because focusing on money will raise all kinds of emotional issues, from fear to greed. It will make you afraid of losses to the point that you will abandon your discipline. It will tempt you to trade too often, too large and with too much risk. Whereas if you focus on making solid, well-executed trades – even if the result is a losing trade that you exit quickly – you will reinforce your discipline and increase your trading potential.

2. Discipline is the one quality that all traders must possess above all others.

The ability to master your mind, your body and your emotions is the key to trading. The disciplined trader – regardless of profit or loss – comes back to trade another day. A great intellect, the ability to take on risk, or even a sense that you’re somehow ‘lucky’ mean nothing without discipline. For a trader, discipline means the ability to devise a trading plan, execute according to that plan, and to never deviate from that plan.

3. Know yourself.

Do you break out in a cold sweat at the mere thought of risking something – such as your own capital? Do you think of trading like ‘gambling,’ a long shot to make a million? Or can you handle risk in a disciplined fashion, knowing how much is ‘too much’ for both your capital and your constitution?

Trading is not for everyone. If risk makes you ill, on the one hand, or if taking a risk brings out the recklessness in you, then trading is probably not for you. But if you can handle risk with discipline, then perhaps you can find a vocation or avocation as a trader. Only you can answer that question.

4. Lose your ego.

No matter how much success you enjoy as a trader, you’ll never outsmart the market. If you think you can, you’re in for a very humbling experience. The market rules, always, and for everyone.

You need to silence your ego in order to listen to the market, to follow what your technical analysis is indicating – and not what your intellect (and your ego) think should happen. To trade effectively, you need to put yourself aside. At the same time, you cannot be so emotionally fragile that unprofitable trades shatter your confidence. Don’t be crushed by the market, but don’t ever think you’ve mastered it, either.

5. There’s no such thing as hoping, wishing or praying.

I’ve seen too many traders staring panic-stricken at the computer screen and begging the market to move their way. Why? Because they have lost their discipline and allowed what was a small loss to turn into a much bigger one. They keep hanging on, hoping, wishing and praying for things to turn around. The reality is on the screen. When the market hits your stop-loss level (the price at which you’ll cut your losses at a pre-determined level), get out.

6. Let your profits run and cut your losses quickly.

When the market goes against you and you hit your pre-determined stop, exit the trade. Period. Exit when the loss is a small one. Then reevaluate your strategy and execute a new trade. Keeping your losses small will keep you in the game. Profits take care of themselves, as long as you execute according to your plan. When you place a trade, know in advance where you’ll exit for a profit. When the market reaches that level, exit the position. If your technical analysis tells you the market still has some room to move, then scale out of the position. But execute according to your plan. Remember, you’ll never go broke taking a profit.

7. Know when to trade and when to wait.

Trade when your analysis, your system and your strategy say that you have a buy or sell to execute. If the market doesn’t have a clear direction, then wait on the sidelines until it does. Keep your mind on the market, but keep your money out of it.

8. Love your losers like you love your winners.

Losing trades will be your best teachers. When you have a losing trade, it’s because of some flaw in your analysis or your judgment. Or perhaps the market simply didn’t do what you thought it would. When you have a losing trade, something is out of sync with the market. Examine what went wrong – objectively – then adjust your thinking, if necessary, and enter the trade again.

9. After three losing trades in a row, take a break.

This is not the time to take on more risk, but rather to become extremely disciplined. Sit on the sidelines for a while. Watch the market. Clear your head. Re-evaluate your strategy, and then put on another trade. Losses can shake your confidence and tempt you to become emotional (fear/greed) But if you take a break, you can gather your wits and regain your composure more quickly than if you become very emotional and angry at yourself and the market.

10. The unbreakable rule.

You can break a rule and get away with it once in a while. But one day, the rules will break you. If you continually violate these ‘commandments’ of trading, you will eventually pay for it with your profits. That’s the unbreakable rule. If you have trouble with any of them, come back and read this one. Then read it again.

Trading and the second marshmallow

By John Piper

 One of the difficulties with trading is that the rules change as you progress. The novice must learn to cut losses and not much else matters at this stage. Once that rule is ingrained, it is down to running profits. But if you try and run profits at the ‘cut losses’ stage you will have a lot of problems.

Another of the difficulties is that many traders break the rules and win! But this can be disastrous, because the market is bound to catch you out if you follow the wrong rules. Trading has a logic of its own. If you allow losses to run, the logic is you will be wiped out. Over many different trades the market will exploit any weaknesses in either the trader or his/her system. Statistically a few ‘bad’ traders will do well for a while – but not in the long run.

1. Reduce position size to the point where you are comfortable.

It may seem odd that reducing position size is my number one idea for making more money, but it is so. Many traders put themselves under excess pressure, by doing so they are prone to make bad decisions and they lose money. So reduce position size and make more money!

2. Consider using option strategies – don’t limit your options!

Options have a lot of plus points, and have a part to play in your strategy.

3. Find a trading mentor.

Trading is a very difficult business. Not least because it is a zero sum game. NO, cancel that – it is a negative sum game, because every time you enter the game you pay commission, not to mention all the other expenses involved, price feeds, computers, software, etc, etc. With futures, the amount every winner wins is paid for by all the losers, but all participants pay commissions and the other costs. So in aggregate it’s a negative pot. It’s no surprise so many lose.

If you need help with your trading, find someone who has experience to help you. Ideally a local trader – many are prepared to help because trading is a fairly dry business with little meaningful human contact. Otherwise you may need to find a professional who is willing to help but he may well expect to charge a fee. I do this myself, but your best bet is to try and find someone who is local to you.

4. Use stops which have some meaning.

Not all traders use stops and by not using stops everything becomes a lot simpler because you get wiped out fairly quickly. Actually that is not totally true but it is true for some, if not many. But if you are using an approach which does utilize stops then try and ensure your stops have some significance, otherwise you tend to be throwing money away.

5. Understand the logic of your trading approach.

Every approach to the market involves risk. As a trader, you must control risk, just as a tightrope walker learns to live with imbalance. Understand the logic of your approach and the risks you are taking, because that risk will come home to roost. In one sense the market is a generator of random sequences, especially if you follow a precise algorithm. If you or your approach has a weakness the market will find it in one of those random sequences.

6. Let profits run – wait for the second marshmallow!

Unless you let your profits run you will never cover your losses, let alone come out on top. You must also cut your losses. Most traders learn to cut losses quite easily but have trouble learning to run profits. This is not surprising. Cutting losses is an active function requiring careful monitoring of what is happening – it requires action. Running profits, in contrast, requires inaction, and doing nothing can be tough. In modern society we are used to quick gratification. We want our goodies and we want them now. The same goes for trading profits: once you see them, you want them – but you cannot have them if you want to let profits run.

The book Emotional Intelligence describes an experiment in which a child is left in a room with a marshmallow and told that if he does not eat it, he will receive a second marhshmallow. Apparently this simple test is a far better guide to success than any number of intelligence tests. It is also exactly what traders must do if they want to let profits run, so don’t eat that marshmallow and you will get two!

7. Be selective

There are so many keys to success but I feel this is the one that separates those who make lots of money from those who just get by.

8. Don’t predict.

Market action is not predictable. A trader does not predict action – he takes calculated risks. He risks a little to make a lot.

9. Don’t panic.

This is critical. Panic is mother to losses. Part of this is not putting yourself under undue pressure. The more relaxed you are, the less likely you are to panic.

10. Be humble – big egos cost a lot to run!

A person who is full of himself has no room for anything else: he will not listen, or learn. A trader who is not humble may not listen to the market and will get wiped out. I suspect we have all heard stories of macho traders who take on the market and get turned into mincemeat. I believe humility is an essential for trading success.

Engaging The Great Humiliator

By Ken Fisher

 1. Engage The Great Humiliator without ending up humiliated by it.

The market is effectively a near living, near spiritual entity that exists for one goal and one goal only – to embarrass as many people as possible for as many dollars as possible for as long a time period as possible. And it is really effective at it. It wants to humiliate you, me and everyone else. It wants to humiliate Republicans and Democrats and Tories. It is an equal opportunity humiliator. Your goal is to engage The Great Humiliator without ending up humiliated by it.

2. Never forget – you are really Fred Flintstone.

If you always remember you have a stone age mind genetically trying to deal with post-industrial revolution problems, you will better understand your cognitive difficulties in seeing the market correctly. We got our brains from our ancestors and they are both genetically identical to those that existed before markets did, but also the ways we process information are almost identical to they way information was processed thousands of years ago. When you think of a tough stock market problem in terms of how would a stone age person think of this, it takes you to rudimentary evolutionary psychology, which is closely linked to behavioral finance and leads quickly to being able to see yourself better and better understand your problem.

3. The Pros are always wrong.

For decades people have presumed that the little guy is wrong and the sophisticated pro is more likely to be right. The concept is cute but is inconsistent with finance theory. The reality is that professional consensus is always wrong. Why?

The market is a discounter of all known information. That is core finance theory. Everyone has information, but on average professionals have a lot more access to information than normal people. Professionals as a group have access to all essentially known information. So, if you can figure out what professionals as a group believe will happen you know what has been discounted into current pricing from all known information and therefore cannot happen. It is theoretically and empirically perfect.

The pros as a group are a perfect guide to what won’t happen. Knowing what won’t happen doesn’t tell you what will but eliminates a big part of the possibility spectrum and gives you a leg up on figuring out what may happen.

4. Nothing works all the time.

Sometimes growth is hot. Sometimes it’s not. Sometimes value leads. Sometimes small caps do. Sometimes foreign stocks lead and sometimes domestic stocks do.

Investors have layered their thought processes on top of thousands of years of a prior process we did well that we now call collecting. Thousands of years ago people collected food, stone points for spears, firewood and much more. Now people collect for fun because our brains are adept at it. Collectors collect consistent with their biases and their access to information and or stuff. Their collections tell you more about who they are than the stuff.

In equities they collect in categories consistent with their biases, like value, growth, etc…. The value guy and growth guy both think their categories are basically and permanently better. But in the long run they all end up with almost exactly identical average annualized returns, and must – it is core to how capitalism’s pricing mechanism works.

5. Most investors will go to hell or die not understanding why.

If you don’t fathom number 4, above, and actually believe that some category of equities is basically better or worse than others, you are not alone. Most investors, being collectors, believe that, including most professionals, most of whom are collectors.

But to say some equity category is basically better permanently is to say that you either disbelieve in capitalism, in which case you are sure destined to hell, or that you don’t fully fathom its pricing mechanism.

In the long term supply is much more powerful in setting securities prices than demand and the only marginal costs of new supply are distribution. All other costs can be amortized over large unit volume to drive them to zero if the price of the equities is high enough. What that means is that as soon as investment bankers see any excess demand for any equity category they busily go about the process of starting to create new supply to meet it. To the extent they do so, which may take some time, they pull that category’s pricing back into line with all other categories. When you look at 30 year average annual returns of equity categories they are all essentially identical and always will be. It is core finance theory.

6. Heroes are myths.

The great investors of the past were mostly innovators, but because they were if they were alive today they wouldn’t do it now the way they did it then. That was then; this is now. Almost everything from the past is obsolete now.

Think of it like being Intel. If Intel made semiconductors now like it did 15 years ago, it would be broke. You have to keep learning, changing, adapting and adopting the latest and newest capability. If you don’t you will get left behind. If you don’t believe that, watch me leave you behind. Hence it is a mistake to say things like, “I want to be an investor like Ben Graham (or any past guru) was” – because they wouldn’t do it like they did themselves – now.

7. Pray to The Luck God.

In behavioral finance theory the ultimate sin is accumulating pride and shunning regret. Accumulating pride is a process that associates success with skill or repeatability. Shunning regret associates failure with bad luck or victimization. Accumulating pride and shunning regret is something people have done in our normal lives for more than 25,000 years, since Homo Sapiens first walked as modern man. It motivates us to keep trying in non-financial activities and is surely good.

But in financial activities it cause us to become overconfident and enter into transactions for which we have no particular training, background, experience or special knowledge and when we enter into overconfident decisions we get bad luck – we become unlucky.

To become lucky reverse the process and learn to shun pride and accumulate regret. Then you assume success was materially luck, not skill and not particularly repeatable. You assume failure was not bad luck or victimization but your own lack of skill and hence mandating introspective lessons to self-improve. When you do that you make less overconfident decisions and become fundamentally lucky instead of unlucky. This is just using finance theory to get lucky.

8. Market timing is terrible unless you time it right.

Most of the time the market rises. Unless it is a real bear market, all attempts at market timing backfire and become very costly. But when you actually encounter a real bear market, recognizing it and taking corrective actions is near life saving. But it is hard to do because you have to build and maintain the skills for so doing while not deploying them for years and sometimes many years during bull markets. Usually people who don’t use skills for a long time eventually lose them. Not very many folks can do this.

9. A bear is bullheaded until you can’t bear it.

The change in psychology that is the sign of a shift from a bull market to a bear market is that early in a bear market downdrafts are met with increased optimism. In a bull market, because the market has been rising more than folks expected, every correction is short, sharp and strong and met with near hysteria from panicky investors who fear the bull markets up-move will be largely retraced on the down side. They didn’t expect or understand the up-move so they fear wild stories about things that could make it vanish.

But after a long bull market they have learned to always buy the break, and that long-term investors always come out ahead. And then as the market drops they see it as an opportunity and become more optimistic (which you can measure by watching professional investor sentiment), and spend their cash, using up their spare liquidity and leaving none to support stocks later.

10. When you get really good: quit.

Kids aren’t so good as investors. They don’t know anything yet. They are impulsive and have very short senses of time. Old investors aren’t very good either. They get rigid and can’t change with the winds. The best investors get best between the ages of about 35, after they’ve gotten some real experience, and peak by about 60 or maybe even a little earlier, by which time they start slowing down.

Different people are different but I’ve never seen a really old investor who hadn’t pretty well lost most of his prior skill set. Part of what makes a great investor is his ability to adapt but when you get too old you lose that ability. So if you’ve been really good, and hit it really well, plan in advance when to quit and when you get there, just stop making decisions. Let go.

The investing methods of Warren Buffett

By Lawrence Cunningham

 1. Don’t be the patsy.

If you cannot invest intelligently, the best way to own common stocks is through an index fund that charges minimal fees. Those doing so will beat the net results (after fees and expenses) enjoyed by the great majority of investment professionals. As they say in poker, ‘If you’ve been in the game 30 minutes and you don’t know who the patsy is, you’re the patsy’.

2. Operate as a business analyst.

Do not pay attention to market action, macroeconomic action, or even securities action. Concentrate on evaluating businesses.

3. Look for a big moat.

Look for businesses with favorable long term prospects, whose earnings are virtually certain to be materially higher 5, 10, 20 years from now.

4. Exploit Mr. Market.

Market prices gyrate around business value, much as a moody manic depressive swings from euphoria to gloom when things are neither that good nor that bad. The market gives you a price, which is what you pay, while the business gives you value and that is what you own. Take advantage of these market mis-pricings, but don’t let them take advantage of you.

5. Insist on a margin of safety.

The difference between the price you pay and the value you get is the margin of safety. The thicker, the better. Berkshire’s purchases of the Washington Post Company in 1973-74 offered a very thick margin of safety (price about 1/5 of value).

6. Buy at a reasonable price.

Bargain hunting can lead to purchases that don’t give long-lasting value; buying at frenzied prices will lead to purchases that give very little value at all. It is better to buy a great business at fair price than a fair business at great price.

7. Know your limits.

Avoid investment targets that are outside your circle of competence. You don’t have to be an expert on every company or even many – only those within your circle of competence. The size of the circle is not very important; knowing its boundaries, however, is vital.

8. Invest with ‘sons-in-law’.

Invest only with people you like, trust and admire – people you’d be happy to have your daughter marry.

9. Only a few will meet these standards.

When you see one, buy a meaningful amount of its stock. Don’t worry so much about whether you end up diversified or not. If you get the one big thing, that is better than a dozen mediocre things.

10. Avoid gin rummy behavior.

This is the opposite of possibly the most foolish of all Wall Street maxims: ‘You can’t go broke taking a profit’. Imagine as a stockholder that you own the business and hold it the way you would if you owned and ran the whole thing. If you aren’t willing to own a stock for 10 years, don’t even think about owning it for 10 minutes.

Trading and Position Sizing™

By Van Tharp

 1. Whenever you enter into a position, always have a predetermined exit point at which you will concede you were wrong about the position.

This is your risk (R), and if you lose this amount, you have a 1R loss. Even if you are a buy-and-hold investor, you should have some point at which you will bail out of an investment because it is going against you (e.g. a drop of 25%). This rule essentially sets up all position sizing rules.

2. The golden rule of trading is to cut your losses short (1R or less) and let your profits run (more than 1R, i.e. a multiple of R).

Let’s say you buy a stock at $50 expecting the price to go up $10, a 20% gain. You decide in advance to exit if the price falls by $1. Now assume that you have four failed breakouts (i.e. 4 x 1R losses) before you have your $10 gain (in this case a 10R gain). You were right only 20% of the time, but your losses totaled minus 4R and your profits totaled plus 10R. Your total gain was thus 6R, six times your initial risk.

3. When the total sum of your R-multiples for all of your trades is positive, you have a ‘positive expectancy’ system. You must have a positive expectancy system to make money in the market.

Expectancy is the sum of your R-multiples divided by the total number of trades. Thus, if you have 50 trades which give you a total R-multiple of 20, then from your 50-trade sample, you would estimate your expectancy to be 0.4. In other words, over many trades, on average, you will make 0.4 times your initial risk on every trade.

4. A low risk idea is an idea with a positive expectancy that is traded at a low enough risk level to allow for the worst possible contingency in the short term so that you can survive to achieve the expectancy over the long term.

This basically means that ‘how much’ you risk on any trade is critical. ‘How much’ is what we call position sizing. In my opinion, aside from personal discipline, it is the most important factor in your trading.

5. Anti-Martingale position sizing strategies work.

Martingale strategies do not work. Martingale strategies are strategies that have you risking more after you lose, such as doubling your risk after a loss. Because people tend to have long streaks against them, they do not work. Eventually you will go broke. In contrast, anti-Martingale strategies, which cause you to increase your position as you win, tend to be very successful. In general, strategies which are based on increasing your bet size as your equity goes up are anti-martingale strategies and they work well.

6. A simple strategy that will work for everyone is to risk a small percentage of your equity on every trade, such as 1% or less.

If you have an account that is worth $100,000, then risking one percent would mean risking $1000. If your stop (i.e. 1R risk) is $5, then you would buy 200 shares (i.e. 1000 divided by 5 = 200 shares). Furthermore, if you applied a 1% risk to the example given in Rule 2, after 5 trades you would be up about 6% since you would be gaining 1% per each R-value. You would be up exactly 6%, since you would only be risking 1% of your remaining equity on each trade.

7. You need to know the R-multiple distribution of your trading system to determine your position sizing strategy.

We frequently play trading simulation games in our workshops in which the R-multiple distribution of the potential trades are known but the value of each individual trade is unknown because the trades are selected randomly from the sample (i.e. a bag of marbles) and replaced. People can become very good at determining their objectives and achieving them in this sort of game.

8. Strategies that are designed to achieve only the maximum return (such as optimal f; the Kelly criteria, etc) are foolish and usually result in huge drawdowns.

For example, if you trade a system that is 55% 1R winners, 5% 10R winners, 35% 1R losers, and 5% 5R losers, then the percentage risk that will achieve the highest average return is 19.9%. With this percentage, you could achieve a huge return if the right sample occurs (i.e. all 10R winners), and this would also give you a very high average return, but you would generally lose a large amount of money on most samples. In other words, you might get one sample in which you make a total of a billion dollars, and many samples in which you lose money. If this were the case, you would have a high average ending equity (because of the huge return in one sample) even though most samples lost money.

9. Position sizing is the part of your trading system that will help you achieve your objectives.

Most people don’t think about position sizing because they are too concerned over what stocks they should buy. However, as long as you have a positive expectancy system, position sizing is what will help you achieve your objectives.

10. Rather than place big bets, scale into positions that go in your favor.

Many long-term traders will only have one or two really successful trades each year that will account for most of their profits. You need to capitalize on those trades. And one way to do that is to add another position each time you can raise your initial stop to breakeven. For example, if you bought JDSU in Feb 99 and kept a 25% trailing stop, you would have made a 32R gain by the time you sold it on April 5th, 2000. If you had added another 1% position each time you raised your stock to breakeven, up to a maximum of 4 times, your exposure on JDSU would have been $5,700. In fact, the maximum exposure to your equity would have been about $1,430 on the 4th scale in. However, your total profit would have been $112,476.

Contrarian advice from Dr Doom

By Marc Faber

Rule 1: There is no investment rule that always works.

If there was one single rule, which always worked, everybody would in time follow it and, therefore, everybody would be rich. But the only constant in history is the shape of the wealth pyramid, with few rich people at the top and many poor at the bottom. Thus, even the best rules do change from time to time.

Myth 1: ‘Stocks always go up in the long term.’

This is a myth. Far more companies have failed than succeeded. Far more countries’ stock markets went to zero than markets which have survived. Just think of Russia in 1918, all the Eastern European stock markets after 1945, Shanghai after 1949, and Egypt in 1954.

Myth 2: ‘Real Estate always goes up in the long term.’

While it is true that real estate has a tendency to appreciate in the long run, partly because of population growth, there is a problem with ownership and property rights. Real estate was a good investment for Londoners over the last 1,000 years, but not for America’s Red Indians, Mexico’s Aztecs, Peru’s Incas and people living in countries which became communist in the 20th century. All these people lost their real estate and usually also their lives.

Problem rule 1: ‘Buy Low and Sell High.’

The problem with this rule is that we never know exactly what is low and what is high. Frequently what is low will go even lower and what is high will continue to rise.

Problem rule 2: ‘Buy a basket of high quality stocks and hold.’
Another highly dangerous rule! Today’s leaders may not be tomorrow’s leaders. Don’t forget that Xerox, Polaroid, Memorex, Digital Equipment, Burroughs, Control Data were the leaders in 1973. Where are they today? Either out of business or their stocks are far lower than in 1973!

Problem rule 3: ‘Buy when there is blood on the street.’

It is true that bad news often provides an interesting entry point, at least as a trading opportunity, into a market. However, a better long term strategy may be to buy on bad news which has been preceded by a long string of bad news. When the market no longer declines, there is a chance that the really worst has been fully discounted.

Rule 2: Don’t trust anyone!

Everybody is out to sell you something. Corporate executives either lie knowingly or because they don’t know the true state of their business and the entire investment community makes money on you buying or selling something.

Rule 3: The best investments are frequently the ones you did not make!

To make a really good investment, which will in time appreciate by 100 times or more, is like finding a needle in a haystack. Most ‘hot tips’ and ‘must buys’ or ‘great opportunities’ turn out to be disasters. Thus, only take very few investment decisions, which you have carefully analyzed and thought about in terms of risk and potential reward.

Rule 4: Invest where you have an edge!

If you live in a small town you may know the local real estate market, but little about Cisco, Yahoo and Oracle. Stick with your investments in assets about which you may have a knowledge edge.

Rule 5: Invest in Yourself!

Today’s society is obsessed with money. But the best investments for you may be in your own education, in the quality of the time you spend with the ones you love, on your own job, and on books, which will open new ideas to you and let you see things from many different perspectives.

Behavioural finance

By Gary Belsky

1. Every dollar spends the same.

People tend to treat money differently depending on where it’s come from. They spend money received as a gift, bonus or tax refund freely and easily, while spending other money – money they’ve earned – more carefully. Try not to compartmentalise your money in this way. Treat it all the same. One way to do this is to park ‘found’ money in a savings account before you decide what to do with it. The more time you have to think of money as savings – hard-earned or otherwise – the less likely you’ll be to spend it recklessly.

2. Control your fear of losses.

A bedrock principle of behavioral economics is that the pain people feel from losing $100 is much greater than the pleasure they get from winning $100. Be careful that this does not lead you to cling on to losing investments in the hope that they’ll return to profit, or to sell good investments during periods of market turmoil when holding them would be better in the long term.

3. Look at decisions from all points of view.

Too many choices make choosing harder. If you suffer from ‘decision paralysis’ try looking at the options from a different perspective. For instance, if you are trying to decide between different stocks or funds, imagine that you already own them all. Your decision then becomes one of rejection (“which one am I least comfortable owning?”) rather than of selection, and you may find this helps.

4. All numbers count, even if you don’t like to count them.

The tendency to dismiss or discount small numbers as insignificant – the ‘bigness bias’ – can lead you to pay more than you need to for brokerage commissions and fund charges. Over time, this can have a surprisingly deleterious effect on your investment returns. Avoid this ‘bigness bias’. Count all the numbers.

5. Acknowledge the role of chance.

A failure to fully grasp the role that chance plays in life leads many investors to be overly-impressed with short-term success and other random or unusual occurrences. Thus, many investors pour money into mutual funds that have performed well in recent years under the mistaken belief that the funds’ success is the result of something other than dumb luck.

6. Your confidence is often misplaced.

Nearly everyone falls prey, at some time or another, to an overestimation of their knowledge and abilities. Most dangerous for investors is the delusion that, with a little knowledge or homework, you can pick investments with better-than-average success. In reality, there is little reason for even the most sophisticated investor to believe that she can pick stocks – or mutual funds – better than the average man or woman on the street.

7. It’s hard to admit mistakes.

This sounds basic, but we’re not talking about pride so much as the subconscious inclination people have to confirm what they already know or want to believe. Because of this ‘confirmation bias’ it’s important to share your financial decisions with others – seeking not only specific advice, but also critiques of your decision-making process.

8. The trend may not be your friend.

In the long term, conventional wisdom is often on target – as it has been over the past 25 years in the trend away from fixed income investments towards stocks. In the short run, however, the vagaries of crowd behavior – particularly ‘information cascades’that result in dramatic shifts in tastes and actions – frequently lead to costly overreactions and missed opportunities. Treat trends and fads with skepticism and caution.

9. You can know too much.

Knowledge is power, but too much ‘illusory’ information can be destructive. Studies have shown that investors who tune out the majority of financial news fare better than those who subject themselves to an endless stream of information, much of it meaningless.

10. Don’t check your investments too regularly.

The less frequently you check on your investments, the less likely you’ll be to react emotionally to the natural ups and downs of the securities markets. For most investors, a yearly review of their portfolios is frequent enough.

Building a margin of safety

By Jim Slater (chairman of the legendary financial conglomerate, Slater Walker Securities)

1. Develop a method that suits you.

Carefully select a method of investment and then, based on personal experience and the performance of your portfolio, hone, temper and refine it until you are satisfied beyond doubt that it works for you. As you become more expert you can use several different methods at the same time according to market conditions.

2. Establish a margin of safety.

Any method, whether it be growth or value, should be based on establishing a margin of safety – a cushion between the amount you pay for a company’s shares and the amount you believe they are worth. The attraction of building a margin of safety is that it helps to protect against downside risk and at the same time provides the scope for an upwards re-rating.

3. Adjust the margin of safety to your approach.

For growth stocks, a typical method embracing a margin of safety would be to seek out shares with strong earnings growth records and a relatively low price-earnings ratio in relation to their future growth rates. Ideally the growth rate should be at least one third more than the price-earnings ratio. To increase the safety factor, it is also highly desirable for the company to have a record of strong cash flow in relation to earnings per share and a strong balance sheet.

For value stocks, the margin of safety can be established by a low price-to-sales ratio, low price-to-book value and strong cash flow. Also with many undervalued asset situations it pays to look for recent relative strength and recent directors’ buying which can be signals that a company is about to turn around.

4. Keep an eye on significant share dealings by directors.

Directors’ buying is frequently linked to a change in a company’s fortunes especially if the directors are buying a significant number of shares in a cluster of three or more. Equally, directors selling large tranches of shares is often a warning signal and should put you on red alert.

5. Judge management by their numbers, not by their manners.

The ability of management is very hard to quantify. If you go to see them or meet them at a presentation, they naturally put their best foot forward. Management can best be judged by several years of good results with brokers’ forecasts confirming that they are likely to continue. The financial results are the best judge of management, not the people going to see them.

6. Look for positive relative strength to corroborate your view of a share.

Shares that perform well in the market are often winners in the making. With growth stocks, relative strength in the previous twelve months should be positive and certainly greater than the one month figure. O’Shaugnessy found in What Works on Wall Street that relative strength was in most years the best single investment criterion.

7. Run profits and cut losses.

This is much easier said than done but it is far better practice to add to winners and pare down holdings that are not performing well. This way your losses will always be small and your gains can be gigantic. Remember that the power of compounding is the eighth wonder of the world.

8. Never stop learning.
There is always a faster gun, so keep reading books on investment by well-known and established experts, attend investment conferences and consider joining an investment club. Also make sure that you have a regular source of sound statistical stockmarket data. In the UK, Company REFS does, of course, come to mind!

9. Be tax efficient.

Use annual capital gains tax allowances, PEPs, ISAs and a personal pension scheme to the maximum possible extent.

10. Don’t kid yourself.

Do not be fooled by your own excuses. Measure your investment performance honestly and regularly and if, over a year or so, you find that you are not consistently beating the market, delegate to an expert manager or invest in a unit trust or tracker fund and use your surplus time and energy elsewhere.

Overvalued stocks and Ponzi schemes

By David Tice

 1. Study stock market history – recognize where you are in the long-term secular cycle.

Most investors remember and learn from what has occurred in the recent past. Investors must realize that they must learn from periods that might extend beyond their own memory. Market cycles can last a long time, and people have too much at stake to make all the mistakes themselves, so they must learn from market history.

Most of the money in the stock market over the last 104 years has been made in secular bull markets. However, being invested at the tail end of secular bear markets can result in very poor investment performance for a very long period of time. Recognize that the greatest contributor to stock market performance is the P/E multiple afforded to earnings, and that in bull markets, the P/E multiple expansion is what drives stock prices.

2. Uniform opinion among analysts about an individual stock is dangerous.

When many Wall Street analysts are unanimously positive on a company, the stock price tends to be too high and reflects very favorable expectations. The key to making money in stocks is selecting companies where your analysis of fundamentals shows better prospects than the current Wall Street expectations. However when all analysts have very high expectations for a company, then it becomes very difficult to beat lofty expectations.

3. There are elements of Ponzi schemes in many areas of investment.

Always keep your eyes open for investments that require a bigger fool to continue to pay a higher price to have the investment make sense. These investments are dangerous, as eventually you run out of buyers willing to continue to pay a higher price. Determine that there are underlying economic fundamentals that justify the investment based on future cash flows, not just that someone is willing to pay a higher price.

These ponzi-like situations can be found both in the investment markets as well as in the fundamentals of real businesses. For example, the recent telecom boom was founded not on the ability of companies to make money, but on their ability to sell the bandwidth they developed on to a bigger company. This was a classic Ponzi scheme. When it was realised that the bigger telecom companies couldn’t buy all the bandwidth that was being developed, stock prices crashed because the business models were not viable on their own merit without the benefit of a bigger fool buying them out.

4. Buy low, sell high – don’t buy high, sell higher.

This advice seems straight forward, but is always difficult to follow. Attractive sounding growth stories have the most intrinsic appeal, but are always the highest priced in the market. These companies have the highest expectations, and it normally requires a bigger fool to keep paying a higher price to keep the stock price rising. Also, there usually exists very little downside asset value support in those cases where the growth story does not come through.

5. Consider selling short to reduce exposure and to create outperformance.

There are always many stocks which reach outrageous price levels and can be sold short. One great attribute of selling short is that it reduces overall equity allocation which reduces portfolio risk and equity exposure. Short exposure of 15% offsets long exposure of 75%, thereby resulting in net long equity exposure of 60%. Reduced equity exposure means lower risk, thereby helping investors generate improved risk-adjusted returns if stock selection is done well.

6. Be a contrarian and independent thinker

Always attempt to challenge the conventional wisdom which is normally wrong. Following the crowd is not normally the way to get rich. Great riches are typically earned by people who identify an opportunity before anyone else and who exploit those opportunities successfully. You should invest in the same manner.

7. Have a long time horizon – it’s the key to riches.

Look for companies that are experiencing short term disappointment. Most investors attempt to chase short term performance which is very difficult to achieve. Earning a 50% performance return over three years, is equivalent to a 15% annual return. The chance of earning that 50% return is higher if all the other investors ignore a stock because they see the performance being too far in the future.

8. Look at micro-cap companies. The market is more inefficient, and the profits can be huge.

Companies with smaller market values are followed less by Wall Street and therefore generally carry lower expectations. If you can identify companies with great prospects before others do, your chances of generating outstanding returns are much greater.

9. Always think about risk vs. return.

Always seek the optimal trade-off between the two functions. Stocks that most people already know about generally possess lesser return potential. Companies that sell at significant multiples of revenue, possess the highest risk in case of disappointment or in a bear market. In a mania bull market, stocks with the highest risk can earn the highest returns for a while, but if market conditions change, they will decline the most.

10. Follow the smartest analysts who are indepedent thinkers.

Read and follow the advice of the most insightful analysts you can find. Sometimes those analysts with the best short term track record have been the ones taking the most risk. This should always be assessed. Look for analysts who make sense and who consider downside support as an important element of the investment strategy.

Trading and the importance of a plan

By Joe DiNapoli

 1. Loss of opportunity is preferable to loss of capital.

There was a time when I felt it was my duty to be personally involved in every wrinkle of the S&P. I’ve traded this market since it’s inception in 82. It took quite a while for me to realise that picking safe, readable, and high probability winning trades was the way to go.

2. Use Logical Profit Objectives for all positions.

The concept of using and executing LPOs is one of the most important I know of. It keeps your percentage of winning trades high and gets you back to the computer the next day. Everyone enjoys a pay day. With the correct concepts this is something you can do.

3. Place your Logical Profit Objectives in the market ahead of time. Markets are squirrelly animals. If you know how to calculate your profit objectives, get them in the market ahead of market action. If you wait for the alert to go off, hoping to capture more, it’s likely the market will move away from your exit before you have time to execute your order.

4. Enter markets on retracements.

Don’t buy new highs or sell new lows. Wait for the market to come to you. Precalculate your entries and be patient. If you miss the move another bus will come by shortly.

5. Above all, follow your trading plan.

Having a clearly defined trading plan is the single most important aspect of profitable speculation. Never trade without one and once you have it, following it is more important than any single profit or loss.

6. Trade quietly.

With the exception of a mentor, tell no one about your positions, profits, or losses. Especially those close to you, like your wife, husband, or friends. This self-gratification process or sharing process puts you under psychological pressure to win on every trade and can be a primary reason for failure to follow your plan.

7. Don’t carry a sizeable position while traveling.

It will catch you!! The laptop won’t work. The hotel internet connection will break. The cell phone battery will run out. The plane won’t land! I know you’ll try it anyway. It’s good for the markets, we need to spread the money around a bit.

8. ‘You are only one trade away from humility.’

For over 15 years this tattered hand-written sign, scrawled with bold black strokes with a magic marker, has hung over my trading table. A swelled head does not belong on a trader’s shoulders.

9. Add to your knowledge before attempting to add to your wallet.

This seems obvious but somehow many newbie traders think they can become pros with little more than a computer and hope. In this business hope is a four letter word. I hear the following a dozen times a month. “I only wish I came across you before I blew 50-500 grand.” I was here. Others like me were here. They thought it was easy and needed to find some humility. Now they’re ready to progress.

10. Develop your sense of humour.

You’ll definitely need it.

11. Help other traders whenever you can.

This is more practical than philosophical: giving keeps the ego in line and when you need help, and you will, you’ll find it!