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Traits of a good trader part 1

The amateur will focus on how much can be gained. The pro will always focus on the risk first – how much can be lost.

If it is your goal to find winners, then how will you act once you encounter a big looser? My guess is that it could discourage you from making further efforts. But if you’re very determined to go on trading, you might instead ignore the loser and put on a few other trades, just so you can keep your mindset positive.

Now instead imagine your goal is to avoid losers. Now how will you act once you encounter a big loser? My guess is that you will deal with it: reevaluate it, look for any signs that you were wrong, get out, and eventually learn from your mistake. Why? Because your fundamental mindset is basically that all trades are losers. Running into one will not come as a shock to you, and it will entice you to work even harder – because losers are what you are expecting to see.

Also, think about the fact that your capital compounds geometrically. Here is what will happen to your capital if you focus on avoiding losers: 2*2*1*2*…=8*…. Here is what will happen if you focus on finding winners: 5*5*0=0. You see the low number in there? A zero will kill it all, a one won’t. Once you hit zero you’re out, no matter how many fives you can get. If you mainly focus on enlarging your profits, eventually you will go broke. If you manage to stay away from big losers, you won’t. You’ll end up better off, even if your profits are much smaller.

The amateur will ask “how much do I need to make?” The pro will ask “how much can I accept to loose?”

Accept it – losing is an integral part of what it means to be trading. Nobody can stay away from losers. The pro will get out when he thinks there might be a loss coming. The amateur will stay in the trade until he thinks he has made enough profit. This also means that every now and then he will make losses that are bigger than he is willing to accept.

How much are you prepared to loose? If your answer is that losing is not your goal, then you are not cut out to be a trader. Good traders constantly think about how much they can loose and how much they are prepared to loose.

The amateur will look for the biggest moves. The pro will look for the most predictable moves.

Imagine trader A trading symmetric 10% moves with a 60% win rate. The average trade will net him 2%. Also imagine trader B trading symmetric 4% moves with an 80% win rate. The average trade will net him 2.4%. Trader A has found a volatile market, trader B has found a predictable one. Add to this the following factors, all of which will work in the favor of trader B:

  • 4% moves come around much more often than 10% moves. Over any period of time, B will have made more trading opportunities than A, thus getting more lessons from the market, and also getting faster feedback as to whether his strategy is working, or need to be changed. Alternatively, he can choose to be pickier with his trades, thereby raising his win rate.
  • 4% moves should also take shorter time than 10% moves. Trader B will have his capital locked up in a trade much shorter time than trader A. This will either allow him to make more trades, or to be out of the market for much greater proportions of his time, thereby decreasing risk from market exposure.
  • Markets that make smaller moves tend to be much cheaper to trade. My experience is that any market that moves half as much as another one will not charge you half the commission, but more like only a quarter or even less. So even if you double your leverage, your commission costs will still be one half of what they are for the more volatile market, even with the same potential moves (after using leverage). Consider for example the cost of trading single stocks versus trading stock index futures: A German DAX future will cost you around €2 to trade, for €275,000 exposure. For the same amount of German stocks, you would probably have to pay at least 10 times that.
  • Markets that make smaller moves tend to be much more liquid, decreasing execution time, spread cost and slippage. It also allows you to trade bigger, making your trading strategy more viable to hold for the long term. This relationship, just as the one before, also tends to be more than proportional – any market with half the volatility will tend to be more than twice as liquid. For example, consider government versus corporate bonds.
  • Volatility can always be amplified with leverage, a measure that requires no effort on your behalf. There is no such no-brainer solution for amplifying your win rate.
  • Psychological research pioneered by Daniel Kahneman and Amos Tversky has shown that losses are felt at least twice as much as gains. This would indicate that a 60% win rate should actually feel more like 43% (60% gains versus 2*40%=80% “felt” losses). This would make it hard to stay motivated. By the same logic, 80% would feel more like 67% (80% gains versus 2*20%=40% “felt” losses). Even if both strategies were equally profitable, and you were disciplined enough to stay with either, which one would you rather work with?

Of course, there is nothing saying that you will have a higher win-rate in more liquid markets. In fact, liquid markets tend to be more efficient, which should decrease your win-rate. The point here is that when choosing between higher win-rate or bigger moves, the pro will always look for the former.

The amateur looks for all the reasons to do a trade. The pro looks for all the reasons not to do it.

Back to the first headline. Who will act more rationally after getting into a losing trade – the person who knew all the reasons that the trade should be a winner, or the person who knew all the reasons why it shouldn’t? Who will be the most surprised, who will be the most angry? Who will be the most discouraged?

The amateur is interested in being a trader. The pro is interested in trading.

Face it, your life will never be like the movies or the TV shows. It is always easier to sell a lifestyle than a business concept. Good traders don’t practice a lifestyle, they run a business operation. Good traders have a passion for the markets, making predictions, winning and handling risk. Don’t learn how to be like trader, learn how to do things like a trader.

What are your views on what makes a good trader? I will come back with more of my own thoughts in the future.

Beating the Street by Peter Lynch

Peter Lynch’s earlier book, One Up On Wall Street, is one of my absolute favorite books on investing. I was hoping for Beating the Street to provide a more in-depth display of his investment decisions. Deeper analysis, more case studies, that kind of thing. That is exactly what it delivered, so I was not disappointed in any way. What most distinguishes the two books from each other is their focus – One Up focuses very much on showing a general theory for how stocks are selected, basically how to build a portfolio. Beating the Street focuses more on how he has applied that general theory, with his own preference for the kind of companies and situations that he feels comfortable analyzing. I think Beating the Street is less likely to appeal to everyone, for this reason. An investor never has to understand everything – there are thousands upon thousands of companies out there that you can buy shares in. Some investors feel that they have an edge when they select stocks in a certain sector that they understand well, others feel their edge lies in specific situations instead (growth, turnarounds, macro, etc.). I have never felt any natural tendencies towards Lynch’s specialties (retail stores, growth opportunities and cyclicals) but I still think I  learned a few things from this book.

The start of the book is a bit slow. It’s very interesting to learn his experiences and how he got started in the industry, but this doesn’t seem to be his passion when it comes to writing. I was a bit dissapointed with that, because I think personal experiences are just as interesting to read about as cold facts, especially when it comes to such a famous investor.

As always, Lynch’s writing is very easy to get through – that’s a good thing by the way. Any approach that is difficult to grasp in writing would undoubtedly be way to hard to apply gainfully in practice. Something I like is that Lynch also talks about foreign investment opportunities (stocks in companies outside of USA, that is), although I have to say I’m a bit disappointed in how lightweight his research seems to be in those cases. I also find it strange how he can so closely connect the future prospects of stock investing to the confidence that USA will continue to excel economically. Everything somehow gets very USA-centric, even when talking about the great possibilities abroad. I would recommend this book for anyone who likes Lynch’s style of writing, and anyone who feels comfortable with his investment style.

Where are the customers yachts? by Fred Schwed

Every now and then, it happens that some poor financially illiterate soul gets suckered into the world of speculation. Tempted by the wealth and the yachts of the bankers and the brokers, he sets out on his own quest for riches. One man seeing the same thing as this man (it’s usually a man) famously asked the question we all ought to have asked:

Where are the customers’ yachts?

Sadly, there is a lot of truth in that comment. “Wall Street”, or financial services at large, are inventions made for making their customers rich, but what often happens is that all the wealth stays there. Sadly, the signs of this phenomenon are everywhere. This is something worthy of inspection and criticism – or satire, as the title suggests.

So why should you read something satirical on such a serious topic as investing? Maybe because we ought to ask ourselves whether investing really is all that deadly serious at all. Maybe we should treat it like everything else that we are good at – something that captures our interest and doesn’t scare us. Maybe that could help us be more objective and analytic, rather than panic-driven and instinctive. Maybe then we would ask more, think more and get fooled less. And since most of us have a really hard time criticizing our own weaknesses, maybe we should look at someone else instead? I think that is one of the purposes with humor and satire – helping improve ourselves.

Schwed’s classic book from 1940 has stood the test of time and still raises lots of questions like the one in the title. The book is by no means a manual for prospective investors, but more like an enjoyable account of all the financial folly that goes on around us. All the answers, comments and habits that just don’t get questioned. Both from the customers and the people within the industry itself. It is especially funny to see that almost all of this folly, 73 years later, is still all around us (with the addition of some other new ones). That, if anything, is a lesson one might take away from this book.

It is a wonderfully funny, rather cynical read all the way through, something I think anyone can enjoy. The language is a bit old but not so hard to follow. It is a pretty short book, and so shall also this review be. I would recommend this book to anyone being at least a bit cynical about the Wall Street culture. Which should be pretty much anyone (both on the inside and on the outside).

Running Money by Andy Kessler

Running Money tells the story of how Andy Kessler and a colleague ran a hedge fund in the late 90’s. That was the time of the dot com-boom – and later also the bubble and bust. Kessler was right in the middle of this, operating his small long-only fund from Silicon Valley and concentrating on computer companies (mostly public, but sometimes also private).

The book covers three different aspects of the same story. One is the development of his fund, how investments were chosen, his experience of the trading etc. The second is the atmosphere around him, both in the tech world and the investment world, or perhaps where they met – in the conferences, events and conversation. The third aspect is Kessler’s own development of a macro-economic theory on how the new technology will create unique investment opportunities. His theory is based on finding parallels to previous economical revolutions, mainly the industrial revolution. This theory of his is not only used as an explanation but is something that he developed during the time he was managing his fund to help find really good investments (and it worked – proving that history can be a great guide in the pursuit of good investments).

When I read a book like this, I mostly aim at exploring someone else’s story. I find that more interesting, unique, verifiable and more informative than being given broad guidelines on what to do. I found Kessler’s story to be a very interesting one, because it tells about the small details and his own personal experiences. It is also somewhat unique in that it mixes some understanding of macro (the historical parallels) into his own practical investment experience. I also like that his ideas come not as a prepared bundle, but that you actually get to see them develop as his career goes by – including all the mistakes.

Such a huge bubble that the dot com-era was, after the crash it has been more or less remembered as a bad hangover of a party you wouldn’t want to remember anyway. Maybe because Kessler got out of the market pretty soon after it peaked out, he doesn’t suffer the common illness of just trying to ignore that historical passage. It is a good reminder that most bubbles originally get started from very sound grounds and grow from developments that actually are quite revolutionary. Maybe this book could help us understand the next big revolution when it comes – if we will live for that long. Or at least help us understand the current one (which is still the digital revolution, this process is still far from being fully matured).

The writing style is very much based on dialogues. I’m not very used to this (I’ve never been a passionate novel reader), so it boggles my mind a bit sometimes. I would think that’s just my own weakness however, and anyway I have to say the book was not hard to get through and I enjoyed every moment of it. But some tech-savvy might be needed to be able to follow all the computer terms. It is by no means a guidance book, it covers a very specific topic and I think it’s fair to say it also assumes some investment knowledge from the reader.

There are 2 small things that I don’t like about this book: The first is the talk about dollars and points (“that stock was up $3 that day”), numbers that don’t tell you anything unless they can be put into proportion ($1 to $4 is quite different from $101 to $104). I don’t think I will ever understand why so many Americans and Canadians refuse to use percentages when talking about numerical changes. The other thing I don’t like is Kessler’s conclusion of his macro theory. After the bubble is over, he concludes that the world has changed dramatically, because now people are developing software in such obscure and faraway places as Norway and Finland. As if technology and creativity only existed in USA. Just plain ignorance I guess (the technology development and the dot com bubble was a global phenomenon). But still, it takes away a lot of credibility from his theoretical conclusion. On the other hand, his theory is just one of the parts of the book, and up to that point it did make a lot of sense, as he indeed proved by the stellar performance of his fund (which was not based on speculative gambles, as was the common way in those days).

In conclusion, I don’t think this is an investment book for everyone, but if you are interested in technology, history, investing and building theories, then this book will definitely be a good read for you.

Socks or stocks?

It might seem ridiculous to compare stocks to socks, but the comparison does make sense.

Imagine that the price of the average stock declined 50% in one year. I can think of three ways to describe this:

  • Stocks on sale! 50% off, first come first served! (positive)
  • Average stock prices 50% lower than last year. (neutral)
  • Stock market crashes! Stocks loose half their value! (negative)

Which one do you see the most? I bet you would say the last one. Which one most suitably describes the general mood of the investing public? Again, the answer probably is the last one. Now imagine if we were talking about socks instead:

  • Socks on sale! 50% off, first come first served!
  • Average sock prices 50% lower than last year.
  • Sock market crashes! Socks loose half their value!

Which one do you see the most? When it comes to socks, I bet you’ve never even seen the last one. What the heck is the sock market? Maybe you’ve seen the second one if you work in the sock industry? But basically, you would only see the first one.

Why is the way most of us buy stocks so different from the way we would buy anything else? Why are stocks the only market that crashes, while all the others are on sale?

Now think about the similarities between stocks and socks. Both of them you buy, and both of them have real value, even if you never sell them. Don’t try to tell me you ever managed to sell your socks at a decent profit.

It turns out that we are very shrewd market participants when it comes to socks. Not because we are good predictors of the sock market, but because we behave the right way when we buy. We buy not because we think something will happen, but because something has happened – they got cheaper. Both socks and stocks have real value, so why couldn’t we turn our sock-picking strategy into a stock-picking strategy?

You still don’t believe me? OK, so when was the last time you heard your colleague say “Oh, man I really lost my shirt on those socks”, when did you hear your friend lament “I knew I should have sold my socks last year, I knew the sock market would go down, didn’t I, didn’t I tell you that?”

Buy stocks like you buy socks and you will be happy to see them get cheaper.

Managing risk: expectations

The best way to manage risk in investing is by keeping your expectations low.

I am a big fan of investing. I think everyone should have a basic understanding of investing, and anyone who can should have some form of investments. It is a great way to get an extra income. As an employee (most of us make our living that way) you are always exposed to the risk of getting laid of. Who knows, maybe the company where you work goes bankrupt? If you earn some income from dividends in 10 different big and stable companies however, that risk is smaller. Basically all of them would have to go bust on the same day for you to be completely out of luck. For that to happen, things would have to get so bad that you would have bigger things to worry about anyway. So it is also a good way to diversify your risks, to own dividend-paying stocks in a basket of stable companies. So I tell my friends: own stocks, accumulate and buy more every year. Never sell, just wait for the dividends to roll in.

But what about the risks? What if the market goes down? What if there’s a stock market crash? They always ask.

That is, “what if stocks get cheaper?”

How could that be a bad thing? What if houses got really cheap? Buy another one, rent it out. What if stocks get really cheap? Buy more of them, collect more dividends.

(If you’re not sure about what a dividend is: A dividend is the distribution of a company’s profits, usually distributed again and again, every year, quarter or month. The dividend is paid to the owners of the company, in proportion to how many shares each one owns. If you buy stocks in a company on a stock exchange, you will become an owner of that company in exactly the same way that the founder or the CEO of that company might be an owner. You will receive part of the company’s profits in the same way as they do, in the form of dividends. A dividend is simply a sum of money that the company deposits into your account. You don’t have to sell any share to receive a dividend, it comes automatically. In fact, if you sell your shares you will stop receiving dividends because then you are no longer one of the company’s owners. There is no limit for how long a stock can be owned, it can be owned for a lifetime or get passed down through generations. The dividends received over all those years can add up to a considerable sum of money, or they can be used as an extra source of income, requiring no work what so ever. Dividends come from the company’s profits, not from the stock price, and not from the stock market. The price of a stock – its “performance”, “gains” or “losses” –  does not affect the amount of dividends the company pays.)

The price only matters to the one who buys and the one who sells. The seller wants high prices of course. Isn’t it to be expected that the buyer should want low prices then?

As long as dividends remain stable, lower stock prices is a good thing. If you’re not expecting to sell your stocks, that is. Lower prices means you can buy more future dividends for the same amount of money. And a company that grows (the company itself, not its stock price) will increase the dividends over time, without the need for you to buy more shares. There are many companies that haven’t cut their dividends in decades.

So why do we perceive lower stock prices as a risk rather than an opportunity? Because we expect to sell our shares in the future, to “get our money back“. So there is a very easy way to manage the risk of lower stock prices: Never be a seller. Decide from the start that you will not sell your shares, ever. Don’t expect to use stocks as a profit machine, but as a means of buying yourself a higher income.

Fundamentally, risk is the probability of unfulfilled expectations. Setting your expectations right is by far the best way to manage risk.

One up on Wall Street by Peter Lynch and John Rothchild

I’ve read this book two times now, but I could probably read it twenty. Lynch is one of my absolute favorite authors on stock-picking, for a variety of reasons: He keeps it simple, he uses a lot of examples, and he has a different approach, an approach that anyone can adopt. If you don’t have any experience investing at all, it might be a good idea to start with another of his books, Learn to Earn.

It’s a pity Lynch hasn’t written more books, this is something I dare say before I’ve even read all 4 of them. Because I really think he has something different to offer. He is one of the few very successful investors that has written books himself, rather than just having a biography authored by someone else. And it’s not just empty talk, Lynch doesn’t just say that you should own stocks, capitalism is wonderful and all that. Neither does he take this as a cheep opportunity to tout his own opinions. No, he actually explains in depth exactly how he himself goes about picking stocks for investing. And if that “in depth” scares you, think again. Lynch has a simple approach that no one could have a hard time understanding through the less than 300 pages. Also, his writing is very compelling, this is easily a book you could read on the bus on your way to work.

I know that Lynch’s simplistic style of writing might raise a few eyebrows. Surely it cannot be that simple to pick stocks? How can something so complicated be explained in so simple ways? Let me tell you, if you cannot make a 5-year old understand what you are doing, then you probably don’t know what you’re doing. Why do you think so many financial commentators talk in complicated terms that are hard to follow? And why do you think they keep on being commentators rather than investors? Lynch knows what he’s doing, and he gives you a superb opportunity to get to know it yourself.

I only have two negatives. One is his US-centrism which makes you wonder if he isn’t missing out on a lot of investment opportunities. Lynch often makes the point that big companies cannot grow so fast, because they have saturated the market, there is no more space to grow. That’s a very good point, but let me quote him on this: “When The Limited [a clothes retailer] had positioned itself in 670 of the 700 most popular malls in the country, then The Limited finally was.” Gee, I wonder if maybe a few people among the remaining 95% of the world’s population also would fancy having some clothes to wear? But on the other hand, he seems to be right on this point in the end anyway, because when he tells about how McDonald’s ran into growth problems in the 70’s, it seems to have taken that company at least 10 years to seriously start considering expansion outside of USA. Eating food and paying for it, somehow seems to be a global phenomenon. Naturally, most of Lynch’s practical advice applies only to US residents/taxpayers/companies etc. Practical advice is not overwhelming though, since this is a book concerned with the theoretical sides of investing (which is at least 90% of what investing is about). And the theoretical aspect will be the same to anyone, anywhere, anytime.

The other negative is that Lynch seems to regard dividends’ only value as making stocks more attractive, pushing their prices higher. While this can certainly be very true, especially for Lynch’s active investment style, I think an educational book on investing should at least mention that future dividends are the only thing that causes stocks to have a fundamental value in the first place. Explaining this briefly at least, would be a fresh way to kill the predominant misconception that stocks have value because they can be sold, to someone who would expect to sell them again… and so on. Of course you don’t have to seek dividends to be a prudent investor, but you should know that they are the reason why the last person in the string of greater fools buy the stock, without the goal of selling it to someone else. Eventually the game of hot potato has to end. Even if you don’t want to invest for the sake of getting dividends, the awareness will help you sleep better, especially through bear markets.

Investment knowledge is timeless, the principles don’t change over time. Don’t get deterred when you see that One Up was only written in 1989, with a new introduction added in 2000. The world’s most respected investment author, Benjamin Graham, wrote his books, Security Analysis and The Intelligent Investor in 1934 and 1949 and they are still in print and being used today. This book is filled with a lot of examples and historical anecdotes, a very rich source of experience and knowledge that took Lynch several decades to acquire. It will continue to be well worth reading for anyone who wants to become a better investor. I’d pretty much recommend it to anyone!

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