Note: While reading a book whenever I come across something interesting, I highlight it on my Kindle. Later I turn those highlights into a blogpost. It is not a complete summary of the book. These are my notes which I intend to go back to later. Let’s start!

  • Now, what do you do when you’re in high school and someone asks you to run for student council? You say, “Sure.” But then you don’t run; you anti-run. Everything is done to de-emphasize it because you don’t want the embarrassment of trying and losing. So I said to myself, “Self, whether you lose because you didn’t run for the Board of Governors or whether you lose because you ran hard, it’s the same outcome. So let’s really run hard. Let’s get aggressive and try to get elected. And if you don’t get elected, you don’t get elected. Big deal.” I did everything I could to get elected. I sent platform letters. I had Jack Salmon send letters. Then I sent hand-written letters asking for votes. Well, nobody else was really running. They were all doing the “I don’t want to run because I don’t want to lose” routine. If you run aggressively in that situation, you win by a landslide. I won 121 votes out of 150 votes.

  • I was elected to the Board of Governors of the CME after only six months in Chicago. I was 33 years old, looked like I was 25 and acted like I was 22, but I was on the Board of Governors. After the election, Leo Melamed came up to me and said that I would also represent the NLM on the Executive Committee of the Board of Governors since I had the most votes in the election. It turned out the Executive Committee was where everything really happened. Anytime you see a committee of more than ten, it isn’t the real committee. There’s a sub-committee somewhere making the decisions. So the Board at that time was eighteen members and the Executive committee was six. I couldn’t believe I had just been elected to the Board of Governors, and I didn’t even know the Executive Committee existed. But suddenly I was on it. I had only been in town six months, and I was elected because I had presence, wore a vest and $80 shoes, knew a lot about the markets and knew a lot of people in the industry.  

  • All losses can be categorized either as: (1) internal; such as self-control, esteem, love, your mind, or (2) external; such as a bet, a game or contest, money. External losses are objective and internal losses are subjective. That is, an external loss is not open to subjective, individual interpretation; it is an objective fact. On the other hand, an internal loss is defined in terms of the individual (i.e., subject) experiencing it. In other words, a loss is objective when it is the same for me, you and anyone else. The loss is subjective when it differs from one person to another; when it is entirely a personal experience.

  • Because people tend to regard loss, wrong, bad and failure as the same thing, it is little wonder that loss is a dirty word in our vocabulary. However, in the markets losses should be viewed like the light bulbs or rotten fruit mentioned earlier: part of the business and taken with equanimity. Loss is not the same as wrong, and loss is not necessarily bad. For example, consider exiting a losing position with a small loss, but before the loss got bigger. That was a loss, but it was a good decision. By the same token, a profitable trade based on a tip may be bad because of the dangers of following tips (i.e., the tipster may have incorrect information or he doesn’t tell you when to get out). Market losses are external, objective losses. It’s only when you internalize the loss that it becomes subjective. This involves your ego and causes you to view it in a negative way, as a failure, something that is wrong or bad. Since psychology deals with your ego, if you can eliminate ego from the decision making process, you can begin to control the losses caused by psychological factors. The trick to preventing market losses from becoming internal losses is understand to how it happens and then avoiding those processes.

  • Most people don’t know whether they are engaging in inherent or created risk activities. Couple this with people’s failure to distinguish between the two types of loss-producing events, continuous and discrete, introduced at the end of the last chapter and you have a disaster waiting to happen. Recall that in discrete events, such as gambling and betting games, there is a defined end to the risk activity. But inherent risk activities are continuous processes with no predetermined end. For instance, running a business keeps you continuously exposed to the risks coincident with the commitment of resources to future expectations. A single sales transaction may be a defined event with a beginning and an end, but the business operation itself is a continuous process. Likewise, a market position is a continuous process, which introduces the possibility of internal losses because of the uncertainty of when the process will end. On the other hand, created risk activities are associated with discrete events, such as sports games, political contests or the rolls of the dice; the game ends, the contest finishes and the dice stop rolling. Betting and gambling are suitable for discrete events but not for continuous processes. If you introduce the behavioral characteristics of betting or gambling into a continuous process, you are leaving yourself open to enormous losses. In betting and gambling games, you wager and wait to see if you are right or to experience some excitement, respectively. Any resulting monetary losses are real, but they are also passive because the discrete event ends all by itself. On the other hand, a position in the market is a continuous process that doesn’t end until you make it end. If you “wager and wait” in the market, you can lose a lot of money. In betting and gambling games if you stop acting and do nothing, the losses will stop. But when investing, trading or speculating if you’re losing and stop acting, the losses don’t stop; they can continue to grow almost indefinitely.

  • We’ve already seen that everyday life involves risk. Likewise, estimating and managing those risks is a necessary part of everyday life. Probability is the mathematics of estimating risk and you know how I feel about math. I’m not going into a long dissertation on the subject. I am, however, going to point out some of the more common misunderstandings about probability and how we psychologically distort situations to make the odds seem more in our favor. I want to point out a few examples of the psychological fallacies most people have when it comes to risk and probability. 1.The first psychological fallacy is the tendency to overvalue wagers involving a low probability of a high gain and to undervalue wagers involving a relatively high probability of low gain. The best examples are the favorites and the long shots at racetracks. 2. The second is a tendency to interpret the probability of successive independent events as additive rather than multiplicative. In other words, people view the chance of throwing a given number on a die to be twice as large with two throws as it is with a single throw — like throwing sixes four times in a row in craps and thinking that must mean their chances of throwing a seven next have improved. 3. The third is the belief that after a run of successes, a failure is mathematically inevitable, and vice versa. This is known as the Monte Carlo fallacy. A person can throw double sixes in craps ten times in a row and not violate any laws of probability, because each of the throws is independent of all others. 4. Fourth is the perception that the psychological probability of the occurrence of an event exceeds the mathematical probability if the event is favorable and vice-versa. For example, the probability of success of drawing the winning ticket in the lottery and the probability of being killed by lightning may both be one in 10,000; yet from a personal viewpoint, buying the winning lottery ticket is considered much more probable than getting hit by lightning. 5. Fifth is people’s tendency to overestimate the frequency of the occurrence of infrequent events and to underestimate that of comparatively frequent ones, after observing a series of randomly generated events of different kinds with an interest in the frequency with which each kind of event occurs. Thus, they remember the “streaks” in a long series of wins and losses and tend to minimize the number of short-term runs. 6. Sixth is people’s tendency to confuse the occurrence of “unusual” events with the occurrence of low-probability events. For example, the remarkable feature of a bridge hand of thirteen spades is its apparent regularity, not its rarity (all hands are equally probable). As another example, if one holds a number close to the winning number in a lottery, he tends to feel that a terrible bad stroke of misfortune has caused him just to miss the prize.   

  • The definition of risk is to expose to the chance or possibility of loss. Most people erroneously try to assign a numerical value to that chance, which simply confuses risk with probability. In the markets we are talking about unique, non-repeatable events so we can’t assign a frequency probability to their occurrence. In statistical terminology, such events are categorized under case probability, not class probability. This means the probability of market events is not open to any kind of numerical evaluation. All you can actually determine is the amount of your exposure as opposed to the probability that the market will, or will not, go to a certain price. Therefore, all you can do is manage your exposure and losses, not predict profits.

  • Perhaps the most common fallacy to which market participants are susceptible is: Money Odds vs. Probability Odds. Many market participants express the probability of success in terms of a risk/reward ratio. For example, if I bought my famous takeover stock (which you will hear about in the next chapter) at $26 and placed a sell stop below the market at $23 with an upside objective of $36, my risk/reward ratio would be 3:10. Risk $3 to make $10. It is clear that I don’t understand probability. Couching my rationalizations in arithmetic terms does not automatically lend credibility to my position. The 3:10 ratio has nothing to do with the probability that the stock can or will get to $36. All the ratio does is compare the dollar amount of what I think I might lose to the dollar amount of what I think I might make. But it doesn’t say anything about the probability of either event occurring.

  • There are two kinds of reward in the world: recognition and money. Are you in the market for recognition, congratulating yourself for calling every market move ahead of time and explaining the move after the fact, or are you in the market to make money? Are you more interested in the psychological reward of gold stars than the financial reward of gold coins? Are you trying to be right or to make money? Are you motivated by the prophet motive or the profit motive? To answer, you have to figure out which type of participant you are: bettor, gambler, investor, trader or speculator. You do this by examining the characteristics and behaviors you are exhibiting, not the activity, i.e., opining on the outcome of a political race, playing at a blackjack table, buying stocks, trading in the pit or buying I selling commodity futures from your Blue Bird Wanderlodge. The characteristics displayed determine the activity. Embarking upon games or entering the markets can be either an end or a means. It is an end for people who yearn for the stimulation and excitement which the vicissitudes of a game or the market provide them (e.g., gamblers), or those whose vanity is flattered by the display of their superiority in playing a game which requires cunning and skill (e.g., bettors). It is a means for professionals who want to make money (e.g., speculators, investors and traders).

  • In Manias, Panics and Crashes by Charles P. Kindleberger we find The Minsky Model: 1) Displacement — some exogenous event (war, crop failure, etc.) shocks the macro-economic system. 2) Opportunities — the displacement creates profitable opportunities in some sectors of the economy and closes down other sectors. Investment and production focuses on the profitable sectors and a boom is underway. 3) Credit expansion — an expansion of credit feeds the boom. 4) Euphoria — speculation for price increases couples with investment for production/sale.

  • The basic distinction between the individual and the crowd is that the individual acts after reasoning, deliberation and analysis; a crowd acts on feeling, emotion and impulses. An individual will think out his opinions, whereas a crowd is swayed by emotional viewpoints rather than by reasoning. In the crowd, emotional and thoughtless opinions spread widely via imitation and contagion.33 Learning the characteristics of a crowd and how it forms will provide a structure which shows how emotionalism affects your decision-making. Once you know the structure, you’ll know what to avoid in order to prevent emotionalism.

  • There are three main characteristics that describe the mental state of an individual forming a part of a crowd. As you will see, the same characteristics can also be exhibited by an individual making investment and trading decisions. 1.      A Sentiment of Invincible Power The individual forming part of a crowd acquires a sentiment of invincible power; the improbable doesn’t exist for the crowd or its members. According to Webster’s dictionary, sentiment is a complex combination of feelings and opinions as a basis for judgment. This feeling of invincible power tends to make a person yield to instincts and emotions that he would ordinarily keep in check. But the crowd is anonymous and anyone in the crowd will shirk responsibility for his actions. In a crowd people do things they wouldn’t ordinarily do, because they are anonymous and feed off the power provided by the crowd. The responsibility that keeps individuals in control vanishes in the crowd. (Witness the actions of fans who storm the football field after a victory and tear down the goal posts.) This is how I was in the bean oil trade. I was invincible. I could do no wrong. As far as I was concerned, there was no question that the trade was going to make $10 million. 2. Contagion The American Heritage Dictionary defines contagion as the tendency to spread as an influence or emotional state. This is like the spontaneous wave at a football stadium, or the riots which break out in a city after a home team’s championship victory. It’s like being hypnotized or mesmerized. Watching prices change on the computer screen, getting quotes from your broker throughout the day, seeing the stock ticker on the bottom of your TV screen or just being in the market and experiencing prices going up and down can serve as the hypnotist’s watch swinging back and forth in front of his subject. This describes my mental state in the motor home when I was keeping up with the markets on the telephone. 3. Suggestibility The best way to describe this is the way a hypnotized subject, in the hands of his hypnotizer, responds to the power of suggestion. He is highly suggestible and no longer conscious of his acts. Under the influence of a suggestion, he will undertake the accomplishment of certain acts with irresistible impetuosity. This sounds just like me when I was driving down the Jersey turnpike, glued to my telephone and listening to the changing prices, and when I took the suggestions on the bean oil trade and the stock trades and ran with them. In the special state of fascination (contagion), an individual is in the hands of the price changes on the screen, the words and suggestions of whoever got him into the market in the first place or anyone else from whom he seeks opinions. The most striking peculiarity presented by a psychological crowd is the following: Once individuals have formed a crowd, however like or unlike their mode of life, their occupation, their character or their intelligence, that fact that they have been transformed into a crowd puts them in possession of a sort of collective mind which makes them act in a manner quite different from that in which each individual would act, were he in a state of isolation. A person in a crowd also allows himself to be induced to commit acts contrary to his most obvious interests. One of the most incomprehensible features of a crowd is the tenacity with which the members adhere to erroneous assumptions despite mounting evidence to challenge them. So when an individual adheres to a market position despite the mounting losses, he is a crowd.

  • Two Psychological Crowd Models Delusion Model The delusion model describes the process an individual becoming part of a psychological crowd before he has a position on. 1. Expectant Attention; 2. Suggestion Made; 3. Process of Contagion; 4. Acceptance by All Present. This model illustrates exactly how the net loser participates in the markets. He is ready! Because he is so anxious to make money, he is in a state of expectant attention. He hears a tip or a casual comment about the market; enthusiasm is contagious and he goes into a hypnotic-like trance, takes the tip as gospel and acts on it. Compare this to when you’ve made hasty, impulsive, spur-of-the-moment decisions or followed someone else’s tip to get in or out of the market I went through the same process when I entered the takeover stock trade and the bean oil position In both of these instances, as well as many others, I was in an expectant state of attention; ready to make money. Once the trades were suggested to me, a process of contagion took over and I acted. The reason why people who try to make back losses quickly lose again is because they are in an expectant state of attention ready to pounce on any trade suggested. This makes them part of the crowd, emotional to the extreme and bound to lose. The Illusion Model The illusion model accurately describes the process of an individual becoming part of a psychological crowd after he has a position on. 1. Affirmation; 2. Repetition; 3. Prestige; 4. Contagion. Consider the following scenario. An opinion about the market is expressed (affirmation) either by you or someone else. It gets repeated (repetition) to others. Friends ask what you think about the markets and you repeat the opinion, selling yourself on the idea once again. Next, prestige comes into play. Prestige is a sort of domination exercised over us by an individual, a work, an idea or a wish. It entirely paralyzes our critical faculty and fills us with wonderment. The market is going your way; you look like a hero; you’re so smart (prestige); you have the adulation of your peers. Emotionalism overwhelms you (contagion). You’re hypnotized. The illusion model can also be applied to losing trades if the prestige involved comes from your daring actions and being able to take the punishment of a losing position. Sure, the market is against you, but you’re courageous and you can take it. The market is wrong and will turn around. You take pride in your courage to go against the crowd because according to market lore, the crowd is supposed to be wrong. People marvel at your ability to stay with a losing position. Once again you become hypnotized (contagion) and are out of control. The trade will end only when you are forced out by external forces (e.g., money, family, margin clerk). This is exactly what I did once the bean oil position started going against me. Why else would I let the once profitable bean oil position erode to the point where I’d basically lost my prior life?

  • Recall from basic economics that markets exist to satisfy the wants and needs of consumers. This means people make purchases for only one of two reasons: to feel better (satisfying a want) or to solve a problem (satisfying a need). Trying to do the former in the financial markets is dangerous. If you are in the markets to achieve a certain emotional state or create self-esteem, then you have some psychological disorders and need to see a therapist.  

  • 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.

  • 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.  

  • All enterprise, all human activity inextricably involves risk for the simple reason that the future is never certain, never completely revealed to us. 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. 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. 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.” 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.

  • 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 to 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. Consider the following story about an individual investor reported by The Wall Street Journal. “After seeing the nearly 87% return that Twentieth Century Investor’s Ultra Fund racked up in 1991 by concentrating on biotech and computer-related stocks, he took the plunge, paying about $18 a share for the Ultra fund. A year later with Ultra shares below $15 a share he felt stuck. ‘Some people say cut your losses, but I’ve already lost too much,’ the investor said. ‘Luckily, I don’t need the money right away.”‘ Well, is the market going to conveniently rebound for him when he does need the money? “I can’t get out here, I’m losing too much,” is the worst thing you’ll hear a trader or investor say! What he is saying is: he’s getting absolutely crushed, crucified and buried and he can’t get out of the market because he’s getting crushed, crucified and buried. That’s stupid. Anytime someone says he can’t get out because he’s losing too much, he has personalized the market; he just doesn’t want to lose face by realizing the loss. To make matters worse, since most stock players pay for their stock in full, they are very prone to extending their original time horizon. Why? Because they are never forced out of the market when the position starts to lose money. Even when they buy stocks on margin, it’s a 50% margin as opposed to normal 4% to 12% for futures traders. So it’s very easy in the stock market to let a loss get out of control simply by lengthening your time horizon and becoming an investor. The stock investor can stay in the position forever. A futures speculator, on the other hand, will be forced out of the market when the contract expires. So even if he has financed a losing futures position, he is forced into making a new decision at expiration as to whether or not to stay with the position. The stock player has no such forcing point, which is why it’s especially important to decide what type of participant you’re going to be when you’re in the stock market. Next, you must select a method of market analysis that you are going to use. Otherwise, you will jump back and forth among several methods in search of supporting evidence to justify holding onto a market position. Because there are so many ways to analyze the market, you will inevitably find some indicator from some method of analysis that can be used to justify holding a position. This is true for both profitable and unprofitable positions: you will keep a profitable position longer than originally intended and possibly have it turn into a loss, and you will rationalize holding a losing position far beyond what you were originally willing to lose. Your analysis is the set of tools you will use to describe market conditions. Fundamental analysis in the stock market doesn’t tell you when to enter the market. There isn’t a magic formula combining the various fundamental data that tells you when to buy and when to sell. A certain level of expected earnings combined with its P/E ratio, price to book value ratio and other fundamental variables doesn’t specifically instruct you on when to make actual purchases and sales. The different methods of technical analysis don’t always offer specific instructions on when to make purchases or sales either. They are means of describing the conditions of the market. Analysis is simply that: analysis. It doesn’t tell you what to do, or when to do it. In order to translate your analysis into something more than mere commentary, you need to define what constitutes an opportunity for you. That’s what rules do; they implement your analysis. Rules are hard-and-fast. Tools (i.e., methods of analysis) have some flexibility in how they are used. Fools have neither rules nor tools. You must develop parameters that will define opportunities and determine how and when you will act. How? By doing homework (i.e., research, testing, trial-and-error), and defining the parameters with rules. Your homework determines what parameters or conditions define an opportunity, and your rules are the “if . . . , then . . .” statements which implement your analysis. This means entry and exit points are derived after you have done your analysis. If the opportunity-defining criteria aren’t met, you don’t act. This doesn’t mean a particular trade or investment which you pass up won’t turn out to be profitable. It might have been an acceptable and profitable trade based on someone else’s rules. Remember, participating in the markets is about making decisions, and as Drucker reminds us, “There is no perfect decision. One always has to pay a price which might mean passing up an opportunity.” You have to accept the fact that profitable situations will occur that you won’t participate in. Don’t worry about the ones you miss; they were someone else’s. Your rules will only enable you to participate in some of the millions of possible opportunities, not all of them. The next step in decision-making is establishing controls; i.e., the exit criteria which will take you out of the market either at a profit or loss. They take the form of a price order, a time stop or a condition stop (i.e., if a certain thing happens or fails to happen then you are getting out of the market). Your exit criteria create a discrete event, ending the position and preventing the continuous process from going on and on. According to Drucker, “controls follow strategy.” So in terms of a business plan, market selection and entry criteria constitute the strategy while exit criteria constitutes controls. Drucker’s observation means that the controls should be consistent with the strategy, not that they should be selected after the strategy is implemented. Unfortunately, most market participants pick their stop after they decide to enter the market and some never put in a stop at all. You must pick the loss side first. Why? Otherwise, after you enter the market everything you look at and hear will be skewed in favor of your position. For example, if someone has a long position and you ask him what he thinks about the market, is he going to tell you all the reasons why it should go down? Of course not. He’s going to tell you all the reasons why it should go up. Another reason controls should precede strategy is that, as we learned in Chapter Seven, you can’t calculate the probability a trade being profitable; you can only calculate your exposure. So all you can do is manage your losses, not predict profits.

  • Regardless of the methodology used, before you decide to get into the market you have to decide: where (price) or when (time) or why (new information) you will no longer want the position.   

  • The distinguishing factor of “the” recipe is determining the stop loss criteria before deciding whether and where to enter the market. Citing Drucker once again, “The first step in planning is to ask of any activity, any product, any process or market, ‘If we were not committed to it today, would we go into it?’ If the answer is no, one says, ‘How can we get out — fast?” As a market participant you don’t have to be committed to the market at all, so you ask the latter question before getting in the market in the first place. After you know where you want to get out of the market, then you can ascertain whether and where you are comfortable getting into the market. In contrast to what most people do, your entry point should be a function of the exit point. Once you specify what price or under what circumstances you would no longer want the position, and specify how much money you are willing to lose, then, and only then, can you start thinking about where to enter the market. Naturally, this procedure will cause you to miss some good trades. Price limit orders that were entered to initiate new positions yet remain unfilled are trades we wish had been made. However, “profitable trades” which are missed actually cost zero; while poor controls (pick the stop later) or no controls (no stop) will sooner or later cost you a lot of money. Having picked your exit loss criteria before entering the position, presumably you choose an amount of loss you could tolerate. After that, leave your exit order alone, change a trailing stop to lock in more profit if you’re following a technical method of analysis, or monitor for any change in the fundamentals which you previously determined would cause you to exit the position if you’re following a fundamental method. If you wait until after the position is established to choose your exit point or begin moving the stop to allow more room for losses, or alter the fundamental factors you monitor in your decision-making, then you: 1) internalize the loss because you don’t want to lose face, 2) bet or gamble on the position because you want to be right and 3) make crowd trades because you’re making emotional decisions. As a result, you will lose considerably more money than you can afford. Your plan is a script of what you expect to happen based on your particular method of analysis and provides a clear course of action if it doesn’t happen; you have prepared for different scenarios and know how you will react to each of them. This doesn’t mean you’re predicting the future. It means you know ahead of time what alternative courses of action you will take if event A, B or C happens. The soundness of this approach for both markets and business is evidenced by something called scenario planning; “a structured, disciplined method for thinking about the future and a technique for anticipating developments in fluid political and economic situations.”

  • You can be right and lose money. But which is more important? Remember, there are two kinds of reward in the world: recognition and money. Are you being motivated by the prophet motive or the profit motive? In the markets and in business don’t concern yourself with being right. Instead, follow your plan and watch the money.

  • Remember, participating in the markets is not about egos and being right or wrong (i.e., opinions and betting), and it’s not about entertainment (i.e., excitement and gambling). Participating in the markets is about making money; it’s about decision-making implemented by a plan. And if implemented properly, it’s actually quite boring waiting for your buy/sell criteria to materialize. The minute it starts getting exciting, you are gambling. The only way to combat falling into the opinion trap is to follow Rand’s lead: think before you answer — if you even answer. If someone asks you what you think about the market, avoid personalizing the market by answering something along the lines of: “According to the method of analysis I use and the rules I use to implement the analysis, if the market does thus and such, I’ll do this. If the market does such and thus, I’ll do the other.” This response expresses your deductive thinking in the form of an objective plan rather than inductive thinking in the form of a subjective opinion. The response is also consistent with viewing the market objectively, instead of subjectively which would lead to personalizing your successes and profits, as well as your failures and losses. Answering in the manner just described is not an attempt to absolve you of responsibility for your decisions. On the contrary. Taking responsibility and taking something personally are two different things. It is possible to accept responsibility for the ultimate outcome of a decision without internalizing the intervening upswings and downdrafts, and postponing the final outcome to the constantly postponed future, hoping the loss will turn around so you can be right.

  • After you have developed your plan, start preparing your speech, so to speak, about what you’re going to do if certain conditions aren’t fulfilled by a certain time and what those conditions are. Like any good speech writer, you should start by putting pen to paper. To prevent unintentional and implicit violation of your plan, no device is more effective than setting down that plan before your eyes explicitly in black and white. This objectifies, externalizes and depersonalizes your thinking, so you can hold yourself accountable.