Is speculation the root of all evil? Consider this excerpt from my third book, Trend Commandments:
The film director Oliver Stone believes that speculation is evil. That’s interesting. He has written some fantastic scripts. He has directed Oscar-winning films. Nevertheless, to say that speculation is “the mother of all evil” is disingenuous. When Stone sets forward to make a new film, he’s speculating that you will spend your money and watch his film. There is nothing wrong with that. That’s life. That’s a good thing.
Speculation in markets is essential too. Think about what drives a market. It is millions of people speculating to make money. One of the most successful trend following traders knows deep down how important speculation is to finding opportunity:
“Speculari, the Latin root of the verb “to speculate” has the literal meaning to observe. To be successful this observation must, of necessity, be detached and unemotive and thus where great social and moral issues are at stake, it is perhaps not surprising that distrust and hostility among the general population can arise particularly when the speculator profits at a time of general discontent. Yet this detached observation is clearly in the spirit of the natural scientist and the act of speculating for money is in the spirit of the empirical scientist’s restless yearning to add to empirical knowledge and put theories to the test.”
Regardless of whether you win or lose, you are speculating—trying to get ahead. Every time you get into a car, you are speculating. If you go to the Apple store to buy an iPhone you are speculating the phone is more valuable than your dollars. Additionally, you are speculating the iPhone will work. When you turn on a show you are speculating that it is worth more than something else. All of these activities don’t always work out, and that is the nature of speculation. All speculators are not winners.
So why is it bad to take advantage of an opportunity that you recognize? It’s not.
Speculate this: Do you consider yourself an investor or a trader? Investors put their money into investments hoping value will increase over time. Typically, they have no plan if it goes down. They usually hold on, praying value will reverse and go back up. Investors typically succeed in bull markets and lose in bear markets. They usually have no coherent response when the losing starts. They often hang tight and continue to lose even more.
Traders are different. They have a defined strategy to put money to work for a single goal: profit. Wise trend traders do not care what they buy or sell as long as they end up with more money in the long run. Bottom line, winning traders don’t invest, they trade. It is a massive distinction. Consider timeless qualities essential to speculation:
1. Self-reliance: A man must think for himself and must follow his own convictions. Self-trust is the foundation of successful effort.
2. Judgment: That equipoise, that nice adjustment of the faculties of one to the other, which is called good judgment—essential to the speculator.
3. Courage: That is, confidence to act on the decisions of the mind. In speculation, there is value in the dictum: Be bold, still be bold; always be bold.
4. Prudence: The power of measuring the danger, together with a certain alertness and watchfulness, is very important. There should be a balance of prudence and courage; prudence in contemplation, courage in execution.
5. Pliability: The ability to change an opinion, the power of revision. He who observes and observes again is always formidable.
I don’t care whether you ever trade, but those precepts should be the first life lessons taught to grade school kids.
How does Ray Dalio, George Soros and Paul Tudor Jones trade? The other big macro traders you read about in the books? How do they make their money? They are all fundamental guys who have big opinions about the directions of major markets (currencies, bonds, stocks, metals, energies, etc.) and use all of their intelligence to make the right bets year after year decade after decade? That’s their process?
Hold that thought.
How do trend followers trade? That answer is the foundation of my books. How can you be sure how trend followers trade? Their performance data for starters. You can see their performance data. You can look at the markets moving and see where the profits originated. And over the years the performance of trend following traders can also be compared to other trend followers where you can see the correlation of their performance. So not only does the story of what trend followers do to make money make sense, you can see the proof.
Confidence builder 101.
Now back to the big macro traders (many of which are positioned as fundamental traders; Dalio, for example, says he is 100% systematic using only fundamentals) that don’t hold themselves out as trend followers, but seem to trade the same markets making money off the big moves across all markets (just like trend following traders). Traders like Dalio, Soros, Simons, etc. are harder to analyze as their performance numbers are not as public (like trend following traders). Plus, even when the big macro traders give hints of what they do–are their words believable? You mean I should just accept that the big macro funds trade using fundamentals? Trust the media accounts? Trust the press releases?
Think about it this way. Consider “Argo” the winner of 2013 Oscar for Best Film.
The craft in this film is rare. It is so easy to manufacture a thriller from chases and gunfire, and so very hard to fine-tune it out of exquisite timing and a plot that’s so clear to us we wonder why it isn’t obvious to the Iranians. After all, who in their right mind would believe a space opera was being filmed in Iran during the hostage crisis?
After all, who in their right mind would believe the most famous macro hedge funds promoted for decades as fundamentally-based are really classic technical trend followers? Look at it this way: If the American government in the late 1970s could pull off the Canadian Caper (the basis of the film Argo) with fantastic subterfuge, isn’t it possible that some of the richest men on the planet could disguise their trading technique to sell a story to investors? Do I know this to be 100% true? No, but draw your own conclusions, do your own homework and try hard to not blindly accept press accounts.
Recently the TV hit me with an ad playing in the background. All I heard was:
“If you are like most your retirement dreams have seen better days.”
If I had a gun at the moment, I would have shot the screen. Not because I am worried about retirement, but because of the weenie culture that is being cultivated by the media. However, I guess that is not surprising when you consider this excerpt from The New York Times:
“…today’s children do grow up with soccer leagues and spelling bees where everyone gets a prize. On some playgrounds dodge ball is deemed too traumatic to the dodging-impaired. Some parents consider musical chairs dangerously exclusionary. Children are constantly feted for accomplishments that used to be routine. They may not all be honored at a fourth-grade graduation ceremony – the event in the movie that inspires Mr. Incredible’s complaint about mediocrity – but they all hear the mantra recited by Dash’s sister in response to his ambitions. “Everyone’s special, Dash,” she says. “Which is another way of saying no one is,” he replies. The villain, Syndrome, makes the same point when he envisions empowering the masses with his inventions. “Everybody will be super, which means no one will be,” he says, gleeful that he will finally have revenge on Mr. Incredible for snubbing him during his childhood.”
Everyone wants it easy, but as Allan Sloan of Newsweek once penned, it doesn’t work that way:
“The message here: unpleasant as it is, let’s admit that there’s no such thing as a free lunch. It’s an up-and-down world; be prepared to take the occasional lump. In the markets, as in life, there’s no such thing as return without risk.”
Banning dodge ball and singing Kumbaya are not a path to success. Group hugs will not generate excellence. While American Idol’s Paula Abdul reflects the warm and fuzzy self-empowerment approach to life it is Simon Cowell who we can really learn from. The path to greatness starts by calling it like it is.
Unfortunately, the average investor to his or her detriment is stubbornly fixated on the security of a ‘nanny’ existence allowing others (mostly media and brokers) to define financial success as: “Take what the average is and be happy you poor sap!” Finding out how great traders actually do it is ignored.
No doubt for average investors great trend traders have been shrouded in secrecy. This mystery has propagated because typical portrayals label super earners as genetic freaks, magicians, charlatans or pedigreed investment bankers. The truth? They are almost all self-starter entrepreneurs who through concentration, drive, and fierce independent streaks, have cultivated their knowledge of how to mint money and achieved tremendous success.
That should be good news. For today, more so than ever, with so much uncertainty, people are scared. They don’t know what steps to take with their money and many just want to hide it under a mattress. The world appears more dangerous than it’s ever been and paralysis seems like a good option to many. And while it might appear harder than ever to make money investing and trading, that”s not the case. The world is actually the same as it always has been unpredictable — which is good or bad depending on your vantage.
Sadly, though millions still vicariously follow Warren Buffett for ideas on when to enter and exit the market or for stocks to buy. Others follow CNBC for stock tips and breaking news looking for ideas. Others treat market gurus as prophets and still others read nonstop columns and blogs trying to divine what to do with their money. When the TV people say its time to buy Exxon or dump Apple, many follow that random advice blindly.
This doesn’t work if you want the chance to make money. If you’re worried about an uncertain future (something every investor should be) the ‘secret’ is not to focus on which stocks to buy or sell, but instead to focus on ‘risk.’ Learning how to manage, control and use risk is the most important technique any trader can know.
However, it is hard. People are smacked daily with noise. For example, I pose the questions: Why do people listen to Jim Cramer on a regular basis? Why should anyone pay attention to him? Are they thinking, ‘Maybe Cramer will help me win the millions in the stock market?’ Or, ‘Maybe he’s right in recommending Google and I can make a killing?’ Or, are people just too sheep-like and gullible to see through the gurus?
The Cramer audience doesn’t understand that following his advice won’t make them a winner. In fact, the odds of winning and losing in the long run by following any talking head’s advice are astronomically bad. Think of it this way: Cramer comes on and says buy ‘XYZ’. Isn’t he saying that to the whole world? Not much of an exclusive. Worse yet, if you allow yourself to buy on Cramer’s tips, does he call you when its time to sell? Or are you just assuming when Cramer says ‘buy’ that the stock will go up forever and you’ll never ‘sell’? And even if you could answer these questions Cramer leaves the most important aspect of making money out. He never tells you how to use, manage, and control risk to your advantage.
While Cramer keeps talk about risk to a whisper, those who know the subject well are the real winners. ‘Risk’ is behind the greatest hedge fund fortunes, the biggest mansions in Palm Beach, Fla. and Greenwich, Conn. Those who used risk management to make millions (and in many cases billions) didn’t get that way writing down television guru’s stock picks every night. They made their money by asking questions like: ‘What can I win?’ ‘What can I lose?’ ‘What are the probabilities of each outcome?’ They don’t waste time with ‘tips’ or the supposed ‘right time to buy’.
No clear understanding of risk or knowledge of risk management? You will lose over the long run. Why? We all have limited money that’s why. Bottom line if we don’t know how to manage our losses, we won’t have any money to play the game to make more. Consider wisdom from a famed trader about ‘risk’:
“Risk is the possibility of loss. That is, if we own some stock, and there is a possibility of a price decline, we are at risk. The stock is not the risk, nor is the loss the risk. The possibility of loss is the risk. As long as we own the stock, we are at risk. The only way to control the risk is to buy or sell stock. In the matter of owning stocks, and aiming for profit, risk is fundamentally unavoidable and the best we can do is to manage the risk. To manage is to direct and control. Risk management is to direct and control the possibility of loss. The activities of a risk manager are to measure risk and to increase and decrease risk by buying and selling stock.”
Maybe you assume you get ‘risk’ already, but my 14 years of experience covering and writing about top traders says most people don’t have a clue. Consider how important risk management is to some of the top market wizards, the top traders who make millions (if not billions):
“Throughout my financial career, I have continually witnessed examples of other people that I have known being ruined by a failure to respect risk. If you don’t take a hard look at risk, it will take you.”
“Frankly, I don’t see markets; I see risks, rewards, and money.”
“If I have positions going against me, I get right out; if they are going for me, I keep them… Risk control is the most important thing in trading. If you have a losing position that is making you uncomfortable, the solution is very simple: Get out, because you can always get back in.”
Paul Tudor Jones
“Don’t focus on making money; focus on protecting what you have.”
Paul Tudor Jones
“You can give anyone the best tools in the world and if they don’t use them with good money management, they will not make money in the markets. We’re convinced that a person could make a profit simply by buying and selling the markets according to the dart board if they followed all the right things as far as money management is concerned.”
“If you have an approach that makes money, then money management can make the difference between success and failure…I try to be conservative in my risk management. I want to make sure I’ll be around to play tomorrow. Risk control is essential.”
I have sat down with many of the great traders. In their offices, in their homes, over dinner, on multiple continents — like a broken record they all lead with risk as their topic number one when it comes to making money.
Risk management can go by different names: asset allocation, position sizing, portfolio heat, portfolio sizing, size management, money management and bet size selection. ‘Bet’ is probably not a word most people associate with managing risk, but every ‘bet’ (read: trade or investment) we take involves the decision to risk something of value for an uncertain prospect of gain in the future. Placing winning bets over the long run requires innumerable decisions in the face of innumerable trade-offs — but it can be done.
The great traders have learned how to win in volatile, uncertain, complex and ambiguous environments (the environments the market is in most of the time) because they understand betting (read: risk management). Play poker in Vegas and you have a fighting chance. Play roulette and over time you will continually lose. Wall Street’s top earners trade like poker players by always knowing the odds and their ‘edge’ (a simple example of managing risk). They bet the ranch when the odds are in their favor and they walk away when the odds are bad.
Bottom line, no one gave me permission to educate clients on these subjects. I seized the education mantle. There was a vacuum, and seizing it gave credibility. It opened doors. Why does a London based hedge fund with billions under management make my first book mandatory reading, but refuse all on the record interviews with me? Why did one hedge fund not mentioned in my first book buy 3000 copies? Why did another not mentioned buy 1000 copies? Why did so many top traders speak with me to begin with?
They know I do the work. They I know the write truth. However, finding the truth, digging it up and putting into digestible form takes time, energy and many Aha! moments — or said another way a jolt of electricity to the brain. One of those jolts for me occurred in 2005 upon learning of the existence of a documentary profiling legendary trader Paul Tudor Jones. Jones made $500 million in 2005, so seeing him in action nearly twenty years before was a must.
My gut said that this out of print documentary would provide serious insights, but it was tough to find. Ebay, Amazon, etc. were dead ends. When it was located my intuition was dead on. Once you start watching, you can’t stop.
The March 1987 documentary was made when Jones was 32 with 22 employees and only $125 million under management. Today he has 300 employees and $15 billion under management. His right hand man at the time, also featured in the documentary, was Peter Borish. He was 27.
This documentary revealed a raw side behind the scenes. Jones and Borish were squarely in the middle of a game with one goal: to get very rich. Borish knew there were no shortcuts:
“I am graded instantly through the harshest teacher in the world — the market. There is no curve. I can’t say, ‘boy I was out late last night and everybody else was in the class was at a pep rally for the football game and I only got a 70, but that was the highest in the class so I still got an A.’ It doesn’t work that way in the market.”
Jones knew all about the non-existent grading ‘curve’. In one scene at his Chesapeake Bay home, he nurses a Budweiser while trading Asian markets late at night. You could hear the passion in his voice when he described what it feels like to hit the baseball hard:
“Whether you are making 100% rate of return on $10,000 or $100,000,000, it doesn’t make any difference. Right? If you complete 78% of your passes, it would be nice to be in the NFL. If you are in college, high school or elementary school, I am sure the thrill is just as great.”
Here is a market athlete competing in the biggest game of all and telling it like it is — that’s rare. Later Jones is skiing in Gstaad, Switzerland. Ray Bans perched on his head. Thoughts of first boss, the famed cotton speculator Eli Tullis, were still fresh:
“The first year I did nothing but get his coffee. I was learning by osmosis. I was a glorified secretary, which is fine because I was soaking in everything, every move that he made and every step that he took.”
Jones was especially juiced about a memorable experience with Tullis that sounded eerily similar to a young Richard Dennis (one of Jones’ major inspirations):
“He sat there right there in the middle of getting absolutely decimated across the board in these commodities with the most beautiful smile, the most incredibly elegant poise and stylish composure and just had a wonderful little chat with me for 45 minutes to an hour. I was just overwhelmed that anyone could be that strong.”
Eli Tullis’ poise under pressure changed Jones’ perspective. It inspired him. It taught him. If you want to end up with a $2 billion dollar net worth, which is what Jones is worth today, a ‘learn from someone else’ attitude is mission critical. Putting your ego aside admitting you don’t know it all isn’t easy, but it’s the mindset of real winners.
One final reminder, about trend following and risk management, comes from David Harding (in my film). Harding has been one of the top trend followers for decades and he puts it succinctly:
“We trade everything using trend-following systems, and it works.”