The New Market Wizards: Conversations with America's Top Traders (35 page)

Your track record shows that you made substantial withdrawals from your account during the 1980s. You don’t seem to be the type of person who’s an extravagant spender. Therefore, I assume that this money was reinvested in some form. What alternative investments did you choose? Why didn’t you simply let the money compound in your account, since you were doing so well?

One of my major investments was starting a trading company. I hired other traders, taught them what I did, and gave them my capital to trade.

Why did you do that?

Because I wanted to be the McDonald’s of trading rather than an egotistical, solitary trader. This venture, of course, didn’t work out as well as McDonald’s [he laughs loudly].

What was the outcome?

Over a five-year period, I trained thirty-eight people. Each of these people spent several months by my side while I taught them virtually everything I knew about the market. Out of these thirty-eight people, five made money.

How did you choose the people you selected for training?

I wasn’t very scientific about it. Basically, I went with my instincts and whims about who might be a good trader. The people I selected were a very diverse group.

Was there any correlation between intelligence and success at trading?

Absolutely, but not in the way you think. For example, one of the people I picked was a high school dropout, who I’m sure didn’t even know the alphabet. He was one of the five who made me a great deal of money.

Why did you pick him?

He was my phone clerk on the American Stock Exchange, and he was very aggressive and alert. Also, he had been in Vietnam and had a hand grenade explode near him, leaving shrapnel in his pancreas. As a result of this experience, he was always afraid of everything. When it came to trading, he was more worried about losing than winning. He took losses very quickly.

On the other extreme of the intelligence spectrum, one of the people I trained was a genius. He had a 188 IQ, and he was on “Jeopardy” once and answered every question correctly. That same person never made a dime in trading during five years.

I discovered that you can’t train people how to trade by just imparting knowledge. The key to trading success is emotional discipline. Making money has nothing to do with intelligence. Think of all the bright people that choose careers on Wall Street. If intelligence were the key, there would be a lot more people making money trading.

You almost seem to be implying that intelligence is an impediment to successful trading. How would you explain that?

Assume that you’re a brilliant student who graduates Harvard summa cum laude. You get a job with a top investment house, and within one year, they hand you a $5 million portfolio to manage. What would you believe about yourself? Most likely, you would assume that you’re very bright and do everything right. Now, assume you find yourself in a situation where the market is going against your position. What is your reaction likely to he? “I’m right.” Why? Because everything you’ve done in life is right. You’ll tend to place your IQ above the market action.

To be a successful trader, you have to be able to admit mistakes. People who are very bright don’t make very many mistakes. In a sense, they generally
are
correct. In trading, however, the person who can easily admit to being wrong is the one who walks away a winner.

Besides trading, there is probably no other profession where you have to admit when you’re wrong. Think about it. For example, consider a lawyer who, right before a big case, goes out with his girlfriend and stays up half the night. The next day, he’s drowsy and inadequately prepared. He ends up losing the case. Do you think he’s going to tell the client, “I’m sorry, I went out last night and stayed up too long. If I were sharper, I would have won the case. Here’s your money back.” It will never happen. He can always find some excuse. He would probably say something like, “I did the best I could, but the jury was biased.” He will never have to admit he was wrong. No one will ever know the truth except him. In fact, he’ll probably push the truth so far into his subconscious that he’ll never admit to himself that his own actions caused the loss of the case.

In trading, you can’t hide your failures. Your equity provides a daily reflection of your performance. The trader who tries to blame his losses on external events will never learn from his mistakes. For a trader, rationalization is a guaranteed road to ultimate failure

Typically, how much money did you give these trainees to trade, and what was their cutout point?

In most cases, I started people out with $25,000 to $50,000. In a few cases, I started trainees out with accounts as large as $250,000. Their cutout point was when they lost it all [
he laughs
]. I never had to fire anyone, they just self-destructed.

On balance, did you lose money on this trainee trading program?

No, because the five of the thirty-eight trainees who were successful made more money than all the others combined lost. The only unfortunate thing was that these five people made so much money that they quit. That was one outcome I didn’t consider at the onset.

In the end, though, you still ended up with net profits on the deal.

Yes, but not very much considering the effort that went into this venture. I certainly wouldn’t do it again.

Why do you think the majority of people you trained lost money?

They lacked what I call emotional discipline—the ability to keep their emotions removed from trading decisions. Dieting provides an apt analogy for trading. Most people have the necessary knowledge to lose weight—that is, they know that in order to lose weight you have to exercise and cut your intake of fats. However, despite this widespread knowledge, the vast majority of people who attempt to lose weight are unsuccessful. Why? Because they lack the emotional discipline.

If you were going to repeat this experiment again—which obviously you are not—do you think that you’d be able to pick a higher percentage of winning traders?

Yes, because this time around I would pick people on the basis of psychological traits.

Specifically, what traits would you look for?

Essentially, I would look for people with the ability to admit mistakes and take losses quickly. Most people view losing as a hit against their self-esteem. As a result, they postpone losing. They think of all sorts of reasons for not taking losses. They select a mental stop point and then fail to execute it. They abandon their game plan.

What do you think are the greatest misconceptions people have about the market?

In my opinion, the greatest misconception is the idea that if you buy and hold stocks for long periods of time, you’ll always make money Let me give you some specific examples. Anyone who bought the stock market at any time between the 1896 low and the 1932 low would have lost money. In other words, there’s a thirty-six-year period in which a buy-and-hold strategy would have lost money—and that doesn’t even include the opportunity loss on the funds. As a more modern example, anyone who bought the market at any time between the 1962 low and the 1974 low would have lost money.

If something happens once, I think logic tells you that it can happen again. Actually, I believe that anything can happen, but certainly if it has happened before, it can happen again. From 1929 to 1932, the market dropped an average of 94 percent. In fact, it has even happened in more modern times—during 1973–74, the “nifty fifty” stocks lost over 75 percent of their value.

Is your point that we could get a bear market that would be far worse than most people could imagine?

Exactly, and people who have the notion that buying and holding for the long term is the way to go can easily go bankrupt.

Wouldn’t your own duration and magnitude rules lead you astray if we get a market that goes down 80 or 90 percent?

Not at all. Remember that I use these statistical studies as only one among many tools.

How do you handle losing streaks?

We all go through periods when we’re out of sync with the market. When I’m doing things correctly, I tend to expand my rate of involvement in the market. Conversely, when I start losing, I cut back my position size. The idea is to lose as little as possible while you’re in a losing streak. Once you take a big hit, you’re always on the defensive. In all the months I lost money, I always ended up trading small—sometimes trading as little as 1 percent of the account.

When I get into a losing streak, I like to read a nonfiction book to learn something new. That action accomplishes two things. First, it takes my mind off of trading; second, by enhancing my knowledge, I help improve my self-esteem. The key is to do something positive.

Do you sometimes pull yourself away from the markets totally?

Yes.

For how long?

Sometimes for as long as a month or two.

Do you think that taking such extended withdrawals from the market is a good practice?

Without a doubt. You don’t want to keep losing if you’re in a rut, because that will only destroy your self-confidence even more.

How do you get back into trading?

Ty Cobb once was asked why he never had slumps. He said that whenever he felt himself getting into a slump, he wouldn’t try to get a hit, but he would simply try to make contact with the ball. To relate that concept to trading, when you’re in a slump, try to be patient and wait for a trade that you feel very confident about and keep the bet size small. Your goal should not be to make lots of money but rather to get your confidence back by making correct decisions.

Why do most people lose money in the market?

I know this will sound like a cliché, but the single most important reason that people lose money in the financial markets is that they don’t cut their losses short. It is a curiosity of human nature that no matter how many books talk about this rule, and no matter how many experts offer this advice, people still keep making the same mistake.

What other mistakes do people make?

They don’t approach trading as a business. I’ve always viewed trading as a business.

Can you elaborate on your business plan for trading?

I view the objectives in trading as a three-tiered hierarchy. First and foremost is the preservation of capital. When I first look at a trade, I don’t ask, “What is the potential profit I can realize?” but rather, “What is the potential loss I could suffer?” Second, I strive for consistent profitability by balancing my risk relative to the accumulated profits or losses. Consistency is far more important than making lots of money. Third, insofar as I’m successful in the first two goals, I attempt to achieve superior returns. I do this by increasing my bet size after, and only after, periods of high profitability. In other words, if I have had a particularly profitable recent period, I may try to pyramid my gains by placing a larger bet size assuming, of course, the right situation presents itself. The key to building wealth is to preserve capital and wait patiently for the right opportunity to make the extraordinary gains.

What is your opinion about chart analysis?

I’ve made too much money trading on technical observations to dismiss technical analysis as many pure fundamentalists do. However, I do believe that technical analysis is insufficient as a sole method of analyzing and trading the market.

Back in 1974, I was approached by a technical analyst who talked a convincing game about how he could help improve my trading. I hired him as an advisor on a trial basis for $125 a week. I also offered to pay him a percentage of the profits on his recommendations. Well, this fellow was very industrious. He worked sixteen-hour days and analyzed his charts in ways that I still don’t understand. However, whenever T asked him for a specific recommendation, he would show me the chart and say things like, “This stock might be forming a top.” He could never give me a straight answer when I asked him if I should buy or sell. My most distinct memory about him is that his shirtsleeves were frayed and he ate homemade tuna fish sandwiches for lunch.