Stock Market Wizards

by Jack D. Schwager

  I had investors from 1995 through 1997. I did very well for them—I was up 58 percent in 1995, 50 percent in 1996, and 60 percent in 1997. By the end of 1997, I was managing about $35 million. It became very difficult to use my style of investment, which involves switching money in and out of mutual funds, because mutual funds don’t like it if you trade more than four times a year.

  But you trade more than four times a year now.

  I trade a lot less money, and I have it spread out over more than twenty mutual funds.

  So you stopped managing money for logistical reasons?

  That and because investors can be such a pain.

  What could your investors possibly have complained about? You made over 50 percent every year with hardly any losing months.

  You can’t even imagine the stuff they complained about. They complained that I didn’t make enough money if I wasn’t up at least 4 percent for the month. They complained that I made too much money because they had to pay taxes on the profits.

  I can’t believe it; you actually had someone complain that you made too much money!

  I told him that I could lose money; then he wouldn’t have to pay any taxes. I asked him if he would prefer that.

  Some investors didn’t trust me. Because the results were so good, they thought I was making up the numbers and had absconded with their money. They would call my accountant every month to ask if the money was really in the account.

  If the market was up a lot on the day, they would call up and ask, “Are we in the market?” That would drive me crazy. If the market was down a lot, they would call up and ask, “Are we out of the market?” Of course, they always expected me to be on the right side of the market.

  How much of your decision to get out of money management was due to the headaches given to you by mutual funds and how much was due to the headaches given to you by your investors?

  Split equally! [He laughs loudly.] I think I used the headache I was getting from the funds as the excuse to give investors their money back. I did feel badly for those investors who had been with me from the beginning and had never opened their mouths.

  Didn’t the friends who were your original investors and hadn’t bothered you try to talk you into not returning their money?

  They did, but my problem was how to differentiate between this friend and that friend? Where do I draw the line? Therefore, I had to do it across the board.

  Did you lose any friendships as a result?

  No, although they still ask me to reconsider whenever we get together for a poker game.

  It is interesting that so many of the traders I have interviewed are poker players.

  I love playing poker.

  I assume the stakes you are playing at are not terribly meaningful relative to the amount of money you are trading. You could stay in every hand, and it wouldn’t make any difference to you.

  It’s pretty hard to get concerned about losing $200 when you’ve just lost $100,000, but I never let my income level interfere with the way I play. I play to win. If a hand is not a good bet, I get out.

  Do you ever break your trading rules?

  Only on the side of caution. I might take partial profits on a position, or not go fully long on a buy signal, but I will never hold after a sell signal.

  Were you that disciplined from the very beginning?

  Yes, because prior to that, I did all my screwing up in futures. I made every possible mistake you could make. I don’t even have to go over them because they are all classic mistakes.

  How long did you trade futures?

  [He searches his memory for a while, as if trying to retrieve an experience from the distant reaches of his mind.] For about three years.

  Were you a net loser?

  Oh, big-time! I made money investing with other futures managers, but trading for my own account, I turned a $125,000 account into $50,000. I did everything wrong.

  Were there any particularly painful trades during that period?

  Too numerous to count.

  What stands out?

  I developed a currency trading system. I bought this computer software program that allowed you to optimize trading systems [to finetune the indicator values in a system so as to maximize the performance results for the tested price data]. Like any stupid trader, I optimized it completely. [He adjusted the system indicator values so that they best fit the past price data.] Of course, the results looked spectacular. [Because by optimizing, he was using hindsight to define and test the system. The problem is that the results will be very misleading when applied to unseen price data—namely, future price data.] I knew better, but I didn’t think it applied to me.

  In a span of two weeks, I lost about 50 percent of the money in my trading account. I started veering from the system, and every time I did, it was the absolute wrong time to do it. It was a nightmare. I realized I wasn’t cut out to trade futures.

  This sounds like the only thing you ever did where you failed. With everything else you kept at it until you succeeded. Why did you give up here?

  Because I realized futures were a losing game. The commissions and slippage [the difference between the screen price and the actual trade execution price] placed the odds too much against you. If you have only a 50 percent chance of being right when you buy or sell, and you pay commissions and incur slippage costs, you have to lose over the long run.

  But that 50 percent assumption presupposes that you don’t have any edge in the market. Couldn’t you have found patterns that had some reliability and gave you an edge similar to what you did in the stock market?

  I couldn’t do it. I couldn’t find any patterns that worked.

  Are you able to take any vacations?

  Yes, as long as I have access to my computer. I own a vacation home on a lake in New Hampshire.

  What if you wanted to go away and hike in the Swiss Alps, or for that matter even take a full-day hike in the White Mountains?

  For five years, I have been available at 3:45 P.M. every day without exception. I have never taken a day off. The problem with taking a day off is that it will probably be the day you shouldn’t have taken off.

  What happened when you had your knee surgery? [Lescarbeau and I had compared notes on personal sports injuries on our drive back from the restaurant.]

  I had outpatient surgery with general anesthesia. I returned home at around 11 A.M., very groggy, and went straight to bed. My wife was supposed to wake me at 3:30, but out of compassion, she decided to let me sleep. At 3:45, I woke up with a start. I was in the bedroom, which is on the other side of the house. I jumped out of bed and with excruciating pain hobbled down to my office. I looked at the screen, and based on what I saw, I sold half my portfolio.

  An hour later, I returned to the office and looked at the screen again. I realized that I had totally screwed up. I couldn’t figure out why I had sold anything. I had completely misread the information. As it turned out, the next day the market tanked. It was utter luck.

  What percent of the time are you in the market?

  About 50 to 55 percent of the time.

  Do you use leverage?

  Selectively. On average, I’m less than fully invested, even counting only those days when I am in the market. Occasionally, if conditions are right, I use leverage. But I have never been leveraged more that 140 percent of my capital—that’s the limit of my comfort level. I have never lost money on a trade that I was leveraged on.

  Do you ever go net short?

  Ninety percent of my success is due to not doing things that are stupid. I don’t sell winners; I don’t hold losers; I don’t get emotionally involved. I do things where the odds are in my favor. Shorting stocks is dumb because the odds are stacked against you. The stock market has been rising by over 10 percent a year for many decades. Why would you want to go against that trend?

  Any advice for novice traders?

  Don’t confuse activity with accomplishment. I think one mistake novice traders make is
that they begin trading before they have any real idea what they are doing. They are active, but they are not accomplishing anything. I hardly spend any time trading. Over 99 percent of my time is spent on the computer, doing research.

  * * *

  Although Lescarbeau refused to reveal any details about his own trading systems, he provides some important insights into the traits of a successful trader. One characteristic that I have repeatedly noticed in winning traders—and that is probably true of winners in any field—is that they are extremely confident. Perhaps no other trader I have interviewed has exemplified this quality better than Lescarbeau. He exudes confidence. Consider, for example, his description of the certainty that he would succeed as a money manager before he had even developed a methodology. (Lescarbeau’s decision to assume trading responsibility before he had developed a trading method is not being held up as model of laudable behavior—on the contrary, for most people it would represent a reckless course of action—but only as an illustration of his sense of confidence.)

  An honest assessment of your own confidence level may be the best indicator of your potential for success. If you are confident that you will succeed in the markets—not to be confused with wanting to be confident—then the odds are good that you will. If you are uncertain, then tread very gingerly with your risk capital. Confidence cannot be manufactured or wished into existence. Either you have it or you don’t. Can’t confidence be acquired? Sure, sometimes hard work—another trait of winning traders—can lead to proficiency, which can lead to confidence. But even then, until you are truly confident, proceed with great caution in the markets.

  Another trait I have noticed among the Market Wizards is that they approach trading and sometimes other endeavors with an intensity bordering on obsession. Lescarbeau is a perfect example. He never misses a day—even surgery didn’t prevent him from checking the market. Whenever the performance of his systems failed to meet his extraordinarily high standards, even though this meant nothing worse than a break-even quarter or two, he worked incessantly to develop better systems. Even his recreational activities—for example, bicycling and weight training—reflect an obsessive streak.

  Is there any single trait that is shared by all great traders? Yes, discipline. Lescarbeau’s unfailing sense of discipline is clear in all his actions. He has never decided to hold a position once he gets a sell signal. If his system tells him to liquidate, he’s out—no questions, no second-guessing, no qualifications. He never thinks “I’ll just give it one more day” or “I’ll get out if it goes down another 2 points.” For Lescarbeau, discipline also demands being there every day to check the system signals and enter the orders. Every day means every day; no minivacations, no days off—not even after surgery. The essence of discipline is that there are no exceptions.

  Many people are attracted to the markets because they think it is an easy way to make a lot of money. Ironically, hard work is one of the key common denominators I have noted among the traders I have interviewed. Even though Lescarbeau has already developed trading systems that are incredible—his trading system results are by far the best I have ever seen and beyond anything I even thought possible—he continues his research without abatement. He doesn’t relax even though what he is using is working and has been working for years, but instead he plows ahead daily, as if what he is using will cease to work tomorrow.

  Risk control means longevity. Some traders achieve high returns for many years, but with large equity retracements as a byproduct of their methodology. Although these traders can attain great track records, they often skate near the edge—and in doing so, they are always in danger of falling. A trader like Lescarbeau, who keeps his losses very low, has a much higher probability of long-term success.

  * * *

  Update on Steve Lescarbeau

  Although Lescarbeau has fared quite well during the bear market—his family partnership was up 39 percent from April 2000 through September 2002—more than half the gains were realized before September 2000, and as indicated in the following update, Lescarbeau has lost confidence in the efficacy of his systems.

  What happened in February 2001? [Lescarbeau’s account was down 5 percent that month—a single-month decline that exceeded his previous worst peak-to-valley equity drawdown.]

  The problem actually began in November 2000 when I lost over 3 percent, which at the time was the worst month I ever had. Although December approximately recovered the entire November loss and the system was profitable again in January, the November loss was an early warning sign that something was potentially wrong. Then came the February loss, and I knew I was dealing with something I had never seen before. It was a period when what I had been doing for many years simply didn’t work.

  How much time do you need to decide that a system is not working?

  Well, there is no easy answer to that question. The system I was using at the time had worked for several years in real time and for decades in backtesting. So, maybe I was bit too slow in reacting.

  When did you switch systems?

  I basically stayed out of the market during April 2001. I really didn’t know what I was going to do because I hadn’t come up with anything. I just knew I couldn’t continue to use the same system anymore because it had stopped working. By May, I had developed a modified system that was workable, but not one I felt really good about. By summer I came up with the system I am using now.

  What would have happened if you had continued to use your previous system after March 2001?

  It would have been a disaster. I would have been down 25 to 30 percent.

  I know you have switched to what you consider improved systems several times in the past. Would some of these older systems have worked better?

  They would have done even worse!

  How is your current system different from the one you stopped using after March 2001?

  Essentially, the system I use now makes it much more difficult to get a buy signal and much easier to get a liquidation signal. So I am making far fewer trades, and when I am in the market, it takes a smaller adverse price move to get me out. For example, I have not had a buy signal in nearly four months. With my old trading system, I would have been trading through this decline and getting killed.

  If, on balance, your system tends to keep you out of the market during periods of declining prices, it seems like you should be able to significantly improve your results by going short during those times instead of going into cash. Why don’t you use your liquidation signals as short signals?

  The truth is that I have never been able to develop a system that could make money consistently—and consistently is the key word—on the short side.

  Why couldn’t you simply reverse to short on a liquidation signal instead of going neutral?

  If I could go short the funds I buy, that would be great, but of course that’s impossible. If I want to go short, I have to either buy a short stock index fund or directly go short stock indexes. The trouble is that my systems work tremendously better on the types of mutual funds I buy—aggressive growth funds—than on stock indexes, for which their performance is only mediocre.

  After our original interview, you decided to accept investor money again. Then in the second quarter of 2001, you once again told investors that you were returning their money. What was the reason for this decision?

  Because I had done so poorly, and I had completely lost confidence that the system I was using would continue to make any money. Moreover, not only did I lose confidence in my system, but I had no idea what I was going to do to fix it. It was just the low point in my career.

  Although the system I subsequently developed kept me from losing money, in truth, my trading approach hasn’t worked since the fall of 2000. For the past six months, I’ve hardly traded at all. I believe the drastic deterioration of the types of systems I use is a direct consequence of the Internet-related surge in hype and speculative activity, which has made the market much more random. There has been
a marked decrease in market follow-through. Trends that used to last a week, last two days; trends that used to last two days, last three hours. I’m not bullish on my approach until we wipe out the excess, which I think will take years. Virtually all primary bull markets have been followed by bear markets and then a long period of malaise. This one will be no different.

  I take it then that you don’t anticipate any significant recovery in the stock market for the foreseeable future, despite the sharp price slide we’ve seen.

  If you study the long-term history of stock prices you repeatedly see that it takes a very long time for markets to recover after major tops. As Schiller points out in his book Irrational Exuberance, after each of the three major peaks in the twentieth century—1901, 1929, and 1966—the stock market took roughly twenty years or so to get back to even [in inflation-adjusted terms]. Since the 2000 peak occurred at even significantly higher valuation levels than any previous market top, including 1929, it wouldn’t be surprising if it took another twenty years to get back to that level [in inflation-adjusted terms]. The implication is that the market bottom probably won’t come for another few years, and if it’s like all other previous major bottoms, it won’t occur until we are at extreme low levels.

  How far down could you see the market going?

  For me the magic number is five: somewhere around 500 in the S&P 500, somewhere around 5,000 in the Dow, somewhere around 500 in the Nasdaq 100, and sometime in about five years [2007].

  That sounds almost mystical.

  Well that’s just my guess. Of course, I won’t let this projection interrupt my trading. The next time I get a buy signal, I will buy.

  What do you think is the biggest misconception people currently have about the market?

  The biggest misunderstanding that the average investor has is the inability to comprehend the concept of years. People who know I trade the markets are constantly asking me where I think the bottom is going to be. “Are we almost there yet?” they ask. When I tell them I think the bottom is at least several years away, they look at me like I have three heads.