by Jim Paul
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.”42 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.”43 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.
The Plan
11 Herbs and Spices
Everyone wants to know the secret ingredients for a successful plan. However, it’s not simply the individual ingredients that are important to know, it’s the entire recipe: the set of instructions telling you in what order and in what quantities to mix the ingredients. Remember the old advertisements for Kentucky Fried Chicken? “The Colonel’s secret blend of 11 herbs and spices.” Well, Colonel Sanders could have safely told anyone the names of his eleven herbs and spices (i.e., the ingredients). As long as he didn’t tell anyone the secret blend of his eleven herbs and spices (i.e., the measurements and the mixing instructions), he didn’t have to worry about anybody stealing business from him.
No one can outline a plan that all market participants will accept. Besides, since there are so many different plans one can follow and be successful, it matters less what the plan is than it does that there is a plan. Remember, there are as many ways to make money in the markets as there are participants. There are also as many possible plans as there are participants, yet only one valid recipe for formulating a plan. 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.
Almost all commentary on the development of a plan will list the ingredients as: entry, stop-loss and price objective. However, to be effective as a loss control tool, the plan must be derived by deciding: STOP, ENTRY then PRICE OBJECTIVE. Failure to choose a price objective could cost the trader some potential profits. A poor entry price could increase losses or reduce profits. But not having a predetermined stop-loss can, and ultimately will, cost you a lot of money. Usually, people pick the exit point after they enter the market — if they even bother to pick an exit point. Their exit point is a function of their entry point and it’s usually some arbitrary dollar amount that they are supposedly willing to lose. Then they rationalize it by expressing the trade in terms of the Money Odds Fallacy — “It’s a 3:1 risk reward ratio! I’l
l risk $500 to make $1500,” — when there is no basis in statistical probability to support the assertion that the price will reach the profitable objective.
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?”44 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.”45 The scenario technique was developed by strategists at the RAND Corporation to think through issues involving the nature of nuclear warfare. Analysts would posit possible outcomes and then identify how and what sequence of unexpected political events and economic trends would lead to each outcome. These would serve as signposts to watch for as the road to the future unfolded. In the early 1970s, planners at oil giant Royal Dutch Shell built on this technique and began applying it to the oil business. “The result was scenario planning which offered a way to evaluate strategy, test investment decisions — and clarify risk and uncertainty.”46 The oil industry operates on very long-term investments, the viability of which can be dramatically affected by social, economic and technological changes. “As part of planning for the future, the Shell planners applied scenario planning not only to the energy business but also to larger global, economic, and social trends.”47 You, too, must use scenario analysis to clarify risk and uncertainty and plan for the future.
If you are using a technical analysis approach to the market, the data you rely on to make decisions take one of two forms: either prices go up or they go down. If you are using a fundamental approach to the market, the events you rely on to make decisions can take many forms. But even with a fundamental method of analysis, you must have some amount of monetary loss which you deem intolerable. Remember, we are trying to manage possible scenarios and losses, not predict the future and profits. “Scenario planning does not, of course, tell us the future; only fortune-tellers can do that.”48 And we already know trying to predict means you’re betting which gets you all caught up in trying to be right. “The objective of the scenario approach is not to decide which scenario is right. . . . There is no ‘right’ answer.”49
A preoccupation with wanting to be right or wanting to be perceived as being right, explains people’s tendency to focus on why the market is doing what it is doing instead of what it is doing. They’re constantly asking, “Why is the market up (or down)?” When someone asks, “Why is the market up?” does he really want to know why? No. If he is long he wants to hear the reason so he can reinforce his view that he is right, feel even better about it and pat himself on the back. If he isn’t long, he’s probably short and wants to know why the market thinks the market is up, so that he can argue with it and convince himself that he is right and the market is wrong. He wants to say, “Oh, that’s the reason? Well, that’s the stupidest reason I ever heard.” He wants to justify his position of being the “wrong” way in the market by asking “why” so he can say, “That’s a stupid reason.” Let me tell you some good news and some bad news about “why” and the markets. The good news is, if you’re long and the market is going up and you don’t have a clue as to why, you get to keep all the money. Every cent. They don’t charge you a single penny if you were “only lucky.” The bad news is, if the market is going up and you’re short and you know exactly why it’s up, you don’t get any money back. Now how important is it to know why? Knowing why doesn’t get you any brownie points with the market. Nor do you get any partial credit like you did in school for knowing why you got a math question wrong. And this is true for all business, not just the markets.
The Wall Street Journal had an article50 on John Kluge, once the richest man in America in the Forbes annual survey. Just before Kluge bought the Ponderosa, Inc. steakhouse chain in 1988 he met with some skeptical bankers who asked. “Don’t you think this is the wrong business to be in?” Everyone in the country was talking about health food at the time and steak wasn’t on the list of food which was good for you. Kluge began pounding his fist on the table. “The people want steak,” he shouted. He was so confident about the nation’s appetite for T-bone and sirloin that he invested close to $1 billion in steak restaurants over the next three years. Lo and behold, although beef consumption was on the decline, steak sales at restaurants held steady. “So Mr. Kluge was right: People do want steak. They just don’t want his steak,” The Wall Street Journal concluded.
But what good did it do for him to be right if he didn’t make any money? Or even worse, lose money? Ponderosa was plagued by heavy losses and Kluge had to pour money into the chain to keep it operating: $60 million in 1992, and another $30 million in 1993 to renovate 360 Ponderosa’s. The Wall Street Journal said that until that point, “Mr. Kluge had been known for his Midas touch.” Sound familiar? I, too, thought I had the Midas touch. “There’s going to be a shortage of bean oil!” And I was right; there was a shortage. But not only did I not make any money on it, I lost a lot. I poured money into that position from other ventures just to keep it going, in a vain attempt to be right. And like Kluge, I was right. But neither one of us made any money on the deals. So 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.
Preoccupation with being right means you’re betting, which personalizes the market and is the root of losses due to psychological factors. Concern yourself with whether or not
you have done your homework to define a set of conditions under which you will enter and exit the market, and whether or not you carry out that plan.
Now that we know what a real plan is, let’s look at how having and following a plan addresses the uncertainty inherent in each of the areas covered in Chapters Six, Seven and Eight.
A Plan vs. Loss, Risk and the Crowd
The uncertainty of the future when facing a market loss triggers the Five Stages of Internal Loss. Have you ever said to yourself, “No way! Is the market really down that far?” That’s denial. Have you ever gotten mad at the market? Called it a name? Gotten angry at friends or family because of a position? That’s anger. Ever begged the market or God to get you back to breakeven so you could get out? That’s bargaining. Has a market loss ever changed your sleep or diet patterns? That’s depression. Ever have a firm liquidate one of your positions? That’s acceptance. Unless you have a plan, your potential loss is unknown and you can count on suffering through the Five Stages, losing more money as you go through each of the stages. As we saw earlier, you can loop back through the first four stages in a vicious circle. You eventually accept the loss, so you might as well set the loss to a predetermined amount and short circuit the Five Stages by going straight to the acceptance stage. Knowing the amount of loss ahead of time reduces the uncertainty factor to nil, because you’ve acknowledged and accepted the amount of the potential loss before it occurs.