by Jim Paul
All effective plans require eliminating the losses due to psychology by defining a stop-loss first, even plans and decision-making that doesn’t involve the markets. A recent example came to mind in when I was watching the news one night in September 1993. Senator Sam Nunn commented on the idea of sending U.S. troops to Bosnia: “We ought to have an exit strategy before committing troops.”55 Senator Bob Dole echoed Nunn’s sentiments in October 1993, when he said “What’s it gonna cost? When are you gonna get out?”56 Before beginning a mission in Bosnia, these Senators wanted to know when or under what set of circumstances the mission would end.
In the same way in which Shell applied scenario planning to a wide variety of situations in very different realms, applying our parable to all decision-making is not as far-fetched as it first may seem. To make the point, consider a slightly less recent public policy example: Lyndon Johnson and the Vietnam War. LBJ did essentially the same thing I did, starting with his belief in past successes. When LBJ considered committing ground forces to Vietnam, he “did so with blind faith buttressed bit remembered victories: The United States always won.”57 As Johnson began to escalate the war in early 1965, protests erupted from students, teachers, senators and columnists. Then in April, in response to a series of coups in the Dominican Republic, Johnson sent 22,000 troops to the Caribbean island. He also sent Secretary of State McGeorge Bundy to negotiate a settlement. The protesters became even louder about this U.S. intervention. But a non-Communist government was elected and the U.S. forces withdrew. This made the critics of the Johnson’s foreign policy look and sound like they didn’t know what they were talking about. His success in the Dominican Republic fed his ego, gave him a sense of the Midas touch syndrome and reinforced his conviction that he was right, and anyone who disagreed with him was wrong.
As the war progressed, the U.S. became more heavily involved. LBJ would come to micro-manage the situation in Vietnam, picking some bombing sites himself and approving most others. He would rise at 2 a.m. (to adjust for the time change) and go to the war room in the basement of the White House so he could monitor developments in Vietnam. Johnson began to identify his personal worth with success in Vietnam. As evidence, consider “LBJ’s impression that he couldn’t lose Vietnam and keep allies or win elections.”58 (Emphasis added.) Johnson had personalized and internalized Vietnam because, for him, it meant his reputation.
It’s not as though LBJ wasn’t encouraged to consider an exit strategy — a stop-loss in Vietnam, so to speak. McGeorge Bundy sent Johnson a memo suggesting “hard analysis on such questions as . . . What is the upper limit of our liability?” if the U.S. committed ground troops.59 In essence, Bundy wanted to know what the U.S.’s stop-loss was going to be. In October 1964, Under Secretary of State George Ball wrote an internal memo which argued that South Vietnam was a lost cause. Ball was acknowledging a loss as a loss. Unfortunately, “to question the ability of the United States to succeed militarily was to challenge Johnson’s pride.”60
This isn’t to say Johnson should have listened to every Tom, Dick and Harry advisor. It simply shows you another example of how all decision-makers can fall prey to the same errors I did. LBJ did not have an exit strategy, much less an entire plan formed after objective decision-making. In fact, according to one of his aides, “it was Johnson’s custom to reach a decision inwardly and then make it appear the decision was the result of consultation and debate.”61 (Emphasis in original.) That was inductive decision-making. Instead of starting with a blank slate, analyzing the situation and arriving at a decision deductively, he inductively took a position and then searched for evidence to support that original position. Put all this together and you have a classic case of someone who personalized previous successes and assumed he would succeed simply because he was involved in the current undertaking. Having personalized the situation, he saw loss as the same thing as wrong which his ego couldn’t take. Therefore, all subsequent decisions revolved around protecting him. His thinking became, as De Bono put it, an ego support device instead of a means of objective decision-making. With no formalized plan beginning with an exit strategy, he became a victim of the same process I did when I was in the bean oil position. He internalized the developing loss in Vietnam, confused being right with doing right (i.e., doing the most prudent thing) and succumbed to emotional decision-making. What might LBJ have done instead? Two professors from Harvard say LBJ should have assessed the downside exposure and created a plan to handle it:
The President might also have paused longer over the question Bundy had posed . . . about “the limit of our liability.” Johnson might have begun to ponder in 1965 the speech he ought to give in 1966 if certain conditions were not fulfilled by then — and what those conditions might be. He might, in short, have planned a test for his presumptions . . . as all decision-makers should routinely do.62
Commit the Plan to Paper
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.
To take an example from business look at powerhouse securities firm Morgan Stanley, one of the most profitable financial institutions in the country. Ever since it converted from a private partnership to a publicly traded company in 1986, Morgan Stanley has achieved the highest average return on equity of any publicly traded U.S. securities firm.63 It’s “avoided disasters and seized opportunities” because it is “fanatical about planning for any contingency, good or bad.”64 And the firm carries out that planning by having staffers write detailed reports about all the consequence would be for the firm if certain hypothetical events came to pass. The worst case scenarios are complied in what the firm calls blue books. “ ‘We’re constantly writing these stupid blue books,’ grumbles one Morgan Stanley principal. ‘It definitely slows us down.’ On the other hand, he concedes with a shrug, ‘We don’t make any mistakes.”65 Whether Morgan Stanley makes mistakes or not is open to debate, but its mistakes are contained. Its commitment to planning, as well as committing those plans to writing, has kept the firm out of disastrous situations.
Conclusion
It’s not wise to violate the rules until you know how to observe them.
T.S. Eliot
In 1965 Steve McQueen starred in The Cincinnati Kid, the classic poker movie of all time. In the climactic scene of the movie, Steve McQueen (The Kid) and Edward G. Robinson (The Man) play a final hand of five-card-stud. The Kid is trying to dethrone The Man in a winner-take-all five-card-stud poker game that has lasted several days and eliminated all of the other players.
With three cards dealt, McQueen’s two up cards are a pair of tens and he bets heavily, $1,000. Robinson is showing the queen and the eight of diamonds. That is a lousy hand for Robinson, but he calls the bet and raises $1,000. He is betting as though his hole card is a queen, or he somehow thinks he will get a straight flush. Or he is pulling the bluff of the century. Robinson’s next card is the ten of diamonds and McQueen’s is the ace of clubs. McQueen bets $3,000. A smart move. Robinson calls and raises. Robinson is playing for the straight flush, not a pair of queens. Or he is bluffing. Robinson’s fifth card is the nine of diamonds and McQueen gets the ace of spades. McQueen bets all he has in front of him, $3,500. “That ace must have helped you, Kid. I’ll call your thirty-five-hundred and raise you five-thousand,” says Robinson.
Now if you can’t call a bet, you fold and go home unless the other player is willing to take your marker (an IOU). Well, McQueen is out of money, and the only way he can continue is if Robinson will take McQueen’s marker. In order to stay in the game, McQueen agrees to give Rob
inson an IOU for $5,000. The only card that can beat McQueen is the jack of diamonds. McQueen asks to see Robinson’s hole card. Robinson turns over the jack of diamonds. McQueen looks as though he’s going to throw up. He has been wiped out. McQueen’s full house, aces over tens, loses to Robinson’s straight flush.
The dealer is incredulous. “You’re raising tens on a lousy three flush?” she says to Robinson. She was right! Robinson never should have made that bet since he had only the slim makings of a straight flush and he was staring at McQueen’s pair of tens. You don’t often beat two pairs, and certainly not a full house.
“Gets down to what it’s all about doesn’t it? Making the wrong move at the right time. Like life I guess . . .” says Robinson to the dealer.
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A poker player risks his money not knowing the cards he will draw or what cards the other players will draw. When you wager in poker, you either try to tell the other players what you’ve got in your hand (a lock-jaw player), or you try not to tell them what you’ve got (a loose player), or you try to get them to think you’ve got something you don’t have (also a loose player), all depending on what your agenda is. The good poker player tries to alternate between being a lockjaw player and a loose player. In other words, measured inconsistency is the key to winning in poker. A lockjaw player is someone who never stays in the game unless he’s got a hand. He folds almost every hand. He antes and he’s gone, antes and he’s gone. The message is that if he’s in, everybody else is playing for second place because the only time he’s in is when he has a good hand. If everybody at the table believes the only time he’s in the game is when he has a good hand, occasionally he can bluff and get away with it.
For example: I’m playing five-card-stud and my first up card is a jack, my down card is a three and somebody else has a king showing. He bets $5 and I call his $5 and raise $10. If everybody at the table thinks that I stay in the game only when I’ve got something, that I’m lockjaw, then everybody thinks I have two jacks. Now everybody is playing against the two jacks even if I don’t have two jacks. If you get the reputation of lockjaw, you have set up the opportunity to fake — to bluff. You can only get to that point if you have folded a lot of hands and if when you have stayed in, you won or finished a very close second. To build that reputation you’ve got to fold much more that you stay, and when you stay you’ve got to win. Once you get that reputation and live by it, not only do you save a lot of money by folding early when you have a bad hand, but you have the opportunity to bluff occasionally. More frequent bluffers are also loose poker players. They try to mislead the other players by betting heavily on a poor hand or betting lightly on a good one. The more you are caught bluffing, the more likely you will be able to really take someone to the cleaners when you have a good hand.
Like the poker player, the investor risks his money not knowing how the individual company, stocks in general or the economy as a whole will perform. While measured inconsistency may be the key to success in poker, disciplined consistency is the key to success in the markets once you’ve developed rules and made it a game. Having and following a plan doesn’t guarantee success, nor does it make you infallible. However, a plan is necessary for consistent loss control. There is nothing to learn from the bluffing aspect of poker, but there is something to learn from part of the lockjaw poker player’s strategy. Which part? The part he uses to build his reputation: he stays when he has a hand and gets out when he doesn’t have a hand. Your plan is structured so that you stay when your position is working, and you get out when it’s not. Take the loss and don’t worry about it. Sticking to the discipline of your plan enables you to stay when you have a good situation and forces you to forfeit the ante when you don’t. If you drop your discipline and try bluffing, you’re exposing yourself to losing all of your money.
To bluff means to intimidate by showing more confidence than the facts support. If you try to bluff the market by breaking your rules, you will eventually lose your money. Oh sure, you might break the rules a couple of times and get away with it. You might even get away with it several times. But if you try to bluff the market by staying in a losing trade and it comes back and turns into a profit, what have you learned? You have learned that doing the wrong thing pays off, which means you will try to bluff again. The problem is: you won’t be able to distinguish between the times when it’s safe to break the rules and when it’s not.
So yes, there are times when breaking your rules still results in a profit; you can be rewarded for doing the “wrong thing,” and you can be rewarded for doing the “right thing” for the wrong reason. I did that a lot during the early part of my life. However, if you continue to do the wrong thing in the market and get rewarded, your profits won’t be linked to any particular recurring set of circumstances or rule-following on your part. This will result in what psychologists call a random reward schedule; the strongest form of reinforcement for getting a person to repeat a behavior. For example, consider the psychologist who wants a monkey to repeat the behavior of pressing a button. The experiment involves having food released into the cage when the monkey presses the button a certain number of times. The psychologist might set the mechanism to release the food after it has been hit a fixed number of times; for example, every five times. Or he might set it to release the food after a variable number of times; for example, five times, then seven, then three, then twelve. The monkey will hit the button more if the reward interval is varied, than if it is fixed. When the reward interval is varied, the monkey will simply keep hitting the button until the reward appears, believing it is inevitable.
One of the best trades I ever made was an $8,000 loss on a short gold trade; I got stopped out at $350 per ounce on its way to $875. One day in early August 1979, the gold market shot above $300 for the first time ever. I thought that was a ridiculous price and sold short two gold contracts at $310. Then I gave an order to a friend of mine to stop me out at $317, left the floor and went to my accountant’s office to finish my 1978 taxes before the August 15th extended deadline ran out. Later that day, while I was meeting with my accountant, I got a call from my secretary. The Board of Governors of the Chicago Mercantile Exchange (of which I was a member) had called an emergency meeting. The gold market had closed in the U.S. for the day, but it was trading $50 higher in Hong Kong, and we had to vote on whether to change the daily permissible limit on the gold futures contract at the CME from $10 to $30. (Needless to say, I recused myself from the vote).
I did exactly the “right thing,” so to speak, of planning the trade, putting in the stop, entering the market and then leaving the stop alone. But the only reason I left the stop alone is because I had given the order to someone else, and I was too embarrassed to go to him to cancel it. In effect, I did “the right” thing for “the wrong” reason At the time, I didn’t learn the proper lesson from that experience. I hated the idea of leaving the stop in, but I knew I had to because I didn’t want the embarrassment of going to my friend and saying, in effect, “I’m so stupid that I want to cancel my stop and stay short this market.” All I got out of that experience was that it was more important to me not to feel embarrassed than it was to make money. I was like the monkey in the psychologist’s cage repeating behaviors that sometimes produced profits and sometimes losses, but not knowing which was which.
Doing the “wrong thing” (i.e., breaking your rules) in the markets and still being rewarded means you will repeat behavior that may or may not have been responsible for the profitable trade or investment. If you don’t know what is making the profitable trades profitable, you won’t know what to repeat in order to repeat the profits (or avoid losses). Your profits won’t be linked to any specific behavior on your part. This means you’re only going to be allowed to make a bad decision once — and you know you will do it at least once. You don’t know if it will be this time, next time or the time after that. But you will do it. And if you bluff, you
will lose your money. If you deviate from your plan you are playing with a lighted fuse. Sure, the bomb may not go off in any particular battle; but before the war is over, the bomb will explode in your face.
What If . . . ?
Robinson’s comment about “making the wrong move at the right time” is another way of saying “deviating from the plan and basing your decision on a hunch, feeling or intuition.” It’s like taking a multiple-choice test in school, not knowing the answer and going with your gut. It’s like the time Conrad doubled his bet at the baccarat table because he got a feeling that we were going to get a run.
The market is no place for “making the wrong move at the right time.” Any deviation from your plan triggers the potential for losses due to psychological factors. It cannot be emphasized enough how important it is for you to stick to your plan. If you get nothing else from this book except the acknowledgment that you need a plan, then at least you’ll know when you’re deviating. At least you will know that you are deviating from something, whereas prior to reading the book you would not have known. However, you also cannot ignore the fact that even after reading this book, at some point in the future you will deviate from your plan and break the rules.