Ivanhoff Capital

It is funny how the best traders of all times basically repeat the same things with different words.

Gerald Loeb is the author of ‘The Battle for Investment Survival’ and is one of the most quotable men on Wall Street.  Here are five of the smartest things he has ever said about the stock market:

Financial markets are often forward-looking.

The market is better at predicting the news than the news is at predicting the market.

To make money in the stock market you either have to be ahead of the crowd or very sure they are going in the same direction for some time to come.

Patiently wait for your pitch

Profits can be made safely only when the opportunity is available and not just because they happen to be desired or needed.

Willingness and ability to hold funds uninvested while awaiting real opportunities is a key to success in the battle for investment survival.

The single most important factor in shaping security markets is public psychology.

In addition to many other contributing factors of inflation or deflation, a very great factor is the psychological. The fact that people think prices are going to advance or decline very much contributes to their movement and the very momentum of the trend itself tends to perpetuate itself.

How to recognize future leaders

One useful fact to remember is that the most important indications are made in the early stages of a broad market move. Nine times out of ten the leaders of an advance are the stocks that make new highs ahead of the averages.

It is not important how often you are right or wrong, but how much money you make when you are right and how much you lose when you are wrong.

The difference between the investor who year in and year out procures for himself a final net profit and the one who is usually in the red, is not entirely a question of superior selection of stocks or superior timing. Rather, it is also a case of knowing how to capitalize successes and curtail failures.

 

The fastest way to become a legend in financial markets is to make a lot of money when almost everyone else is losing a lot of money. It doesn’t matter what you do afterward. Jesse Livermore made 100 million dollars during the market crash in 1929. Five years later, in March 1934, Livermore filed for bankruptcy. No one really knows how he managed to lose so much money in such short period of time. Nowadays, he is still one of the most quoted men in the trading circles. His book “How to Make Money in Stocks” is cited as one of the favorite trading books by just about everyone who is anyone in finance.

Here are a few of Livermore’s most interesting thoughts about markets and speculation:

1. The only leading indicator that matters

Watch the market leaders, the stocks that have led the charge upward in a bull market. That is where the action is and where the money is to be made. As the leaders go, so goes the entire market. If you cannot make money in the leaders, you are not going to make money in the stock market. Watching the leaders keeps your universe of stocks limited, focused, and more easily controlled.

2. Patterns repeat because human nature hasn’t changed for thousand of years

There is nothing new on Wall Street or in stock speculation. What has happened in the past will happen again, and again, and again. This is because human nature does not change, and it is human emotion, solidly build into human nature, that always gets in the way of human intelligence. Of this I am sure.

All through time, people have basically acted the same way in the market as a result of greed, fear, ignorance, and hope. This is why the numerical formations and patterns recur on a constant basis.

I absolutely believe that price movement patterns are being repeated. They are recurring patterns that appear over and over, with slight variations. This is because markets are driven by humans — and human nature never changes.

3. Your first loss is your best loss.

When the market goes against you, you hope that every day will be the last day – and you lose more than you should had you not listened to hope. And when the market goes your way, you become fearful that the next day will take away your profit and you get out – too soon. The successful trader has to fight these two deep-seated instincts.

When you make a trade, “you should have a clear target where to sell if the market moves against you. And you must obey your rules! Never sustain a loss of more than 10% of your capital. Losses are twice as expensive to make up. I always established a stop before making a trade.

4. On the importance of sitting tight and being patient with your winners

They say you never go broke taking profits. No, you don’t. But neither do you grow rich taking a four-point profit in a bull market.

I did precisely the wrong thing. The cotton showed me a loss and I kept it. The wheat showed me a profit and I sold it out. Of all the speculative blunders there are few greater than trying to average a losing game. Always sell what shows you a loss and keep what shows you a profit.

The market does not beat them. They beat themselves, because though they have brains they cannot sit tight. Old Turkey was dead right in doing and saying what he did. He had not only the courage of his convictions but also the intelligence and patience to sit tight.

After spending many years in Wall Street and after making and losing millions of dollars I want to tell you this: It never was my thinking that made the big money for me. It always was my sitting.

5. You don’t have to be active every day.

First, do not be invested in the market all the time. There are many times when I have been completely in cash, especially when I was unsure of the direction of the market and waiting for a confirmation of the next move….Second, it is the change in the major trend that hurts most speculators.

Always remember; you can win a horse race, but you can’t beat the races. You can win on a stock, but you cannot beat Wall Street all the time. Nobody can.

There is the plain fool, who does the wrong thing at all times everywhere, but there is also the Wall Street fool, who thinks he must trade all the time. No man can have adequate reasons for buying or selling stocks daily– or sufficient knowledge to make his play an intelligent play.

Remember this: When you are doing nothing, those speculators who feel they must trade day in and day out, are laying the foundation for your next venture. You will reap benefits from their mistakes.

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Who is Stanley Druckenmiller?

Here is what hedge fund manager Scott Bessent says about Druckenmiller in the book “Inside the House of Money’:

Stan may be the greatest moneymaking machine in history. He has Jim Roger’s analytical ability, George Soros’s trading ability, and the stomach of a riverboat gambler when it comes to placing his bets. His lack of volatility is unbelievable. I think he’s had something like five down quarters in 25 years and never a down year. The Quantum record from 1989 to 2000 is really his. The assets grew from $1 billion to $20 billion over that time and the performance never suffered. Soros’s record was made on a smaller amount of money at a time when there were fewer hedge funds to compete against.

What is most interesting to me about the breaking of the pound was the combination of Stan Druckenmiller’s gamesmanship – Stan really understand risk and reward – and George’s ability to size trades. Make no mistake about it, shorting the pound was Stan Druckenmiller’s idea. Soros contribution was pushing him to take a gigantic position.

Druckenmiller is famous for making concentrated bets:

The first thing I heard when I got in the business, not from my mentor, was bulls make money, bears make money, and pigs get slaughtered. I’m here to tell you I was a pig. And I strongly believe the only way to make long-term returns in our business that are superior is by being a pig. I think diversification and all the stuff they’re teaching at business school today is probably the most misguided concept everywhere. And if you look at all the great investors that are as different as Warren Buffett, Carl Icahn, Ken Langone, they tend to be very, very concentrated bets. They see something, they bet it, and they bet the ranch on it. And that’s kind of the way my philosophy evolved, which was if you see – only maybe one or two times a year do you see something that really, really excites you… The mistake I’d say 98% of money managers and individuals make is they feel like they got to be playing in a bunch of stuff. And if you really see it, put all your eggs in one basket and then watch the basket very carefully.

If you don’t look at it from different perspectives, you might get disillusioned that Druckenmiller recommends to always take very concentrated bets. There are some nuances that you have to consider:

1. He always has an exit strategy. When Soros and Druckenmiller made their famous bet against the British Pound, the knew exactly how much they could lose – their entire YTD gain of 12%.

Soros is also the best loss taker I’ve ever seen. He doesn’t care whether he wins or loses on a trade. If a trade doesn’t work, he’s confident enough about his ability to win on other trades that he can easily walk away from the position. There are a lot of shoes on the shelf; wear only the ones that fit. If you’re extremely confident, taking a loss doesn’t bother you.

2. He says that the right conditions to make a concentrated bet happen only once or twice a year. Not everyone is able to recognize those conditions. Proper Timing is Everything when you trade big. A good entry point allows you to go through normal market reactions.  An amazing entry point allows to use tighter stop and therefore bigger position size. Here’s hedge fund manager Scott Bessent on Stan Druckenmiller:

One of the things that I learned from Stan Druckenmiller is how to enter a trade. The great thing about Stan is that he can be wrong, but he rarely loses money because his entry point is so good.

3. You have to earn your right to bet big first.

It’s my philosophy, which has been reinforced by Mr. Soros, that when you earn the right to be aggressive, you should be aggressive. The years that you start off with a large gain are the times that you should go for it.

The way to build long-term returns is through preservation of capital and home runs. You can be far more aggressive when you’re making good profits. Many managers, once they’re up 30 or 40 percent, will book their year [i.e., trade very cautiously for the remainder of the year so as not to jeopardize the very good return that has already been realized]. The way to attain truly superior long-term returns is to grind it out until you’re up 30 or 40 percent, and then if you have the convictions, go for a 100 percent year. If you can put together a few near-100 percent years and avoid down years, then you can achieve really outstanding long-term returns.

What else, other than taking concentrated bets and impeccable timing, stay behind Druckenmiller’s exceptional performance?

A) Flexibility

The Friday before the 1987 crash, Druckenmiller goes from net short to 130% long. Here is his conversation with Jack Schwager in The New Market Wizards’ book:

– You’ve repeatedly indicated that you give a great deal of weight to technical input. With the market in a virtual free-fall at the time, didn’t the technical perspective make you apprehensive about the trade?

– A number of technical indicators suggested that the market was oversold at that juncture. Moreover, I thought that the huge price base near the 2,200 level would provide extremely strong support— at least temporarily. I figured that even if I were dead wrong, the market would not go below the 2,200 level on Monday morning. My plan was to give the long position a half-hour on Monday morning and to get out if the market failed to bounce.

***

Another important lesson to be drawn from this interview is that if you make a mistake, respond immediately! Druckenmiller made the incredible error of shifting from short to 130 percent long on the very day before the massive October 19, 1987, stock crash, yet he finished the month with a net gain. How? When he realized he was dead wrong, he liquidated his entire long position during the first hour of trading on October 19 and actually went short. Had he been less open-minded, defending his original position when confronted with contrary evidence, or had he procrastinated to see if the market would recover, he would have suffered a tremendous loss. Instead, he actually made a small profit. The ability to accept unpleasant truths (i.e., market action or events counter to one’s position) and respond decisively and without hesitation is the mark of a great trader.

***

Druckenmiller flipped the portfolio from short to long, a reversal that saved Quantum in 1999, but then hurt it a few months later in 2000. Druckenmiller finished 2000 up for the year. He went from down 12% in March to up 15% for the year in his own portfolio. If you remember, the Nasdaq dumped in March 2000 but then it almost made a marginal new high in September at which point he changed his mind again, went from net long to net short, and caught the whole move down from September to December 2000.

Stan is better at changing his mind that anybody I’ve ever seen. Maybe he stayed with it a little too long, but one of the great things about Stan is that he can and does turn on a dime. To paraphrase John Maynard Keynes, when the facts change, he changes his positions.

B) What actually matters in trading.

I’ve learned many things from Soros, but perhaps the most significant is that it’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong. The few times that Soros has ever criticized me was when I was really right on a market and didn’t maximize the opportunity

Soros has taught me that when you have tremendous conviction on a trade, you have to go for the jugular. It takes courage to be a pig. It takes courage to ride a profit with huge leverage. As far as Soros is concerned, when you’re right on something, you can’t own enough.

C) Great defense wins championships

Druckenmiller’s entire trading style runs counter to the orthodoxy of fund management. There is no logical reason why an investor (or fund manager) should be nearly fully invested in equities at all times. If an investor’s analysis points to the probability of an impending bear market, he or she should move entirely to cash and possibly even a net short position.

D) You could be right on a market and still end up losing if you use excessive leverage.

One basic market truth (or, perhaps more accurately, one basic truth about human nature) is that you can’t win if you have to win. Druckenmiller’s plunge into T-bill futures in a desperate attempt to save his firm from financial ruin provides a classic example. Even though he bought T-bill futures within one week of their all-time low (you can’t pick a trade much better than that), he lost all his money. The very need to win poisoned the trade— in this instance, through grossly excessive leverage and a lack of planning. The market is a stern master that seldom tolerates the carelessness associated with trades born of desperation.

Sources:

INSIDE THE HOUSE OF MONEY, STEVEN DROBNEY, WILEY, 2008
Schwager, Jack D. (2009-10-13). The New Market Wizards: Conversations with America’s Top Traders. HarperBusiness.