Those who preach diversification as a risk control
measure are essentially hedging their fundamental ignorance of their
own holdings. – Michael Lauer – Stock Market Wizards by Jack Schwager
I think a lot of successful traders are unemotional, hardworking, and
disciplined. Ironically, I find myself lacking on each of those counts. I
get very emotional; I really don’t work that hard; and I’m not as disci-
plined as I should be.
The problem is that their approach depends on the “greater fool”
premise. [It’s okay to buy a stock that is grossly overpriced, as long as
you sell it to someone else—a greater fool—even higher.] This
process always ends in tragedy for those left holding the bag, which in
this case will likely be mutual fund investors.
So you’re saying that many individual investors who believe they
have placed their money into the most conservative stock funds
are unwittingly holding high-risk investments.
Absolutely. What started out as a conservative, passive investment
strategy has metamorphosed into a “greater fool” investment pyramid.
When this situation begins to unravel, the losses will be horrific.
Remember,
I’m seeking pricing inefficiencies, not high-quality companies. In
fact, as a direct consequence of my methodology, my typical long
position will be a company that has had some difficulty, while my typical
short will be a universally admired entity.
I think of myself as a reasonably courteous person. If an investor
called and asked me why I owned a certain stock, I would probably
tell him. But in the process, I would certainly be wasting my time,
Any investment approach that is dependent on stock market direction
for profitability is doomed to mediocrity. Any investment approach
that is heavily reliant on accurate forecasting or involves the purchase
of high-expectation stocks is inherently risky. Market supply and
demand forces create spectacular pricing inefficiencies. All that is
required for successful investing is the commonsense analysis of
today’s facts and the courage to act on your convictions.
They used what they called “a-pig-at-the-trough” approach. If you
found a stock that you liked and wanted to buy you had to convince
one of the other people to liquidate one of their holdings to make
room in the portfolio, just like one pig has to push another pig out of
the way if he wants to get a spot at the trough.
The assets of the fund were growing rapidly.
Stock investing is not an exact science. The greater the number of
useful things you can look at, the greater you increase your odds.
Do you also mean to imply that you don’t use charts or Wall
Street research?
I never looked at a chart for 99 percent of the stocks I bought for our
funds.
Some
of my research analysts have good friends who are sell-side analysts
and have seen them pressured to recommend stocks they didn’t like.
I usually don’t get excited about winners; I’m
too busy looking for the next trade.
You can’t be afraid to take a loss.
How would you rate the quality of Wall Street research?
Not very good.
For what reason?
Most analysts don’t have a logical reason why a stock should be at a
given price. As long as the company does well, they don’t care what
the price is. Typically, if a stock reaches their target, they will just
raise the target, even though the fundamentals haven’t changed.
What did you learn from your experience in losing all your
money?
I realized that no one was going to do it for me; I had to do it for
myself. My broker still got a commission, but I was sitting there
broke. Incidentally, although I didn’t realize it then, I now fully
believe that losing all of your money is one of the best things that can
happen to a beginning trader.
Why?
Because it teaches you respect for the market. It is much better to
learn the lesson that you can lose everything when you don’t have that
much money than to learn the same lesson later on.
I guess that implies you are not an advocate of paper trading for
beginners.
Absolutely. I think paper trading is the worst thing you can do. If you
are a beginner, trade with an amount of money that is small enough so
that you can afford to lose it, but large enough so that you will feel the
pain if you do. Otherwise, you’re fooling yourself. I have news for you:
If you go from paper trading to real trading, you’re going to make
totally different decisions because you’re not used to being subjected
to the emotional pressure. Nothing is the same. It’s like shadowboxing
and then getting in the ring with a professional boxer. What do
you think is going to happen? You’re going to crawl up into a turtle
position and get the crap beat out of you because you’re not used to
really getting hit. The most important thing to becoming a good trader
is to trade.
The key is to know when to do nothing. Most
people, even if they have a winning strategy, will not follow it because
they lack discipline. For example, everyone knows how to lose
weight: you eat less fat and exercise. So why are most people overweight
(assuming they don’t have a medical problem)? Because they
lack discipline.
Most people prefer to forget
about their failures instead of learning from them,
You need to have a plan for every contingency.
The most important contingency plan is the one that will limit your loss it you are wrong.
Normal human tendencies are traits that cause you to do poorly.
Therefore, to be successful as a trader you need to condition abnormal
responses. You hear many traders say that you have to do the
opposite of your gut response—when you feel good about a position,
you should sell, and when you feel terrible about it, you should buy
more. In the beginning that’s true, but as you condition yourself for
abnormal responses, somewhere along the line you become skilled.
Then your gut becomes right. When you feel good, you actually
should go long, and when you fell bad, you should sell. That’s the
point when you know you have reached competency as a trader.
What did you do after you graduated college?
I decided to go to business school, which allows you to put off the
decision of doing anything for another couple of years.
(Failing out of college, not getting a job, etc.) It was something that I psychologically really wanted to happen.
Although he liked science, he was disenchanted because the career scientists
he observed were forced to spend much of their time seeking
grants instead of doing research.
Do you ever go net short?
Ninety percent of my success is clue 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.
If John Bender is right about options*—and, given his performance, there is
good reason to believe he is—then virtually everyone else is wrong. Bender
asserts that the option pricing theory developed by Nobel Prize-winning
economists, which underlies virtually all option pricing models used
by traders worldwide, is fundamentally flawed. This contention is not
just a theoretical argument; Bender’s entire methodology is based on betting
against the price implications of conventional option models. Bender
places trades that will profit if his model’s estimates of price probabilities
are more accurate than those implied by prevailing option prices, which
more closely reflect standard option pricing models.
What did they get for backing you?
Initially, 50 percent of my profits. I eventually bought them out.
There are a lot of similarities between gambling and trading, although
gambling is a bad term.
Because?
Because it implies that your results depend on luck. The people that
I’m talking about look at poker or backgammon as a business, not a
game of chance. There are a few things that are essential to success
in both trading as well as playing gambling games as a business. First,
you have to understand edge and maximize your edge. Second, you
have to be able to deal with losing.
I don’t mean to suggest that Black and Scholes made stupid
assumptions; they made the only legitimate assumptions possible, not
being traders themselves. In fact, they won the Nobel Prize for it.
Although, to be honest, that always seemed a bit strange to me
because all they used was high school mathematics. All my trading
operates on the premise that the most important part is the part that
Black-Scholes left out—the assumption of the probability distribution.
Why do you say with such assurance that stock prices don’t even
come close to a random walk?
As one example, whether you believe in it or not, there is such a thing
as technical analysis, which tries to define support and resistance levels
and trends. Regardless of whether technical analysis has any validity,
enough people believe in it to impact the market. For example, if
people expect a stock to find support at 65, lo and behold, they’re
willing to buy it at 66. That is not a random walk statement.
Even though you manage a quarter of a billion dollars you seem
to keep an incredibly low profile. In fact, I’ve never seen your
name in print. Is this deliberate?
As a policy, I don’t do interviews with the media.
Why is that?
My feeling is that it is very difficult for a money manager to give an
honest interview. Why would I want to be interviewed and tell the
world all my best investment ideas? Let’s say I am a fund manager
and I have just identified XYZ as being the best buy around. Why
should I go on TV and announce that to the world? If I really believe
that is true, shouldn’t I be buying the stock? And if I am buying it,
why would 1 want any competition?
Don’t accept anything; question everything.
Actually, there is really no way to prove that is the case. All you
can ever demonstrate is that the specific patterns being tested do
not exist. You can never prove that there aren’t any patterns that
could beat the market.
That’s exactly right. All that being said, I grew up with the idea that, if
not impossible, it was certainly extremely difficult to beat the market.
And even now, I find it remarkable how efficient the markets actually
are. It would be nice if all you had to do in order to earn abnormally
large returns was to identify some sort of standard pattern in the historical
prices of a given stock. But most of the claims that are made by
so-called technical analysts, involving constructs like support and
resistance levels and head-and-shoulders patterns, have absolutely no
grounding in methodologically sound empirical research.
But isn’t it possible that many of these patterns can’t be rigor-
There are three variations of this theory: (1) weak form—past prices cannot be used lo
predict future prices; (2) semistrong form—the current price reflects all publicly
known information; (3) strong form—the current price reflects all information,
whether publicly known or not.
ously tested because they can’t be defined objectively? For example,
you might define a head-and-shoulders pattern one way
while I might define it quite differently. In fact, for many patterns,
theoretically, there could be an infinite number of possible
definitions.
Yes, that’s an excellent point. But the inability to precisely explicate
the hypothesis being tested is one of the signposts of a pseudoscience.
Even for those patterns where it’s been possible to come up
with a reasonable consensus definition for the sorts of patterns traditionally
described by people who refer to themselves as technical analysts,
researchers have generally not found these patterns to have any
predictive value. The interesting thing is that even some of the most
highly respected Wall Street firms employ at least a few of these “prescientific”
technical analysts, despite the fact that there’s little evidence
they’re doing anything more useful than astrology.
Even if there’s no change in the fundamentals?
Oh sure. I always tell my traders, “If you think you’re wrong, or if the
market is moving against you and you don’t know why, take in half. You
can always put it on again.” If you do that twice, you’ve taken in threequarters
of your position. Then what’s left is no longer a big deal. The
thing is to start moving your feet. I find that too many traders just stand
there and let the truck roll over them. A common mistake traders make
in shorting is that they take on too big of a position relative to their
portfolio. Then when the stock moves against them, the pain becomes
too great to handle, and they end up panicking or freezing.
You have had quite a run—years of mammoth returns and a sizeable
amount of capital under management. Are you ever tempted
to just cash in the chips and retire?
A lot of people get scared and think that since they made a lot of
money they’d better protect it. That’s a very limiting philosophy. I am
just the opposite. I want to keep the firm growing. I have no interest
in retiring. First, I have nothing else to do. I don’t want to go play
golf. You know the old saying: “Golf is great until you can play three
times a week, and then it’s no fun anymore.” Second, I enjoy what
I’m doing.
One procedure I introduced at S.A.C. seven years ago was to go
around the room and have each trader promise his results. In the
early years, I got a lot of resistance from just about everyone except
Steve Cohen, who was always very willing to promise an extraordinary
result. It took a long time lor people to accept this process, but now it
is ama/ing how much it has become part of the company culture.
If you are not reaching your target, it forces you to focus on
what you are doing wrong or what you may not be doing that you
should.Sometimes when people reach their target and nothing happens, they
stop paying attention to whatever the commitment was to get there.
This explains why some people begin to lose after they succeed.
When someone achieves his goal, the question
is often, “What now?” My answer, which is based on comparing
athletes who have won gold medals with those who haven’t, is to set
up another target that will provide a challenge. The gold medal winners
are always stretching for a goal that is uncertain.
Failing to redefine the goal can limit success.
One trader came to me and said, “When I’m winning, I keep winning—
I can do no wrong; when I’m losing, I keep losing—I can’t do
anything right.” The solution was to create the same state of mind
when he was losing as when he was winning.
When he is on a winning streak, he is fearless, intuitive,
and makes the right choices. When he is on a losing streak, he needs
to visualize, remember, and feel those same positive traits so that
when he comes into the office, he has the same attitude toward his
trading as when he is in the middle of a winning streak.
Any other examples of personal flaws that prevented a trader
from reaching his full potential?
One trader who runs a large hedge fund is never willing to buy a stock
at the market; he is always trying to bid it lower. As a result, he misses
a lot of trades.
What is another example of a behavioral pattern that was holding
a trader back?
One trader selected his stocks fundamentally and then scaled into
the position as the stock declined. Even though he had chosen to
enter his positions by averaging down, when a stock got back to even,
he was so relieved that he would often get out.
Disagreed with the following – A disagreement requires a reason, my reason is in ()
Now consider two money managers: one only buys stocks and is up an
average of 25 percent per year for the period while the other only sells
stocks and is up 10 percent per year during the same period. Which manager
is the better trader? Again, this is a nonsensical question.
(Well, the guy that made 25 percent was the better trader; 25>10)
Funny Blurbs
Had you had any experience before?
Not picking stocks.
Then how did you get a job as a portfolio manager?
I didn’t have a whole lot of respect lor him as a portfolio manager.
I’ll tell you one story that is a perfect example. During the time I
worked for him, junk bonds had become very popular. Henry had a
friend at a brokerage firm who offered to give him a large account if he
could manage a junk bond portfolio. We had no clue. Henry gave us
all a book about junk bonds and told us to read it over the weekend.
The following Monday we began trading junk bonds
Another hedge fund manager I interviewed who also does a lot of
short selling said that the value of audits on a scale of 0 to 100
was zero. Do you agree?
Yes.
Even if it’s a leading accounting firm?
Oh yeah.