by John Boik
(McGraw Hill, New York, 150 pages) $14.95
Scientists relentlessly use the trial and error method to find out what works and what doesn't. Time and again, things go wrong in experiments. But these failures eventually point them in the right direction. In the end, there is the great irony of triumph: Nothing succeeds like failure.
That is one of the themes of this lively, once-over lightly book. All the great traders briefly profiled here – Jesse Livermore, Bernard Baruch, Nicholas Darvas, Gerald Loeb and William O'Neil – shared one humbling characteristic: They made fortunes, but they also lost fortunes.
This little book's main value may be in its study of the latter. The errors of the great are probably more important than their victories. For example, the author, a private money manager, and former stock trader, notes that many of the greats couldn't resist overdoing their initial successes. They often started venturing into areas they should have avoided.
Writing of Jesse Livermore, the boy plunger who turned heads at a tender age, the author notes he didn't know when to quit, or, at least, when to take a rest.
"He kept listening to others and their so-called stock tips. He also kept trading too much." (page 5). Livermore, who made a fortune in stocks when he was very young, couldn't avoid jumping into commodities. His move into cotton futures soon wiped out even his considerable fortune. Livermore, who significantly enough died broke, violated his own loss control rules and losing positions by letting his emotions rule.
"As he tried to get his money back, he lost even more in desperate trading." (page 7). Yet Livermore, when he stuck to his disciplined strategies of riding gains – pyramiding and identifying opportunities to short in a weak market – was brilliant. He made so much money in the stock market crash of 1929 that many people believed he was the one personally responsible for their misfortunes and made threats on his life.
What makes these trading mini-biographies interesting is the common skepticism of these men about themselves and markets. For example, Bernard Baruch, who at the end of his life was proclaimed as an investment genius, a man who was consulted by many presidents, had many of his plans blow up. He made and lost much early in his life. Indeed, he followed the same wayward path at almost the same time as Livermore.
"He (Baruch) made a mistake in 1906 when he entered the commodities market and bought coffee (which he did not know about – his first mistake), and as it started to drop in price he was told to hold on (another mistake – listening to others). He held on and watched it drop," the author writes. (page 44).
Rocky Experience
And despite all Baruch's experience and self-criticism, he came to believe that most investment and trading plans must go awry. I conclude from these annals of rocky experiences, that one must approach trading the way the premier hitters in baseball approach the game.
They recognize that even the best are going to fail a large part of the time, but they subject themselves to unending self-criticism. That's because in baseball, and probably in life in general, the best performers make out about 66 percent of the time. Those kind of dismal numbers were familiar to Baruch or anyone who has ever tried to accomplish anything of substance.
For Baruch, a good deal of failure was unavoidable. However, what was important was how one reacted to failure. Did one understand it in its early stages and admit mistakes, thereby limiting the damage? Another thing that was important was whether one actually learned enough from a humiliating history so that the next time would be an improvement.
The most common mistakes Baruch tended to find were professionals who traded "beyond their financial capital capacity" and not knowing enough about a "company's management, earnings, prospects and possibility for future growth." (page 45).
Law of Averages
But always, Baruch reminded those who would listen, that there is a law of averages – a law very similar to that maddening summer game of my youth – that will inevitably catch up to even the best traders and money managers.
"No speculator," said Baruch, "can be right all the time. In fact, if a speculator is correct half of the time, he is hitting a good average." This is a remarkable admission for a man who was widely admired in his lifetime. But there's still more modesty, but also some hope.
"Even being right three or four times out of ten should yield a person a fortune if he has the sense to cut his losses quickly on his ventures where he has been wrong." (page 38).
I think anyone who puts money at risk should read this statement slowly. Read it several times. Read it especially when one is riding high and hearing that he or she is the latest incarnation of Benjamin Graham. Read it in the middle of the next bull market, when credulous souls are proclaiming to even more credulous journalists that bear markets have been outlawed. Read it when you, once again, start to hear that market making is a can't fail business.
Indeed, here is one of the benefits of this book. Its philosophy of self-criticism has many applications outside of the narrow subject of the book. How many times would nations, institutions and individuals have been spared incredible pain if they had simply had the ability to turn back from what one great historian once called "The March of Folly?"
Gerald Loeb, another legendary trader, also emphasized that the first law of trading success is "the ability to accept losses, cut them short and move on if the stock moves against you. This was his insurance policy against large losses. Just like Livermore and Baruch before him, his rule was to limit his losses to no more than 10 percent. This was his absolute maximum and a rule that he could simply not ignore." (page 59).
Can a trader critically self-examine himself or herself and apply these kinds of rules or any kind of rules, for that matter? Can a professional be a tough critic? One finds these sorts of questions running throughout this book. And how many traders can pass this test of self-analysis?
Indeed, how many human beings have had the intestinal fortitude to admit losses before they run up big numbers? And does one have the ability to critically examine oneself, even when one is bloodied?
The author, in summarizing the common threads of these remarkable traders, writes that they all "learned that the key to reducing losses and getting on the road to profits is to constantly analyze the trades one makes, and then learn from mistakes."
How many professionals want to do that? How many professionals have the ability to do that? And how many of their bosses insist on it?
Profitable Gains
The author continues: "They understood their successes so they could eliminate the loss-causing actions and capitalize on the transactions that led to profitable gains. All would write down when they made their trades, and they would go back later and review, especially the losing trades. It's not easy to admit and then keep looking at your mistakes as a reminder…" (Page 128).
As the Bard of Avon might have written about the last part of that advice, "there's the rub."
