More Thoughts on Human Nature and Speculation

Continued reading from Tape Reading & Market Tactics.

Chapter 18

More Thoughts on Human Nature and Speculation

Greed

I have watched traders in brokers’ offices with deep interest, and have tried to learn the traits that crippled their profits. The desire to “make a killing”—greed—has impressed me particularly.

Perhaps this desire to squeeze the last point out of a trade is the most difficult to fight against. It is also the most dangerous. How often has it happened in your own case that you have entered a commitment with a conservatively set goal, which your judgment has told you was reasonable, only to throw over your resolutions when your stock has reached that point, because you thought “there were four more points in the move?” The irony of it is that seemingly nine times out of ten (I know, for it has happened with me) the stock does not reach your hoped-for objective; then—to add humiliation to lost profits—it goes against you for another number of points; and, like as not, you end up with no profit at all, or a loss.

Maybe it would help you if I told you what I have done to keep me in my traces: I have opened a simple set of books, just as if I were operating with money belonging to someone else. I have set down what would be considered a fair return on speculative capital, and have opened an account for losses as well as for gains, knowing that the real secret of speculative success lies in taking losses quickly when I think my judgment has been wrong. When a commitment is earning fair profits, and is acting as I had judged it should act, I let my profits run. But, so soon as I think that my opinion has been erroneous, I endeavor to get out quickly and not to allow my greed to force me to hold for those ephemeral, hoped-for points. Nor do I allow my pride to prevent an admission of error. I had rather, by far, accept the fact that I have been wrong than accept large losses.

Another helpful thing to do, especially when you feel in doubt about your position, is frequently to close out all commitments (except your investment backlogs) and stay out of the market for a time. This clears your perspective and allows your judgment to “congeal.” Never hold to a position because of pride in an original conclusion which your later judgment whispers is wrong. If you will limit your losses quickly and allow your profits to run, you have to be right only two or three times in every five to earn extraordinary profits.

For fear of being misunderstood, I want to explain that the foregoing is not to be construed as advising daily scalping, or in-and-out trading “for a point,” as, to my mind, there is nothing but grief to result from that in the long run. Rather, it offers suggestions for conservative speculation within the major or intermediate swings of stock prices. Concentrate your trading on these more important, intermediate moves and concentrate your mind on the action of the stock. Force yourself to forget “self” in order to trade in an impersonal, business-like manner.

Look Upon Your Stock Certificates as a Merchant Looks Upon His Merchandise

A merchant buys goods which he expects to sell at a profit. Your speculative purchases of stock certificates, to be successful, must be consistent with the same merchandising principle. Before you buy a stock, be satisfied that you can sell it to someone else at a higher price. Do not forget for a moment that for every share of stock sold there must be a buyer. I know that this sounds childish, but many evidently forget it. You do not make a personal sale when you sell your stock; simply, somebody somewhere buys it. It is your judgment, or your advisor’s, which must decide whether there is somebody who will pay more for your merchandise than you did, plus your overhead expenses.

Likewise, just as a merchant knows that certain styles will not long remain in demand, so must speculators realize that certain stocks which are popular now, may lack demand three months hence. What does a merchant do when he learns that a certain coat which he has purchased does not sell readily? He immediately marks it down, let us say, 10 percent. Then, if after a few days it is still on his hands, he again lowers the price, until finally he may transfer it to the “basement bargains. “But he sells that coat—he does not hang on to it hoping that it will sell as originally priced.

If you are not familiar with retail merchandising, hunt up a friend of yours who is in the retail business—preferably women’s wear—and ask him to tell you the principles of buying and selling for profit. I assure you that if you will do this and then thoughtfully consider the similarity of your market trading to retail trading, you will see the matter from a new and more profitable angle.

The most important factor in merchandising is the reading of the public’s psychology of style, just as I claim that market, or investor, psychology is the most essential study in forecasting. There is an old saying in retail merchandising that “well bought is half sold.” Is this not true of stocks? If your interpretation of market action—as it relates to demand—is correct, then your stock is half sold at a profit the moment you buy it.

Forget stock certificates as such and consider them as merchandise whose salability depends on fickle style. If you find that you have misjudged your market, offer your merchandise at cut prices and get rid of it. Take a loss and try again. Remember that if you limit your losses you can afford to accept many losses and still be ahead, because your correctly purchased merchandise will earn big profits for you.

Finally, do not try to sell winter coats in the spring. Sell them all before the last snow has gone. In other words, let your “competitors” have the last few points in a move. The surest profits are those in the middle—at neither the top nor the bottom.

Do Not Believe Anything You Read

Here are two headings which appeared over two practically identical financial articles, one published in The Wall Street Journal, the other in The New York Times, on Tuesday morning, July 29, 1930:

The Wall Street Journal:

Continental Oil 2nd Quarter Off; Consolidated Profit $2,120,518 Against $3,842,081 Year Ago; Six Months’ IncomeUp

The New York Times:

Continental Oil’s Net Profit Jumps; Quarter’s Total Reported at $2,120,518 Against $523,302 in First Three Months. Big Curtailment Made; Company Forecasts Enviable Position When “Value for Products” is Received

It is not difficult to sense which newspaper was interested in publishing optimistic news. The remainders of the two articles were very much alike; doubtless each paper received the report from the company’s publicity office. The headlines in The Times read as if they, also, were written in that office. These remarks are not made to render an opinion on Continental Oil stock one way or the other, but the illustrations are printed to point out that the unwary, thoughtless reader is at the mercy of the newspaper headline writer or a company’s publicity man.

Actually, the only wise course to pursue in reading financial news is to believe nothing! Remember the wise counsel of Sir Francis Bacon: to “doubt all before you believe anything.”

Bear in mind two important facts, facts which may cause your own downfall market-wise unless you are on your guard every minute.

First, newspapers, as a rule, do not wish to publish pessimistic news. Whenever possible the best foot is put forward in any piece of business reporting. Ask any publicity man and he will tell you that there is little use in sending any financial releases to newspapers, with the hope that they will be printed, unless they are optimistic in tone.

Second, corporations will seldom stress any but the best news of their operations. You constantly read news items about corporations, wherein new improvements, increased sales, new products, and what not, are reported. These items may be published purely for the purpose of interesting the public in the company’s stock. Probably a pool is operating in the stock and it is soliciting the public’s aid through advertising—the best advertising, next to rising stock prices on the ticker tape, being frequent news items.

A noted economist once told me that he tried never to believe anything he read in financial reports, but endeavored to place his own interpretation upon the facts and statistics published, paying no attention to the implied opinion of the writer. He admitted, however, that oftentimes he himself was carried away unwittingly by colorful reports which he did not analyze coldly and critically.

Referring again to the headlines at the beginning of this article, I wish to remark, lest you have not noticed it, that The Times’ headline would imply a sensational increase in business if you saw only the report for the two quarters of 1930, although the half-year income was only slightly in excess of 1929 and the second quarter of 1930 was nearly two millions under the same period of the previous year.

A friend once sent me a clipping from the financial page of The New York Herald Tribune, which I reprint herewith. It hardly needs comment, for it simply bears out what I have said in this section:

The following two quotations, appearing in different newspapers yesterday, may, when taken together, help one understand just what went on in the stock market: “Operations for the rise,” states one commentator, “which had been checked yesterday by profit-taking, were resumed with vigor on the Stock Exchange this morning and, despite further selling to realize profits, made excellent headway during the abbreviated session in a well diversified market.” Exhibit No. 2: “Heavy selling went ahead in the principal industrial stocks in the weekend session. Uncertainty over the business outlook was induced by the recent bad breaks in cotton and wheat, and the decline in iron and steel prices.”

I am told that many big operators scarcely ever read the financial pages of newspapers, because they wish to draw their own conclusions and formulate their own judgments from cold statistics and the action of the market, realizing that unconsciously they may be swayed by publicity releases and financial writers’ opinions, which may be based upon hearsay rather than facts.

The Value of the Impersonal Viewpoint

If we all had the impersonal viewpoint concerning our investments and speculative commitments, I know that profits would be much larger, chiefly because losses would shrink. I honestly believe that the most important problem before both the investor and the speculator, is limitation of losses. In other words, the emphasis in the handling of all commitments should be put on the prevention of large losses and the willingness to accept many small losses.

We can do this only if we have the impersonal viewpoint. In your business, you doubtless never give a second thought to some small loss which your business judgment tells you to take, whereas if it were out of your own pocket you would have it on your mind all day. A merchant marks down a coat to move it quickly, but does not worry over the loss; a buyer, in a rush to get in some supplies, may find he has paid a few dollars more than would have been necessary if he had had the time to obtain several bids; a business man will spend the company’s money for a trip which is not actually essential, but the expense will not worry him, although it indirectly may be his own money. In all these examples—and you can think of many more—the minds were focused upon the job in hand rather than upon the money expended.

How may you obtain this same viewpoint in the market? My only suggestion, which I have found works fairly well (not perfectly, I admit), is for you to look upon your market transactions, whether they are long-pull investments or commitments for the shorter swings, as simply constituting a business in which you are interested. Open a simple set of books, setting up a stipulated percentage of your capital (start with 33 1/3 percent) as a reserve against losses. Decide upon a conservative income from your investment, which will not tempt you at any time to become overextended. Open an account for surplus, and add to it each month (if you are actively trading) a specific percentage of your profits (at least 50 percent, which, in turn, should be invested in bonds or long-term common-stock investments).

I believe that, if you will do this, you will unconsciously find your mind to be upon the operation of your business, rather than upon the fact that each point means fifty or a hundred dollars in your pocket.

To return to the matter of limitation of losses: you will find that you are willing, even entirely satisfied, to accept a number of small losses, inasmuch as your mind will be focused impersonally on the business problem of adding to your surplus each month and as you will realize that you have a reserve against your losses which it is perfectly good business to use up, and because, if your percentages are worked out soundly, your losses are an expected and normal sequence in your business operation. In other words, to earn consistent profits you have to take losses, and many of them.

The Public is Always fooled

Early in the summer of 1930, it was generally quoted that brokers had instructed their employees to take their vacations early, because a brisk market was expected in August. The public naturally looked for a young bull market. Instead, during the greater part of the summer we witnessed declining prices. I did not hear of any broker who was not able to keep up with business, and I doubt if many were forced to work their staff’s overtime.

It is rather discouraging to some of us to read so many announcements apparently released to fool the public. However, I rather suspect that some of the “big boys” themselves were fooled that summer, as I am certain many of them were quite positive that the inactive weeks in the latter part of May were periods of accumulation. Still, although some were fooled, others fooled the public. One thing is almost as sure as taxes, and that is: that trying to outguess “them” in daily fluctuations is financial suicide for the vast majority. Some may be lucky for a few trades, but not for many more than that. Remember this: the big operators and pool-managers, when successful, outwit or outwait the public. The thing for you and me to do is to try to time our commitments so that we tag along with “them” for the trend (of maybe 1 week, maybe 16 weeks) and precede the public, both in buying and in selling.

And this means not allowing ourselves to be “kidded” into some move, or pushed into following the crowd.

Never Answer a Margin Call

The Market Philosopher’s advice to his class is: never answer a margin-call. Tell your broker to sell enough of the shares he is holding for you to meet his requirements. The margin clerk is your best friend: he can be depended upon to tell you when to sell; and if you do not follow his tip, he will sell anyway.

In order to check up on this theory of it’s being best never to answer a margin call, I once interviewed a number of brokers. They all, without exception, told me that traders would fare much more profitably than they usually do, if they never replied with more money to protect their margin accounts.

And why should they not?

Your judgment is bound to be biased when your stocks are going against you. It is impossible for you to consider all factors calmly. When you purchased your stocks you expected them to advance. If the opposite movement occurs, your judgment was wrong. Then why, in Heaven’s name, throw good money after bad? What is the difference, after all, between a paper loss and an actual loss? Your equity is exactly the same on the broker’s books (minus the selling commissions). You are no better off, holding on, than you are if you sell out—in fact, you are not as well situated, because more of your capital is tied up: thus you weaken your position, possibly to the point where you cannot take advantage of whatever bargain prices there may turn up later.

The Danger of Too Much Nerve

I know that there are many who are opposed to the thought I shall expand upon here—that it is dangerous to call upon your nerve to help you stay with a commitment.

Fear is probably the outstanding emotion in the market. (In making these remarks, I have marginal operations in mind.) Although a certain small amount of fear is a wonderful safety-valve, I believe you will agree that any more than that much paralyzes sound reasoning, and that without sound reasoning we have no business speculating.

Let us look at it from another angle: suppose you and I have purchased a certain stock after due deliberation. From our study of the transaction it is our belief that the stock should advance, and, although minor reactions (of two or three points, let us say) are to be expected we nevertheless think the trend is up. If, instead of advancing, the stock immediately reacts (contrary to our previous opinion that reactions were expected during, but not prior to, the advance), we know that our calculations of the technical position were not accurate. This beclouds the outlook; our original conclusion was erroneously arrived at. If we are confused, or afraid of the result, what is the sensible thing to do? Sell; get out and make a new analysis.

Why sell? Why not grit our teeth and say: “By George, I am in this thing and I’ll stick it out as long as my money lasts. I’ve got enough margin to carry it down fifteen more points; I’ll show this stock it can’t bluff me.”

Figure it out for yourself. Perhaps my thinking is askew, but until someone proves to me that it is sounder to use nerve and stick to a commitment which I know, if I were out of it—if I were sitting on the sidelines—I should not buy into, I am going to continue to be afraid, and can do nothing better than get out. This is a profitable method of reasoning, is it not—to get out of a stock which you would not buy?

I have heard so many traders say, again and again: “I wish I were not long of that stock; if I weren’t, believe me, I’d never buy that dog.” When I ask them why they do not sell, I am informed: “Oh, I can’t lose my nerve and sell now; I have a loss in it.”

Well, all that I can say is that this shows you one of the many, many reasons why pool operators and professionals make money by trading with the public.

You may reply that, if you sell when in doubt, you may lose a good position. As you know by now, there is, to me, no such thing as “position” in trading. You certainly cannot lose a good position if the position you are in shows you a loss. Likewise, remember, the stock market is not going to close down soon. It will still be there next year, making money for the few who are smart and losing money for the many who are foolish.

Remember: it is not the price you pay for a stock, but the time at which you buy it, which counts in trading.

Averaging to Satisfy Pride of Opinion

Once, in the fall of 1930, when I was on my way to Vermont for a weekend, I ran into an acquaintance in the parlor car. It was not long before our talk swung to the stock market.

He pulled out of his pocket a list of stocks which he had purchased at 1929 near-highs. I listened while he told me of his plans. He said: “I am going to buy more of each of these stocks pretty soon, when I think the bottom has been reached.”

I asked him if I might look at his list. I noticed some stocks whose companies were unlikely to prosper to any great extent during the coming year or two. I was naturally interested to learn what prompted his decision to buy more shares of each present holding.

“Well, you see, I hate to look at the prices at which I bought these stocks; and if I buy more at these low levels I can average my prices, and I shan’t mind so much then. For example, I paid $75 a share for my United Corporation, and if I buy some more at around $20, my average price will only be $47.50, which doesn’t look so high.”

“Are you going to buy more of every stock regardless of the outlook for the companies? I have no quarrel with your decision on United Corporation, but cannot quite see why you buy more of two or three of your other holdings.”

“Oh, yes, i’ll buy them all; they’re all good stocks.”

To my mind, averaging is, in itself, wrong reasoning; but to average simply to satisfy your pride of opinion is financial suicide. In averaging, you are buying more of something which is worth less than you previously thought it should be worth. When, on the other hand, you buy more of a stock which has advanced above what you paid for it, your judgment has been confirmed and your profits are helping you. In averaging down you never know for certain that you are buying at the bottom: a friend of mine averaged Chrysler four times in 1929 and 1930, and the fourth time it was in the eighties!

The fellow who averages at the exact bottom, will immediately rise from his seat and tell me that this theory is all wrong. Perhaps even then it is not wrong, because until the stock has showed him a profit he is not positive that he has not purchased a “sleeper,” one which will stay down.