How important to investing is trading?

I didn't provide any specific pointer for my contention that George Soros, in his great book "The Alchemy of Finance", says his trading (in the glorious year he chronicles throughout part III as "The Real Time Experiment" -- 1985-86) was poor. Fortunately, thanks to Google Books' search ability, it's really very easy to check: just go to the book and search for trading, and you'll find as the top two hits of the search:

• p. 308: "The record shows that my trading was far from flawless even in Phase 1. I was too late in buying bonds and too early in selling them" (&c).
• p. 207: "In short, my trading was poor".

and more hits such as

• p. 160: "On balance, my trading has been poor"

not to mention other choice (not fully germane, but irresistible to quote;-) tidbits such as (p. 278) "At present, the stock market is dominated by program trading and portfolio insurance schemes. These schemes are fundamentally unsound. They virtually assure a loss for exchange for peace of mind in a declining market."

Isn't George Soros, among the legendary investors, primarily a trader (as opposed to, say, Warren Buffett, notoriously more of a buy-and-hold type)? And, if so, how can he make money while repeatedly bemoaning his own trading? Read the book for the detailed answers, but, in short: overall, through the year, he was directionally right. E.g., wrt the first search hit above: he did buy bonds cheap (though definitely not as cheap as he might have bought them in hindsight had he timed the bottom in that market perfectly) and sold them dear (though not as dear as he might have sold them in hindsight had he timed the top in that market perfectly).

Nobody can time the market perfectly in the sense of accurately calling the bottoms and tops -- but it doesn't matter as much as our hindsight-based perfectionism screams in our inner ear: as long as we buy cheap and sell dear, we're still making good money. Making good money, just a bit less than you"might" have on the same trade in hindsight, had you timed it perfectly, is not losing money, and framing it as a loss is deleterious to our best judgment since it triggers strong "loss aversion" impulses in our brain.

Even in a dynamic, strongly trading-based investment style like Soros', what matters is being mostly right, most of the time -- that's even more so, of course, in a diametrically opposed (call it Buffett-like) investment style, where the trading part (the buying and the selling) is merely instrumental to the real money making, which is obtained by holding (or, being short of) the right securities at roughly the right time.

More on "The ABC of Stock Speculation" - part 2: "get rich quick" schemes vs patience and prudence

disadvantage of the small operator in following this policy is that he seldom provides sufficient capital for his requirementsContinuing the idea I started here, I'll keep irregularly doing some posts based on quotes from Nelson's 1902 book -- all the quotes in this and other posts of this ilk are from Google Books' scans, except for typo corrections I'm making along the way.

It is an old saying in Wall Street that the man who begins to speculate in stocks with the intention of making a fortune, usually goes broke, whereas the man who trades with a view of getting good interest on his money, sometimes gets rich.

This is only another way of saying that money is made by conservative trading rather than by the effort to get large profits by taking large risks.

Nelson's core idea for this "conservative trading"

starts with the assumption that the operator knows approximately the value of the stock in which he proposes to deal. It assumes that he has considered the tendency of the general market; that he realizes whether the stock in which he proposes to deal is relatively up or down, and that he feels sure of its value for at least months to come.
Suppose this to exist: The operator lays out his plan of campaign on the theory that he will buy his first lot of stock at what he considers the right price and the right time, and will then buy an equal amount every 1 per cent. down as far as the decline may go.

This systematic "averaging down" procedure, of course, when compared to simply buying your whole position (whatever total amount you're comfortable investing in the stock) when the stock reaches "the right price and the right time", saddles you with far more in commissions (and that was even truer in Nelson's time, when commissions were more substantial -- nowadays, depending on your broker &c, you may get a number of commission-free operations, or pay a very small amount even for non-commission-free ones).

More importantly, it makes the overall size of your position highly dependent on Mr Market's whims -- after all, as Nelson says, "Any operator proposing to follow a stock down, buying on a scale, should make his preparations for a possible fall of from 20 to 30 points. Assuming that he does not begin to buy until his stock is 5 points down from the top, there is still a possibility of having to buy 20 lots before the turn will come" (!). So, if you're prepared (say) to invest a total of $10,000 in stock X, you must do it in $500 increments... and may end up owning only $500 or $1000 of it if the decline on which you start buying lasts but a short time!

Whether these substantial strategic disadvantages are compensated by reducing your overall cost basis by up to 10% downwards (buying 20 lots "on a scale" at price points decreasing by 1% each time) may depend on individual tastes... to me, though, this sounds like a procedure for trading, not one for investing. I'm definitely not a great trader -- and I find it heartening to read in George Soros' fascinating book "The Alchemy of Finance" (highly recommended, BTW) that he disparages his own trading (short-term market-timing, &c) skills in even less-uncertain terms (!). Maybe (said he self-soothingly) there's a negative correlation there...?-)

Nevertheless, net of specific procedures, I think that the core messages -- "money is made by conservative trading rather than by the effort to get large profits by taking large risks", and "don't over-trade!" -- or, as Nelson puts it, that the

disadvantage of the small operator in following this policy is that he seldom provides sufficient capital for his requirements

(i.e., he over-trades, over-margins himself, and so forth) -- remain, after more than a century, immortal principles to live by.

Ken Fisher's "Debunkery"

50 "myths" (or "bits of bunk") exposed and debunked in 4-5 pages each -- I suspect that's a good format for many readers with short attention spans or busy lifes full of interruption, though I personally like good old-fashioned reading and in-depth analysis and explanation, so I found myself somewhat annoyed by the glib, facile, over-simplified tone of each short "bunk". However, while I do have many objections to the format, exposition, and style, somewhat surprisingly to me (while reading critically and in a somewhat annoyed/peeved mindstate from the above issues;-), I found myself more or less in substantial agreement with 49 of the 50 points (far more than I would have expected a priori) though not necessarily with the slant the author gives to his "debunking" explanation.

Let me give an example of me disagreeing with the slant...: Fisher's debunking of beta's mythical status (bubk #19, "Beta measures risk") entirely focuses on the fact that it's backwards-looking, because, he spouts, "past performance is never indicative of future results" -- now that is unadulterated bunk. (Or would Mr. Fisher like to get me to perform surgery next time he needs some? I have no "past performance" while he could get a surgeon with extremely good past performance, but if he truly believed what he so stupidly spouts, that should count for nothing at all with him... harder to think of a more stupid attitude to life: past performance is no guarantee of future results, but to jump from "no guarantee" to "never indicative of" is, truly, totally absurd).

No, the #1 reason to debunk beta is what he himself erroneously states (100% wrong, but similar to what most people just as wrongly believe -- I'm still angry with Fisher because I'm sure he knows better, and just lets "glib and facile" overwhelm "correct and precise"!): that an equity with a beta "Lower [[than 1]] ... was less volatile than the market" (!). False! Bunk!

What β<1 means is that the covariance of that equity with the market is less than the market's variance: in other words, that the equity's volatility (which per se may be high, low, or middling) tends to be less correlated with the market's volatility, than the market itself. You can perfectly have an equity with extremely high volatility and a very low beta (even negative!) -- all it takes is for that equity's peaks and troughs to tend to coincide more with the overall market's throughs and peaks rather than viceversa.

Adding some of that equity if the rest of your portfolio is "the whole market" (e.g. via a S&P 500 index, as that's usually what beta's computed with respect to) will lower your total portfolio's volatility... in as much as the correlation of that equity with the market doesn't change drastically in the future. But unless you bother to compute beta with respect to your specific portfolio (and hardly anybody ever does), even that is not much use.

Other perfectly valid (and important) objections to beta as a measure of risk include the fact that it's based on variance -- which treats the "risk" of outperforming the market exactly as severely as the risk of underperforming it, at total variance with the psychological impact of "risk" and the way everybody uses the word in question in real life (including investing); semivariance, alas much harder to treat mathematically!, while still imperfect, would be much closer to people's understanding of, and psychological reaction to, "risk". And many others... but focusing exclusively on the "backwards looking" aspect, and capping that with that absurd proclamation claiming the past has nothing at all to teach us (as if half of the book itself wasn't about looking at historical information...!!!) is really objectionable.

Of course, the one point of the 50 I think is total bunk is the one ferociously attacking covered call writing, where not only is the argument objectionable, but the implied conclusion is totally absurd and unwarranted. But, I guess that will have to be explained in some future post!

"The ABC of Stock Speculation"

Few investors would consider reading a book written in 1902, but in the specific case of Samuel Nelson's "The ABC of Stock Speculation" I think they might be losing something thereby. I am admittedly fascinated by old, great classics, but this one is a real find -- so much of the advice sounds just as fresh and applicable today, over 100 years later.

I'm really happy I got the Kindle edition (just $9.57 -- it's essentially an image scan of some sort, not very readable to me on my Android phone with the Kindle reader program, but just fine on my Kindle for Mac; the paperback's cheap too, $11.48 also from Amazon). Google Books also has it -- for free, and with a plain-text version that makes it a joy to copy and paste (which the Kindle editions -- and the paper ones -- don't;-). So, consider, for example (from the end of chapter XII)...:

If people with either large or small capital would look upon trading in stocks as an attempt to get 12 per cent. per annum on their money instead of 50 per cent. weekly, they would come out a good deal better in the long run. Everybody knows this in its application to his private business, but the man who is prudent and careful in carrying on a store, a factory or a real estate business seems to think that totally different methods should be employed in dealing in stocks. Nothing is further from the truth.

Isn't this condemnation of the "get rich quick" approach to the stock market just as true and fresh today, as it was when written, over 100 years ago?-)

Nelson's analysis of stop-loss orders (essentially: a good idea if you're wildly speculating on a stock you actually know little about, based on "stock tips" [[which he calls "points"]] and/or overtrading compared to the amount of capital you can really afford to risk -- very bad idea if you have an investment position in a stock of a company you know well, and are trading well within your means... IOW, a bad idea if you're investing as you SHOULD be, rather than just gambling!-) is also pretty much immortal. I can't recommend this book highly enough!

Options: investing or gambling?

Most people associate "options" with sheer gambling -- just read the rousing condemnation of them in Peter Lynch's generally excellent book "One Up on Wall Street", for example. Yet -- pause for a moment and think about it -- each option trade has two counterparts, a buyer and a seller... can they both be "gambling"?

Option trading is a zero sum game, after all (net of commissions -- and, on a deep-discount brokers today, those aren't too terrible): if one party is taking a likely small loss in the unlikely chance of scoring a large gain, doesn't it stand to reason that the other party must be accepting a likely small gain in the unlikely chance of giving up a large loss (or, more precisely, the unlikely chance of missing out on the possibility of a large gain)?

The way I like to look at it is: options (covered calls, specifically) are somewhat like lottery tickets. The buyer of a lottery ticket pays a small price and usually gets nothing in return, but once in a while "might" walk off with a jackpot; the seller of a lottery ticket has no chance of thereby making a fortune, but pockets with certainty the ticket's small price and, by repeatedly selling many tickets, makes a pretty steady income. Once in a while the ticket just sold will have been a winning one -- this is not "a large loss" to the seller, unless said seller incorrectly "frames" it mentally in that way;-), but it can be seen as having "missed out on the possibility of a large gain".

A lottery seller who was terrified of one day selling the jackpot-winning ticket and thereby hoarded all tickets himself, never selling any, would nullify the small but steady and certain income they might have realized by selling the tickets to the public. If anything, this is the "gambling" attitude -- never sell a ticket because it just "might" be the big winner -- really similar to buying tickets with a similar hope, after all.

And this, believe it or not, is what most conservative investors end up doing, without realizing it: by not selling covered call options on their stocks, they're unknowingly turning into gamblers!-)

OK, this is put somewhat paradoxically, mostly to whet your appetite for more discussion of options, but more and more writers are getting convinced of that and making a good job at explaining and evangelizing this strategy. I'll have much more to say about it, too, but, for now, you could start e.g. with this site, which seems to do quite a decent job getting you started, or many of the excellent books on the subject.

I recommend Ron Groenke's books and site (if you don't mind the idea of paying 150+ $/year for his Windows-only software) and Paul D. Kadavy's "Covered Call Writing" and "Put Option Writing" books (his software, actually just several simple and useful Excel spreadsheets, is free -- you just have to write to ask for a copy at the address given in the books -- but differently from Groenke's it doesn't get info such as stock prices and option premiums from the net, you have to look it up and enter it manually).

For better-explained theory (no sw though!-), Thomsett's "Options Trading for the Conservative Investor: Increasing Profits Without Increasing Your Risk" is, I think, still best. (Haven't read Wolfinger's "The Short Book on Options: A Conservative Strategy for the Buy and Hold Investor", but I believe it supports the same core ideas and strategy).