Authors: Jim Paul & Brendan Moynihan
Published: 2013; first published in 1994 (160 pages)
Started reading: 6.October.2016
Finished reading: 9.October.2016
[NB: This post is longer than usual. Approximate total reading time is 7 minutes].
Standing well above six foot, gravelly voice booming across the trading floor of the Chicago Mercantile Exchange, Jim Paul – for a while – felt invincible.
What I Learned Losing a Million Dollars (Columbia Business School Publishing) (WILLAMD) is his own parable, transcribed and co-written by finance academic and managing director at Marketfield Asset Management LLC Brendan Moynihan.
The genius of this small book is this: most advice about investing focuses on how to make money, as opposed to how not to lose money. WILLAMD is entirely about the latter.
So why is that a ‘genius’ move? The reason is simple yet overlooked.
There are a million-and-one ways to make money in the markets. In fact, there are as many ways to make money as there are participants.
When he turned to history’s best investors for advice, after losing $US 1.6 million (which I’ll get to in a second), Jim Paul noticed something incredibly telling: their methods were different, and in many cases conflicting.
Take legendary investor Jim Rogers on whether he prefers technical or fundamental analysis:
“I haven’t met a rich technician.”
Fair enough. Now enter Marty Schartz, who made $600, 000 in his first year as an independent trader, then $1.2 million the next:
“I always laugh at people who say, ‘I’ve never met a rich technician.’ I love that! It is such an arrogant, nonsensical response. I used fundamentals for nine years and then got rich as a technician.”
On the topic of averaging down, Peter Lynch, who averaged a 29.2% annual return managing the largest mutual fund in history, seems to believe there are times when it’s a sensible tactic:
“You have to understand the business of a company you have invested in, or you will not know whether to buy more if it goes down.”
On the other hand, you could listen to William O’Neil (incredibly successful investor and founder of Investor’s Business Daily):
“Averaging down is an amateur strategy that can produce serious losses.”
What about diversifying your portfolio?
The late John Templeton (rhodes scholar and billionaire):
“Diversify your investments.”
“Concentrate your investments.”
And the list goes on.
There is only one principle that these guys agree on. The number one rule of investing: don’t lose money.
All approaches to the market – investor, trader or speculator -, as well as differing analytical frameworks – such as fundamental and technical -, are valid methods for making money. Assuming continuing global economic growth, if you apply one of these methods and stick to it, you will, over time, make money – provided one thing.
That one thing is, surprisingly, that you don’t lose money – you minimise the downside.
And while there are a million-and-one ways to make money in the markets, there are only a few surefire ways to lose it.
This is why negative advice is so valuable, and why What I Learned Losing A Million Dollars is a genius book.
So how do you not lose money?
Jim Paul lost $1.6 million effectively betting on the soy-bean industry. It worked – indeed, it worked spectacularly – for a while. On one single day he made $248, 000. But when the market collapsed it only took him 75 days to lose it all, have all his positions liquidated, see his career in tatters, and nearly commit suicide.
What he realised was that he was really a glorified gambler masquerading as a ‘trader’. Attributing his long run of luck to skill, it was almost inevitable that a negative Black Swan (an unpredictable yet consequential event) would cause his tenuous success to come toppling down.
Betting, gambling, speculating, trading and investing are all different activities, but whether a person is a bettor, gambler, speculator, trader or investor depends on the characteristics he or she displays, not on the activity itself. Many professional poker players are actually speculators, and many professional traders are actually just betting.
Jim Paul, who passed away in 2001, may not have been erudite but he was unquestionably intellectually honest.
In WILLAMD Paul and Moynihan argue that big losses in the markets are essentially due to failures, as a result of psychological distortions, to apply whatever analytical framework the speculator has adopted. Although the authors don’t put it in these terms, loss-incurring investors fail to ignore sunk costs, they hold on to losing positions too long, and they allow themselves to be guided by emotions.
The key reason for this emotionalism is that we personalise and internalise losses, we let the market reflect poorly or prestigiously on our own egos. Bad investors refuse to cut their losses when they should because that would admit defeat. This is, you will note, characteristic of the gambler or bettor’s mentality: the delicious feeling that you were right or wrong about an outcome.
But successful trading, speculating or investing is not about being ‘right’ or ‘wrong’ about an outcome; it is about managing risk in an admittedly unpredictable market (no one knows the future, otherwise trading wouldn’t exist) in order to make money.
So how can you limit the downside? And how can you prevent emotions from creeping into your decision-making?
WILLAMD says you need a plan. First you need to decide whether you’re a speculator, trader or investor – these different types have implications for how long you hold a position.
Then you need to decide what market you want to play in (stocks, bonds, futures, options etc).
Finally, you need to establish an exit criteria: at what profit or loss will you sell? Taking this crucial step before you buy means that your pre-made, objective rules can guide subsequent decision making when events start to take over, reducing the possibility of losing money thanks to emotionalism.
Simple advice, yet often overlooked.
Tim Ferriss credits roughly one half of his net worth to this book’s influence, and Nassim Taleb described it as “One of the rare noncharlatanic books in finance.”
Two ringing endorsements for me.
> Don’t lose money. Provided you don’t lose money (by which I mean big losses; small individual losses are inevitable), and if you continue to apply your chosen analytical framework for long enough, making money is a nearly foregone conclusion. The precise level profit is indeterminable, but at least you can control the downside. A good strategy for not losing money is Nassim Taleb’s barbell strategy.
> Write down a stop-loss criteria before you invest. How much loss are you willing to incurr? At what price, time or with what new information will you sell? This really is the key actionable advice of WILLAMD, and it caused me to realise I haven’t developed a sophisticated exit criteria of my own. A stop-loss criteria must be stated before you buy a stock, otherwise you risk handing your decision-making over to emotions. An example of what emotional decision-making looks like: Many people buy speculative stocks with a view to selling in the short term, only to witness the stock price plummet. They then rationalise not cutting their losses (selling) by telling themselves the story that the stock is now an ‘investment’ – they hold it, and lengthen the horizon. Of course, sometimes the price continues to fall, all the while they’re rationalising why they’re holding the stock. In these cases, if the speculator had set up parameters before investing, his or her well-reasoned, prior-made rules could have prevented or contained the loss. Absent these established rules, emotion takes over.