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The Four Real Keys to Making Money

four keys to making moneyThe winning methods of successful professional investors are even sometimes contradictory. For example, in the book Market Wizards the successful pro Jim Rogers is quoted as saying that he often examines charts for signs of “hysteria,” and also that “I haven’t met a rich technician.” In the same book an equally successful pro, Marty Schwartz, is quoted as saying, “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.” If you think that is confusing, in the book What I Learned Losing a Million Dollars the legendary John Templeton is quoted as saying, “Diversify your investments.” In the same book, the equally legendary Warren Buffett says, “Concentrate your investments. If you have a harem of forty women, you never get to know any of them very well.”

So as I studied other long-term winners on Wall Street, I found that instinctively or otherwise, they had come to the same conclusions that I had. While the methods of Warren Buffett, Peter Lynch, and John Templeton are very different from my risk-management, asset-allocation, market-timing orientation, all of these men have been exceedingly humble, made multiple mistakes, and rarely (if ever) get headlines about a spectacular call. Yet they all use objective methods for picking stocks, their investment philosophy is disciplined and designed to limit risks, and they are flexible when they must be.

As I continued studying legendary investors, I discovered that all of these winners shared four key characteristics, some of which I had already learned by the time I completed kindergarten.

  1. OBJECTIVE INDICATORS: These legendary investors all used objectively determined indicators rather than gut emotion. We have a little riddle about this. In a room there were three people: a high-priced lawyer, a low-priced lawyer, and the tooth fairy. In the middle of the room was a $100 bill. Suddenly the lights went out, and when they came back on the $100 bill was gone. Who took it? The answer, of course, is the high-priced lawyer—because the other two are figments of the imagination. We want to make sure that what our indicators say is factual and not a figment of our imaginations. As our teachers tried to help us understand in kindergarten, it is critical to learn what is real and what is imaginary. What is an objective indicator? It must be mathematical, with long historical analysis to demonstrate its effectiveness. One example might be the rate of inflation. Perhaps it is because the Fed is supposed to control inflation, or perhaps it is because bond yields have an inflation premium, but inflation is one of the best macroeconomic indicators to use to call the stock market.

But in all of the noisy data, how much does inflation need to rise or fall on a monthly basis to be important? The chart in Figure 1.3 looks at the year-to-year rate of inflation relative to a five-year moving average. In the 41.3 percent of the time since 1952 that the year-to-year inflation rate was at least 0.5 of a percentage point below the five-year average, the S&P 500 shot up at a 13.5 percent annual rate—almost double the 62-year buy-and hold average of 7.2 percent. And when inflation was more than one percentage point above the five-year average, one actually lost money in stocks.

four keys to making money

Figure 1.3: S&P 500 index versus consumer price index

  1. DISCIPLINE: All the winners are very disciplined, remaining faithful to their systems through good and bad times. I sometimes compare investing to classical Greek tragedies, in which the hero is inevitably ruined by some character fl aw. My own biggest flaw in investing, as noted earlier, is letting my ego get involved in my market view. This makes it very difficult to admit mistakes. Thus, to shift from concentrating on being right to making money, I had to learn discipline. That is how I came up with the idea of using computer-derived mathematical models for stock-market timing that would force discipline upon me. That discipline may not have made me more right over the past 40 years, but it did control my mistakes and allowed me to be a much more successful investor. In June 1998 Dan Sullivan said in his The Chartist newsletter, “Successful investors have several things in common. First, they have patience. Second, successful investors are like great athletes, they adhere to a strict discipline.” As my teacher taught me in kindergarten, there will be chaos if you don’t have discipline.
  2. FLEXIBILITY: While disciplined, these winners were flexible enough to change their minds when the evidence shifted, even if they did not understand why. In his book Winning on Wall Street, Marty Zweig talks about how bearish he was during a sell-off in February and March 1980: “I was sitting there looking at conditions and being as bearish as I could be—but the market had reversed. Things began to change as the Fed reduced interest rates and eased credit controls. Even though I had preconceived ideas that we were heading toward some type of 1929 calamity, I responded to changing conditions.” In conclusion he states, “The problem with most people who play the market is that they are not flexible . . . to succeed in the market you must have discipline, flexibility, and patience.”

Barton Biggs once called Stan Druckenmiller “the investment equivalent of Michael Jordan. . . . He is the best consistent macro player.” Biggs said, “He is a combination of being very intellectual and analytical, but also using technical analysis.” In Market Wizards, author Jack Schwager writes of Druckenmiller:

Another important lesson . . . is that if you make a mistake, respond immediately! Druckenmiller made the incredible error of shifting from short to 130 percent long on the very day before the massive October 19, 1987, stock crash, yet he finished the month with a net gain. How? When he realized he was dead wrong, he liquidated his entire long position during the first hour of trading on October 19 and actually went short. . . . The flexibility [emphasis added] of Druckenmiller’s style . . . is obviously a key element of his success.

So as I learned in kindergarten: expect surprises. Things change.

  1. RISK MANAGEMENT: Finally, all of these successful investors were risk managers . I asked Paul Tudor Jones once what he does at work all day, and he answered, “The first thing I do is try to figure out what is going to go wrong, and then I spend the rest of the day trying to cover my butt.” In Market Wizards, Paul says, “I am always thinking about losing money as opposed to making money.” And he is widely known as a risk taker!

Nearly all of the pros I have studied are clear about one thing: they want to control their losses. In Market Wizards, fundamentalist Jim Rogers says, “Whenever I buy or sell something, I always try to make sure I’m not going to lose any money first . . . my basic advice is don’t lose money.” In the same book, technician Marty Schwartz says, “Learn to take the losses. The most important thing in making money is not letting your losses get out of hand.” In his book, Pit Bull, 1 0 Schwartz says, “Honor thy stop . . . exiting a losing trade clears your head and restores your objectivity.” Controlling losses is one lesson I wished I had learned in kindergarten. They did tell me to be careful, but it wasn’t until much later that it sunk in. I learned this from Warren Buff ett, who once stated his two favorite rules for successful investing: Rule #1: Never lose money. Rule #2: Never forget Rule #1. In What I Learned Losing a Million Dollars, the legendary Bernard Baruch is quoted as saying, “Don’t expect to be right all the time. If you have a mistake, cut your loss as quickly as possible.”


This article is an excerpt from Being Right or Making Money, 3rd Edition by Ned Davis (Wiley; October 2014; ISBN: 978-1-118-99206-7)

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