06 – How To Spot Good Investment Advice

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Successful Investing

Whatever your definition of successful investing, it must have something to do with making money while losing as little of it as possible. This can be done by having lots of winners and few losers. Or by having small losers and big winners. As it turns out the real control can be found in the (average) size of our winners and losers, instead of in their sheer frequency. When we open a position we cannot know for sure if it is going to be a wining or a losing position, no matter how much analysis we throw at it. But at any time we can evaluate a position’s history and choose to close it down just by hitting the sell button. To put it another way: if we sell every loser as soon as it hits a certain threshold, take -5% for example, our average loss can never get larger than -5%. Reading Jack Shwager’s ‘Market Wizards’ series, containing dozens of interviews with highly successful traders, you will find this a common thread. Almost none of them address the aspect of analysis as highly important to their success, while almost all of them stress the importance of cutting your losers and riding your winners. From this simple idea, we can take quite a lot.

A Winner’s Track Record

Show me an investor’s losses and I can tell you if we have a winner. To be consistently profitable over the long haul, one has to learn to cut his inevitable losses. Some of the most successful investors have less than 50% winners. But they make up nicely for the more frequent but little losses.

So a successful trader’s track record will likely show a substantial amount of certain but small losses. These losses more often than not will prove to have been taken early on, when the idea did not materialize and the newly put on position started showing a loss. If any prospect advisor tries to dodge the question asking him to show his past losses there’s but one answer: run! Any successful investor can show you his losses. Only a loser hides them. Be very careful when you get an evading answer containing company figures or something like ‘buy and hold’, ‘the long run’ or ‘investment horizon’.

Winners on the other hand, although probably smaller in number, will on average be substantially bigger. They will have been built up from a small toe in the water entry position followed by add on orders at sequentially better prices. Watch out when focus is put on the number of winners or yearly returns to the detriment of what truly matters: are they able to mount up on their winners.

A Winner’s Portfolio

When a track record is not available, start questioning the whole thing. However, there are some tell-tale signs one can get from a snapshot view of a portfolio as well.

Looked at when positions where opened. The oldest should be big winners. These winners should be protected by a stop or, better yet, be void of cash through cash extraction, replacing the big positions with call options. Fresh positions (up to two weeks max) should could show insignificant losses but should have a clear escape route, preferably by a hard stop. Old but small winners or losers have no place in winner’s portfolio. Because all the cash we can get our hands on is needed to buy more of our winners.

There should be entry stops (with limits) on the side as fishing lines, waiting to hook a position.

If possible, look how positions where built up. In the big winners, you should see a small start position, followed by bigger but decreasing add on orders that got filled on ever higher prices.

Beware of Experts

After winning the Nobel Prize, Planck toured around giving a speech. The chauffeur memorized the speech and asked if he could give it for him, pretending to be Planck, in Munich and Planck would pretend to be the chauffeur. Planck let him do it and after the speech someone asked a first tough question. The real chauffeur said that he couldn’t believe someone in such an advanced city like Munich would ask such an elementary question and as such, he was going to ask his chauffeur (Planck) to reply.

The “chauffeurs” of this world often distract attention from their shortcomings by putting on a great show. They may have a commanding presence, a way with words, huge self-confidence and they can make a hell of an impression. But in the end, all they have is chauffeur knowledge.

True expertise is found in being able to explain what you are doing in simple language. They do not tell what, but explain why, preferably with an easy to understand credibility. Don’t fixate on the what (return) but ask for the how(risk control and money management). It’s the chauffeurs who seek refuge in jargon and obfuscation. They  never admit that they don’t know the answer to a question. It’s the Plancks who have the self-confidence to admit ignorance when the circumstances call for it. If an expert can show you his long list of small losses, be very careful. If he claims not to have any: run!

Economy 101

If you haven’t got an expensive education in economics or never have read a book on the subject, you get a long way by keeping in mind that economics is about incentives. Who does what and why? If you’re thinking about rodent control by offering a bounty, people are going to start breed rats.

So ask yourself, this guy in front of you, how is he making money? By investing or by selling advice? After all does who can do, those who can’t teach. Does he eat what he serves? Is he making money if you do and losing it as well if you do? Don’t get me wrong here, I think it might even be better to get non-biased advice from someone who doesn’t own your stock. But there’s quite a distance between someone being able to make money in the stock market and someone just talking the talk without having walked the walk.

Be very careful when returns are being thrown at you. Take the 7% return in a month heist, as an example. Skill or dumb luck? If you think about it, that would amount to slightly then 6000% in the next five years. Think about … take all the time you need.

Bullet Points

  1. Look at the average size of winners and losers. Not so much at their frequency. What you are looking for is an average profit to loss ratio of at least 2. Meaning that, again on average, you make $2 for every dollar you lose along the way. If this ratio is 2 or better, you can afford to lose two out of three times and still come out ahead.
  2. Make sure not to be led astray when asking for a track record. A track record of positions, not a track record of returns. A yearly return can hide a lot when luck rather than skill is involved.
  3. Ask yourself how the one giving advice is earning his living. Does het practice what he preaches and eat what he serves?

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