History teaches us many lessons, and it seems the lessons of the market are taught more often by the bear than the bull. During the last bull market cycle, like those that preceded it, the energy was electrifying. The bulls ran through the Streets (Wall Street and Main Street) with the blood of any short sellers dripping from their horns. When the “new economy” was fed to the public by industry spokespeople disguised as CEOs of Internet companies, it was swallowed whole by the media and the trusting public alike. Analysts dove into the fray and were a driving force behind the entire circus act, fooling themselves into believing the garbage they themselves spewed. As long as the market rallied, many analysts were willing to disregard ethics for instant gratification. Most were not motivated by sound research, but by investment banking deals and CEO influences.
Many investors believed they were invincible, racking up thousands if not millions of dollars, but it didn’t take long for the self-cleansing mechanism of the market to take its course. The business of trading is Darwinist—survival of the fittest—and most didn’t survive. Those who survived were able to dismount the bull and remount the bear, but as industry statistics prove, they are few. Regardless which bull market we describe, the attitudes and results have been nearly the same. Statistics prove that it takes more than a bull market to be profitable. History also proves this. I believe the eighteenth-century mathematician Daniel Bernoulli unknowingly described what it takes to survive the market best—“Human Capital!”
Human capital describes, among other attributes, one’s education, talent, and ability to perform. Most people pay too little attention to human capital and too much attention to the ideas and methods of others. As we have learned from the most recent bear market, this diversion is at their own peril. The public took to Internet trading like a fish to water—or should I say a sheep to the slaughter. The analysts and brokers fed investors ideas and the bull market made these players heroes. As such, most participants didn’t consider risk. Beginner’s luck syndrome quickly developed and most participants did not fully appreciate the risks embedded within the analysis they consumed. New participants tended to be gullible and trusted data fed to them from analysts under the guise that big money equals smart money. But we must not be confused and turn the bear market into a scapegoat for the reasons most investors lose. Luck breaks down with the emergence of a bear market, but bear markets are not to be blamed—the lack of knowing how and when to sell is the reason. Investors who don’t know why they bought won’t know when to sell. Analysts didn’t miss the call to sell. They had no incentive to make it in the first place as Chapter 1 will explain. As a result of this misguided trust the public placed on the analysts, luck quickly ran out and human capital suffered with little personal investment into self-development.
Back in the 1700s Bernoulli introduced another factor of paramount importance that can be applied to today’s stock market—The Law of Diminishing Returns. This law states that not all risk can be defined in intrinsic or mathematical terms. Bernoulli discovered that “the utility resulting from any increase in wealth will be inversely proportionate to the quantity of [wealth] previously possessed.”* Because wealth is relative to each participant, each person must make their own decisions regarding risk. What may be acceptable risk for one person may not be for another. Therefore Bernoulli’s law of diminishing returns reminds us that trading and investing is a very individual endeavor. This historically valid discovery applies today, explaining why successful traders and investors tend to remain profitable. The combination of patience and fear contribute to decision making. Objectively analyzing and waiting for the right trade while relentlessly protecting downside risk are among the best skills a trader can acquire. Decision making at an institutional level where all participants of a fund are subjected to the same risk does not address such personal risk tolerances.
Even objective market analysis does not cancel out all subjective factors, such as fear or the psychological pressures of the market. Like it or not, when you commit your capital, you also commit your emotions. In bull markets, greed too often takes a front seat to fear, but it is a healthy dose of fear that develops discipline—something most investors never learned. I believe that no participant, regardless where they are in their career, escapes the psychological demands of the market! Perhaps the easiest way to describe this is to say that the analysis of markets (stocks, options, bonds, futures, currencies, etc.) are determined by objective considerations (statistical analysis, probability, back testing, technicals, fundamentals, etc.), but the motivation to act on the analysis is personal and influenced by the laws of diminishing returns. Do the potential gains warrant the risk? The conundrum created for many who contemplate these very real issues (consciously or unconsciously) often lead to a form of ambiguity. The way that many people deal with dubiety is to delegate the decision making to others—hence the contradiction. This raises other important questions regarding the risk/reward relationship.
This theory of risk and utility is known as The Petersburg Paradox, and was only translated to English in 1954, 216 years after its creation! The only reason it was translated was because the modern-day economist John Maynard Keynes made reference to it in his great work, Treatise on Probability. Both published works are readily available and deserving of your study. The salient points and relevance to the market are quite enlightening. Is a millionaire proportionately happier with each additional million dollars acquired? The law says no, and his happiness is only incremental and eventually it diminishes because he is less willing to take risks. The paradox in today’s terms is that as you accept the responsibility of doing your own analysis, you begin to understand the very real risks embedded within the markets. Most investors never truly understand this until too late. Investors who rely on others for research perhaps temporarily escape the paradox by not understanding the true risks, but are later punished for their apathy. Bull markets tend to provide a false sense of security and even overconfidence which only sets up the greater fall. Ignorance is not bliss and the delegation of risk management to institutional funds is not the answer that many seek. The oddity can be surmised by stating that while acquiring market knowledge also reveals its risks; equivocating the responsibility to others exposes even greater risks. This is not to say that money should never go into managed accounts, but if these accounts are used, the risks the fund is taking must be fully understood.
Regardless of age, gender, or status, all participants will find the market to be an evolutionary process and challenge every step along the way—an endeavor of relentless demand yet limitless bounty. Therefore, every participant must answer this question about risk. Those who cut corners and hunt for an easy solution to the market have the most to explore and the least to find. Those who accept the responsibility of finding their own path are in a position to achieve success. Research done by others does not account for the individual subjectivity of each person. The confluence of using objective analysis for making decisions and the ability to define individual financial risk is the role you must accept. The act of following research and analysis for which you have had no hand in is clearly the greatest risk. The individual who trades their own capital becomes the trader, the analyst, psychologist, coach, and risk manager. This begins to define both the objective (analytical skills) and subjective (psychological demands) knowledge one must possess in order to be successful. There are no divine answers.
What is certain is that the cash (equities) markets are not a zero sum game. As long as others buy after you do, like in the case of long positions (buy low sell high strategy), or others sell after you do, like in the case of short positions (sell high buy low), many participants can simultaneously make money. Risk is not linear or equal to all participants. Conjointly, institutions want you to react to their analysis because they can tolerate more risk than any individual. Accordingly, the influences they imbue upon the market naturally create reactionary pressures most individuals fall victim to. The market cliché “if they don’t scare you out, they will wear out” comes to mind. The first step is to avoid being the “dumb money” that is bamboozled by this classic market activity by becoming your own analyst and understanding how this activity is manifested in the market. Once this manifestation can be seen through objective data (which will be discovered throughout the text), decisions can be made with predetermined risk that meets your own individually defined parameters. The same firms that employ analysts and brokers produce news that moves and gaps the market. These firms not only help to produce the tsunami of market moving news, but they are better prepared both through prior knowledge and capital wherewithal to “batten down the hatches” and deal with it. This book is an introduction to understanding the forces at play in the market to not only avoid foreseeable risk, but to also gain an edge to compete and win.
An entire generation of traders and investors have been conditioned to follow the analysts’ ratings, research, and brokers. This diversion from the truth is at the expense of building the requisite skills of understanding one’s self and developing the human capital as your own analyst. I draw on history to make an important point; history repeats itself because human nature is not prone to change. The study of the market is the study of human nature, and the past teaches us important lessons that must be applied. In other words—be Market Wise!
David S. Nassar
*See Against the Gods, 1996, pg. 105.