Stock Market Wizards by Jack Schwager

This is the 3rd book of the “market wizards” series by Jack Schwager. Jack continued to document his interviews with the top traders, with a focus on stocks trading in this 3rd book. At times, due to the varying practices and philosophies from traders, you may be confused with the clash of ideas. There are traders who just fundamentals, some technicals, some do both, some use scientific research, some use gut, etc. It would be helpful to know what style suits you best, in terms of your inclination, perspective and knowledge.

Stuart Walton

“I understood that stocks don’t go up and stay up because of stories, tips, or people’s opinions; they go up for specific reasons. I was determined to find those reasons, shut out the world, and then act on my own knowledge.”

“The fundamentals of the stock are only about 25 percent of it… Another 25 percent is technical… Another 25 percent is watching how a stock responds to different information: macroeconomic events, its own news flow… The last 25 percent is my gut feeling for the direction of the market as a whole, which is based on my sense of how the market is responding to macroeconomic news and other events. It’s almost like looking at the entire market as if it were an individual stock.”

“I get out either because the stock looks as though it’s rolling over, and I am in danger of losing what I have made, or because the stock has made too much money in too short a period of time.”

“My philosophy is to float like a jellyfish and let the market push me where it wants to go. I don’t draw a line in the sand and say this is my strategy and I’m going to wait for the market to come to me. I try to figure out what strategies are working in the market. One year it might be momentum, another year it might be value.”

“Sometimes the opportunities are so obvious that you almost can’t lose when they come around; the only problem is that they don’t come around that often. The key is not to lose money in the times in between.”

“I constantly evaluate market sentiment – is the market hopeful? Is it fearful? – and wait for the price action to confirm my assessment.”

“By cleaning out my portfolio and reinvesting in solid stocks I made back much more money than I would have if I had kept the other stocks and waited for a dead cat bounce.”

“Currently, the biggest misconception is the widespread belief that it is easy to make a living trading in the stock market. People feel they can give up their jobs and trade for a living; most of them are bound to be disappointed.”

Steve Watson

“…we begin by looking for companies that are relatively cheap – trading between eight to twelve times earnings. Within this group, we try to identify those companies for which investors’ perceptions are about to change. Typically, these may be companies that are having some trouble now, but their business is about to turn around. We try to find out that information before everyone else does.”

“…talking to companies is our primary focus. I have two people who spend three-quarters of their time booking calls with company management and five research people who spend virtually their entire day calling companies and talking to CFOs. In this business, you can’t wait for a new product to come out and be successful. By that time, you will have to pay three times as much for the stock.”

“A low price and the prospect for imminent change are the two key components. Beyond that, it also helps if there is insider buying by management, which confirms prospects for an improvement in the company outlook.”

“Too many people use charts. If too many people are using an approach, I feel that I can’t get a competitive edge.”

“You need a catalyst that will make the stock go higher… A change that will lead to a dynamic improvement in margins… Sometimes the catalyst can be a new product.”

“But that same trait of liquidating stocks too early has also helped us during market declines because we’re not long the stocks with high price/earnings ratios that get hit hardest in a market correction.”

On selecting shorts, “We certainly look for the higher-priced stocks – companies trading at thirty to forty times earnings, or stocks that have no earnings. Within that group, we seek to identify those companies with a flawed business plan.”

Dana Galante

On picking shorts, “I looked for companies that I anticipated would have decreases in earnings, instead of shorting stocks that had already witnessed decreases in earnings.”

Defining support, “Price areas that have witnessed a lot of buying in the past – points at which prices consolidated before moving higher.”

More on picking shorts, “I look for growth companies that are overvalued – stocks with high P/E ratios – but that by itself is not enough. There also has to be a catalyst… And expectation that the company is going to experience a deterioration in earnings.”

“I won’t short a stock that is moving straight up. The stocks has to show signs of weakening or at least stalling.”

“When a company blames the price decline in its stock on short sellers, it’s a red flag… We [short sellers] represent maybe one billion dollars versus nine trillion on the long side.”

Other red flags for a company, “Lots of management changes, particularly a high turnover in the firm’s chief financial officer. Also, a change in auditors, can be a major red flag.”

More on selecting shorts, “We also screen for revenue deceleration, earnings deceleration, high P/Es, high inventories, and some technical indicators, such as stocks breaking below their fifty-day moving average.”

Risk control – “If I lose 20 percent on a single stock, I will cover one-third of my position. I limit the allocation to any single stock to a maximum of about 3 percent of the portfolio. If a stock increases to a larger percentage of the portfolio because of a price rise, I will tend to reduce the position. I also control risk through diversification: There are typically fifty to sixty names in the portfolio spread across different industry sectors.”

Mark D. Cook

When he has a streak of losing trades, unlike most traders who would take a break from trading, he does the opposite – “Whenever I am down, the frequency of my trading steps up.”

“Hope should never be in your vocabulary. It is the worst four-letter word I know. As soon as you say, “Boy, I hope this position comes back,” you should reduce your size.”

“Never increase the size of your positions on a winning streak. Otherwise you guarantee that you will have your largest position on a losing trade.”

“If you decide to trade for a living, you have to treat it just like any other business endeavour and go into it with a plan.”

“You need to select a market that fits your personality because a market is a reflection of the people who trade it.”

“Approach trading as a vocation, not a hobby… hobbies cost you money.”

“People underestimate the time it takes to succeed as a trader. Some people come here and think they can sit with me for a week and become great traders… It is a vocation that takes time, study, and experience. Wisdom is a product of knowledge and experience. If you have more knowledge, you can get away with less experience. If you can get both, the learning curve is very steep.”

“The main thing is that every trader has to be honest about his or her weakness and deal with it. If you can’t learn to do that, you will not survive as a trader.”

“People ask me all the time, “How long do you think it will take for me to succeed?” I tell them, “three to five years of twelve-hour days and losing money.” Very few people want to dear that.”

“I teach people not to have any preconceived notion about the market direction – to react to the market, not to anticipate it… Even their language reflected their bias. When they referred to the market decline, they used the word “correction,” not “downtrend”. It never occurred to them that we might actually be in a bear market.”

“A true trader can make money in any environment as long as he reacts and doesn’t anticipate. He must feel the markets flow and never fight. He may often be wrong, but never inflexible.”

Ahmet Okumus

“Don’t get involved when there is too much mania. Just stick to things that have some predictability. You can’t forecast mania. If a stock that should be selling at 10 is trading at 100, who is to say it can’t go to 500.”

“… my main goal is to make money on every investment, not necessarily to catch every trade. I don’t have to make a lot on each trade, as long as I make something.”

On insider buying – “I compare the amount of stock someone buys with his net worth and salary. For example, if the amount he buys is more than his annual salary, I consider that significant… you have to be sure that insider buying represents purchases of new shares, not the exercise of options.”

“Of course, if management already owns a significant portion of the company, they don’t have to buy more… In contrast, in some companies, insiders only own about 1 percent of the firm. In companies with low insider ownership, management’s primary motivation will be job security and higher bonuses, not a higher stock price.”

“I buy companies that have a good balance sheet, a high book value, consistent business track records, good management, and large insider buying ownership. These are not the type of companies that go bankrupt.”

“Now, regardless of how extremely overvalued a stock may be, I won’t sell it until there has been a catalyst for change.”

“I wouldn’t short it as long as the trend in the fundamentals was still improving. I would wait for the fundamentals to start deteriorating… Once the fundamentals get broken, market manias get broken as well.”

“All my longs are long-term investments, but my shorts are usually short-term precisely because of the danger of unlimited risk.”

On trading rules – “Do your research and be sure you know the companies that you are buying. Buy low. Be disciplined, and don’t get emotionally involved.”

Mark Minervini

“The market is not a science. The science may help increase the probabilities, but to excel you need to master the art of trading. People always want to know what’s in my computer model. I think that is the least relevant issue to successful trading. Of course you need an edge, but there are thousand ways to get an edge. Some people use strategies that are completely opposite mine, yet we can both be very profitable.”

“Developing your own strategy is what is important, not knowing my strategy, which I have designed to fit my personality. Understanding my trading philosophy, my principles, and my money management techniques, that may be valuable.”

“I think people spend too much time trying to discover great entry strategies and not enough time on money management. Assume you took the top two hundred relative strength stocks [the two hundred stocks that outperformed the market average by the greatest amount during a specified number of past months] and placed the names on a dart board. Then each day, you threw three darts and bought the resulting stocks, and whenever any stock went down, say, 10 percent from your entry level, you sold it instantaneously. I would be willing to bet that you would make money because you are exposing yourself to a group of stocks that is likely to contain some big potential winners while at the same time you are cutting your losses.”

“I think almost anyone can be net profitable in the stock market given enough time and effort, but to be a great trader, you have to have a passion for it. You have to love trading. Michael Jordan didn’t become a great basketball player because he wanted to do product endorsement. Van Gogh didn’t become a great painter because he dreamed that one day his paintings would sell for $50 million.”

“…I now fully believe that losing all your money is one of the best things that can happen to a beginning trader… It is much better to learn the lesson that you can lose everything when you don’t have that much money than to learn the same lesson later on.”

“If you are a beginner, trade with an amount of money that is small enough so that you can afford to lose it, but large enough so that you will feel the pain if you do… If you go from paper trading to real trading, you’re going to make totally different decisions because you’re not used to being subjected to emotional pressure.”

“Most people, even if they have a winning strategy, will not follow it because they lack discipline. For example, everyone knows how to lose weight: you eat less fat and exercise. So why are most people overweight? Because they lack discipline.”

“Concentrate on mastering one style that suits your personality, which is a lifetime process. Most people just cannot weather the learning curve. As soon as it gets difficult, and their approach isn’t working up to their expectations, they begin to look for something else. As a result, they become slightly efficient in many areas without ever becoming very good in any single methodology. The reality is that it takes a very long time to develop a superior approach, and along the way, you are going to go through periods when you do poorly. Ironically, those are the periods that give you the most valuable information.”

“They treat investing as a hobby instead of like a business; hobbies cost money. They also don’t take time to to do a post-trade analysis on their trades, eliminating their best teacher: their results.”

“Sometimes people will ask me whether they can spend one weekend with me so I can show them how I do this stuff. Do you know what a tremendous insult this is? It’s like saying to a brain surgeon, “If you have a few days, I’d like you to teach me brain surgery.””

Steve Lescarbeau

“If you develop a system that you have thoroughly tested and truly believe works, don’t tell anyone about it. Use it, because it’s going to go away at some point in time. Understand that it won’t last forever, and work on coming up with something different for when that happens.”

“Shorting stocks is dumb because the odds are stacked against you. The stock market has been rising by over 10 percent a year for many decades. Why would you want to go against that trend?”

“Don’t confuse activity with accomplishment… I hardly spend any time trading. Over 99 percent of my time is spent on the computer, doing research.”

Michael Masters

“A catalyst is an event or an upcoming event that has potential to trigger a stock price move by changing the market’s perception about a company… Most catalysts are repetitive events – earnings are reported four times a year; retail companies report same-store sales monthly; airline companies report load factors monthly, and so on.”

“… one of the problems with the efficient market hypothesis. The market doesn’t discount all information instantaneously.”

“For every trade I put on, I have a time window within which the trade should work. If something doesn’t happen within the time stop, the market is probably not going to discount that event.”

“We use technical analysis not because we think it means something, but because other people think it means something. We are always looking for market participants to take us out of a trade, and in that sense, knowing the technical points at which people are likely to be buying or selling is helpful.”

“I believe that writing down your trading philosohy is a tremendously valuable exercise for any investor. Writing down your trading ideas helps clarify your thought process. I can remember spending many weekends at the library writing down my investment philosophy: what catalysts I was looking for; how I expected them to affect a stock; and how I would interpret different price responses. I must have accumulated over five hundred pages of trading philosophy. Frankly, it was a lot of drudge work, and I could only do it for so long in one sitting. But the process was invaluable in developing my trading approach.”

John Bender

“When you turn on some financial TV program and see someone tell you to buy a stock, there’s a good chance he’s telling you to buy what he wants to sell.”

“It became recognized that some companies recommended stocks to their clients and then sold the same stocks themselves all day long. Not only were these firms the largest sellers of a stock on the day after they recommended it, but they were also the largest buyers of the stock during the preceding week.”

“Even for those patterns where it’s been possible to come up with a reasonable consensus definition for the sorts of patterns traditionally described by people who refer to themselves as technical analysts, reseachers have generally not found these patterns to have any predictive value.”

“The problem, of course, is that as soon as these anomalies are published, they tend to disappear because people exploit them.”

“… it’s been our experience that the most obvious and mathematically straightforward ideas you might think of have largely disappeared as potential trading opportunities. What you are left with is a number relatively small inefficiencies that are often fairly complex.”

Steve Cohen

“They [Wharton] taught you that 40 percent of a stock’s price movement was due to the market, 30 percent to the sector, and only 30 percent to the stock itself, which is something that I believe is true.”

“My best trader makes money only 63 percent of the time. Most traders make money only in the 50 to 55 percent range. That means you’re going to be wrong a lot. If that’s the case, you better make sure your losses are as small as they can be, and that your winners are bigger.”

“If you think you’re wrong, or if the market is moving against you and you don’t know why, take in half. You can always put it on again.” If you do that twice, you’ve taken in three-quarters of your position. Then what’s left is no longer a big deal. The thing is to start moving your feet. I find that too many traders just stand there and let the truck roll over them.”

“You have to know what you are, and not try to be what you’re not. If you are a day trader, day trade. If you are an investor, then be an investor. It’s like a comedian. Here’s one I really don’t understand: I know these guys who set up a hedge fund that was part trading and part small cap. Small caps are incredibly illiquid, and you have to hold them forever – it’s the exact opposite of trading!”

“I’m looking for people who are not afraid to take risks. One of the questions I ask is: “Tell me some of the riskiest things you’ve ever done in your life.”

“You can’t control what the market does, but you can control your reaction to the market. I examine what I do all the time. That’s what trading is all about.”

“Ari’s (Ari Kiev) experience includes working with Olympic athletes. I saw some similarities: Traders also work in a highly competitive environment and are performance driven. I felt that the inability of some traders to achieve success was usually due to personal flaws rather than a consequence of bad ideas versus good ideas. All traders have something holding them back.”

Ari Kiev

“Promising the result commits you to doing it and leaves you no alternative but to do it if you are going to live by your word. Letting others know that you have set a goal and are committed to achieving it makes it more likely you will achieve that goal, whether it is in the realm of athletics, trading, or something else.”

“… being preoccupied with not losing interferes with winning. Trading not to lose is not a good strategy. You need to trade to win.”