Definition of Zero Sum Game: In a zero sum game, if you add up the gains and losses made by all of the players, you get zero. Alternatively, everything you gain from a zero sum game has to be matched by other players’ losses.

Let’s imagine a commodity in which there are only 5 active traders, each trading $10,000 and watch what happens.

We’ll assume they pay $10 to their internet broker per trade. Yes, I know you can get cheaper brokerage, but $10 is a nice round number.

Our traders are fairly active and each makes 100 trades a year.

Let’s Follow the Money Trail

The total money in the game at the beginning is $50,000.

After one year:

Winners and Losers

The total money in the game at the end of the year is $45,000 ($11K + $10K + $9K + $8K + $7K.)
This game has summed to a negative number: -$5,000.
It doesn’t take an accounting genius to know where the $5,000 has gone; yes, it’s the broker, who – with very little effort compared to the players – has made more money from the game than anyone else.
This is hardly news. Read Fred Schwed’s 1995 book Where Are the Customers’ Yachts – if you need convincing that it’s easier making money as a broker than a trader.
What does need repeating (in the light of continued ill-thought-out references to zero sum games) is that even if your trading skills are good enough to beat the market, you might still only break even. (Like Trader 2 in our example above.)

Summary:
You’ll make much more money from trading if you treat it like a business.

If you’ve got the skills to beat the market, cutting your brokers fees are the easiest ways for you to improve your business’s bottom line.

Treat the broker any other seller, negotiate. Tell them you want cheaper trades. If the fees are still too high, move on. If you trade frequently, Interactive Brokers for example, has an attractive fees.

The performance of Keynes’s Chest fund is shown below.

The Chest grew at an annual compounding rate of 9.1 percent while the general British stock market fell at an annual compounding rate of slightly under 1 percent. Given that the Chest fund distributed all dividends rather that reinvesting them, this is a truly exceptional performance.

Keynes described his investing philosophy as follows:

“It is the one sphere of life and activity where victory, security and success is always to the minority and never to the majority. When you find any one agreeing with you, change your mind. When I can persuade the Board of my Insurance Company to buy a share, that, I am learning from experience, is the right moment for selling it.”

The Uncomfortable Contrarian

Psychologically, a contrarian investment strategy can be uncomfortable.

You will be buying when the popular media is full of reports about how bad your choice of investment is. You will be selling when the media is celebrating the success of your investment, and no doubt predicting it will continue to perform well.

You can feel lonely when you’ve bought an unpopular investment; you hold it for what seems like forever until the price moves in your favor, and keeps moving in your favor.

Keynes’s biographer summarised his approach, saying, “He selected investments with great care and boldly adhered to what he had chosen through evil days.”

Investing With Great Care

The words “great care” are crucial. Don’t expect to become a successful contrarian investor simply by buying anything whose price has fallen. Typewriter stocks became unpopular a few years ago with good reason! Fortunately for IBM, however, some employees ignored their chairman, Thomas Watson, when he said in 1943, “I think there is a world market for maybe five computers”.

Selling

When you buy, you should buy with a selling price already in mind. You might express this price as a ratio. For example, you might enter the real estate market when the average home price to salary ratio is at 75% of its long term value with the idea of selling when it reaches 140% of its long term value. It’s up to you to look at the numbers and judge what’s appropriate. When you exit real estate, you should search for another market you can invest in that’s currently unpopular and underpriced.

The exit is crucial to contrarian investment. The underlying philosopy was nicely encapsulated by Ben Graham’s Mr Market in The Intelligent Investor:

Mr Market comes along each day quoting you a variety of prices for assets. He will buy or sell at the quoted price. Often his quotes are about right – they reflect fair value. Mr Market is, however, a manic depressive. On some occasions he is so down than he prices assets too cheaply. Other days he’s so optimistic that his quotes are much higher than fair value. The contrarian’s job is to buy from Mr. Market when he’s depressed and sell to him when he’s optimistic.

Waiting for the Price to Rise

It would be unfair to close this discussion without another quote from John Maynard Keynes:

“Markets can remain irrational far longer than you or I can remain solvent.”

The above is a concise summary of the debt-fuelled boom that came to an end in the credit crunch of 2007. Investment bankers with little more financial skill than a jackrabbit earned millions in bonuses for leveraging themselves and their banks as high as the Moon before they were caught with their financial pants down in the bust. The taxpayer picked up the tab for the bust.

Beta, aka Luck

Beta is a statistical measure of market volatility. You don’t need any skill to benefit from it. If you’re in the market when it moves in your direction, you make money. Otherwise, you lose.

In financial jargon, we can say that pre-crunch, the highly leveraged jackrabbits bankers had profited from beta – they had benefited (at first) from the market rising, just as they would have from an index fund. When things went pear shaped, they lost on beta. The market moved in the wrong direction and, like the mom and pop investors who didn’t sell their index funds before the markets tanked, the jackrabbits lost. (Except most didn’t lose anything; the taxpayer lost.)

Alpha, aka Skill

Alpha measures how much you can beat the market by; it is a measure of the skills of investors or traders. For example, if your index fund rises in value with the rising market, you are profiting from beta. If you judge the market is going to fall and you cash in your fund before the crash, you are benefiting from alpha.

Warren Buffett prefers to make what he calls “mistakes of omission” rather than “mistakes of commission”.

A mistake of omission – such as not buying a stock that goes on to perform well is irksome. It does not destroy your capital and endanger your ability to make a future profit.

Making mistakes of commission, however, and seeing your account fall in value by, say one-third, means you have a lot of catching up to do just to break even. (To return to break even after a one-third fall in the value of your investments requires a fifty percent gain!)

You must preserve your capital so you must select your stocks or trades with care. If in doubt, stay out! Another opportunity will always present itself.

For those seeking to trade rather than invest, Alexander Elder, in Trading for a Living, says:

“A trader who wants to survive and prosper must control his losses. You do that by risking only a tiny fraction of your equity on any single trade. Give yourself several years to learn how to trade. Do not start with an account bigger than $20,000, and do not lose more than 2 percent of your equity on any single trade. Learn from cheap mistakes in a small account.”

Van K. Tharp, in The Harriman Book of Investing Rules says:

“A simple strategy that will work for everyone is to risk a small percentage of your equity on every trade, such as 1% or less. If you have an account that is worth $100,000, then risking one percent would mean risking $1,000. (This is not the amount of money you enter the trade with; this is the amount of money you are prepared to lose before exiting the trade.)

In the same publication, Joe DiNapoli echoes Buffett’s sentiments, saying:

“There was a time when I felt it was my duty to be personally involved in every wrinkle of the S&P. I’ve traded this market since its inception in 82. It took quite a while for me to realise that picking safe, readable, and high probability winning trades was the way to go. Loss of opportunity is preferable to loss of capital.”

Emphasising the care needed before making investment decisions, Robert Hagstrom reports Warren Buffett saying:

“An investor should act as though he had a lifetime decision card with just twenty punches on it. With every investment decision, his card is punched, and he has one fewer available for the rest of his life.”

The money you want to invest has been hard won. Holding onto it can, at times, be even harder than earning it in the first place. Select your investments carefully and if in doubt, stay out.

Don’t try to buy stocks at bottom.
Don’t stress yourself trying to achieve the impossible. Give yourself time to make sure an uptrend has truly begun before buying shares.

Never throw good money after bad.
If you’ve bought shares in a stock that subsequently falls, never, never, NEVER buy more shares. Long term, the strategy of “averaging down” – buying more shares when a stock’s price falls – is a sure way of averaging down your investment performance. (Note: If you are passively investing each month in an index fund, do not heed this advice.)

Selling Stocks

Cut your losses and let your profits run.
Don’t keep your money in a stock after the trend has turned downwards. Only keep your funds in stocks whose trend is upwards.

Never be too proud to take a loss and move on.

When studying new methods

Analysis is simplifying, breaking down things into parts, picking out strands and elements. Analysis is comparing unknown things with things that are known. Analysis also involves picking out relationships and putting them back together as a whole.
Edward de Bono

When trying a new approach

Striving and struggle precede success, even in the dictionary.
Sarah Ban Breathnach

When you just know you are right and the market is wrong

Markets can remain irrational far longer than you or I can remain solvent.
John Maynard Keynes

At all times

The most powerful force in the universe is compound interest.
Albert Einstein

For every managed fund that beats the market, another underperforms. After fees are deducted, the average managed fund is a loser.

It’s said that every dog has its day and it’s often the case that last year’s loser is this year’s winner (before it becomes a loser again).

And this is the source of an investing scandal. Fund managers know that they’ll get lucky some years, regardless of how poor their stock picking skills might be. It’s just like throwing a pair of dice once a year. Sometimes you’re going to score 10, 11 or 12. Every time you get a high score, you don’t say, “hey, wasn’t I lucky”. Instead you say, “Hey, it’s time to charge a fat performance fee.”

How Fund Managers Get Rich Creaming Off Performance Fees

Consider the “Lucky Fund” which has $200 million of investors’ money in it. One year the stock market rises by 10 percent but the “Lucky Fund” does better, rising by 15 percent. By the end of the year the fund has gained $30 million to reach a value of $130 million. $20 million of this would have come from merely tracking the stock market. $10 million is so-called “outperformance”. The manager then takes a 25 percent “outperformance” fee – i.e. $2.5 million. (This of course comes on top of other fees.)

The following year, the stock market rises by another 10 percent but the “Lucky Fund” rises by only 5 percent. Does the manager return last year’s bonus to compensate for this year’s poor performance? Of course not silly, it’s already been spent on a new yacht.

Some investors don’t seem to mind paying extra fees in “the good years”, forgetting they don’t get them returned in “the bad years”. The net effect is that their investments grow by much less than they would have if they had placed their funds in a low-fee, index-tracker fund.

Warren Buffett advises non-expert investors to put their money in index-tracker funds – this way their savings will at least keep pace with the general stock market without lining the pockets of undeserving money-managers. If you’re looking for an index-tracker, choose a fund with a reputable company that charges the lowest fees.

Alternatively, you can search for a fund manager who charges only when successful. DUNN, whose founder we discuss elsewhere operates such a policy. They charge no management fees whatsoever – they are purely performance based and past losses must be recouped before further performance fees are charged.

Unfortunately, DUNN only caters to corporate investors and very wealthy private investors. DUNN’s fee structure is, however, a model crying out to be adopted by the wider investment industry.

Applied to stocks, we say, “any fool can buy but it takes an expert to sell”.

Of course, I mean sell profitably. Any fool can get lucky but if you aim to make profits consistently in the stock market, you’ve got to be an expert at selling.

It never ceases to amaze me how badly many private investors’ portfolios perform. To see why they perform so badly, we need to look at the way they have managed their portfolios.

Consider the chart below, showing the “progress of a loser”, as the stock he bought refuses to behave the way he expected it to.

Read about uptrends and downtrends first if you need to.

Naturally, some of the stocks in investors’ portfolios rise and some fall – there is nothing unusual about that. Many first timers are surprised when I tell them it’s selling decisions that differentiate the winning portfolios from losing portfolios.

Why should this be?

Losers hate to sell stocks that are falling. They don’t like the idea of making a loss. Instead they sell their rising stocks and say “Hey, I’m good at investing – I’m making a profit”. They then hold on to their falling stocks, hoping they will rise again. Unfortunately, most stocks fall because they are poor value. Once a stock enters a downtrend, the chances are it will continue to track downwards for a considerable period of time.

A buyer’s comments on his “long term” investment

When their stocks continue to fall, losing investors put these stocks into the “bottom drawer”. They wait – sometimes for years – for the stock to come back to the price they paid for it. Sometimes the stocks don’t come back. They keep falling right down to zero. The loser does not limit his loss.

Winning investors are ruthless when it comes to weeding out poor performers. They only want to invest in winning stocks. They buy stocks that are trending upwards and hold onto them while the uptrend lasts. If the uptrend stops, they sell. Often this will be at a profit. There will also be losses. The key to winning, however, is this: winning investors limit their losses. They never suffer big losses. If a stock performs poorly, they sell. Compare this approach with the loser who holds onto his downtrending stocks indefinitely and can lose 100 percent of his invested funds when stocks go to zero. Trust me, I know. In my early days as an investor I clung, limpet-like, to three stocks right to the end. The end was $0.00. I have never made that mistake again.

Market trends are real. They have statistical significance. Provided you are disciplined in executing your strategy, trends can be ridden profitably. Ride your gains for as long as an uptrend lasts. Some uptrends last for years, lifting the share price by multiples of five, ten or twenty. You only need to ride the trend with one or two big winners to underpin a hugely successful portfolio. It’s crucial you allow your gains to be unlimited. You must not sell while a stock is trending upwards. When an uptrend ends, sell. You will then have given yourself every chance of becoming a successful investor.

“Cut your losses and let your profits run.”

If you have ever traded stocks, it’s likely you’ll have felt a strong urge to do the opposite. Most likely you’ll have wanted to:

• Sell your winners quickly – using a justification such as: “I want to lock in my profits”.
• Hang on grimly to your losers – hoping that tomorrow’s price will be higher than today’s. Usually, though, it just keeps falling.

I can write confidently about this, because I’ve been there. Several years ago, when I began trading stocks, I was in the habit of selling my winners to lock in profits (of 5 to 10%) while hanging on to losers and watching them fall by as much as 80%.

Thankfully, I weaned myself away from this sort of destructive behavior and my trading record improved dramatically. It still takes an enormous amount of resolve to sell my losers quickly though; it’s a huge fight against my instincts. I still have a strong urge to hang in there with stocks that fall, waiting for the upswing.

Making Choices – Profits and Losses

Daniel Kahnerman and Amos Tversky carried out experiments in the late 1970’s that go a long way to explain our instincts to sell our winners and hold on to our losers.

They carried out experiments in which people were questioned about their preferences. Here are two questions, similar to those asked by Kahnerman and Tversky. Try answering them yourself:

Q1. You are offered a choice between two outcomes:

A. You have an 80% percent chance of winning $4,000 with a 20% chance of winning nothing.

or

B. You have a 100% chance of winning $3,000.

Which of these would you choose? Make a choice before answering Q2.

Q2. You are offered a choice between two outcomes:

A. You have an 80% chance of losing $4,000 and a 20% chance of losing nothing.

or

B. You have a 100% chance of losing $3,000.

Which of these would you choose?

It turns out that the vast majority of people choose outcome B in question 1 and outcome A in question 2. In other words:

• When we are winning we prefer to choose certainty.
• When we are losing we prefer to gamble.

These are our basic human instincts.

If your gut instinct was to answer A to Question 1 and B to Question 2, you may have the instincts of a successful stock trader. Your instinct is to gamble when you are winning – in other words let your profits run – and to choose certainty – in the form of a definite limit on your losses – when you are losing – in other words cut your losses.

After carrying out a number of experiments, Kahnerman and Tversky concluded that people are naturally averse to losing and are more willing to gamble their way out of a losing position than to gamble in a winning position:

“It’s not so much that people hate uncertainty – but rather they hate losing.”

And it’s this natural hatred of losing that destroys most beginning traders. Trading success comes when we accept losses as a natural outcome of our endeavors and take action to make sure all our losses are small losses. This allows us to profit mightily from our victories, when we are courageous enough to grow them into large victories.

What can stock investors learn from the tactics of card counters?

If you look at the history of bullish expansions compared with bearish contractions in stock markets, it is striking how well they correlate with interest rates. Every month, the world’s central banks – such as the United States’ Federal Reserve and Britain’s Bank of England – make decisions about interest rates. Every month, interest rates are raised, lowered, or maintained at current levels.

When central banks embark on a cycle of interest rate increases, stock markets usually suffer. The reasons why this should be so are straightforward:

• Debt-free companies are rare. When interest rates go up, companies pay more interest on their loans, and their profits fall.
• Interest rates offered by banks to their customers increase, as do interest rates offered on bonds. Investors move money from stocks into high-interest products, causing stock prices to fall.

Probability – The Odds Are Against You

Not all share prices fall during a cycle of interest rate rises, but most do. Stock markets do not always suffer during a cycle of interest rate rises – but they usually do. Trying to make big profits from buying stocks when interest rates are rising is like trying to profit from an evens bet that you’ll toss 5 heads in a row using a fair coin – it’s not impossible but it is highly unlikely.

Stock Market Timing – Lessons from Card Counters

Many investors could improve their long-term returns by learning from the example of card counters – professional gamblers. Card counters play blackjack in casinos. Their strategy depends on the fact that high cards are good for the player while low cards are good for the dealer. They count the high cards as they emerge during a spell at the table. When their count indicates that there are an unusually high number of high-value cards left in the pack, they know that the odds have shifted in their favor. They then make very large bets. The card-counter’s basic strategy is simple; make small bets when the odds are against you and very large bets when the odds shift in your favor.

Favorable and Unfavorable Times in the Stock Market

There is abundant evidence that when central banks consistently cut interest rates, or keep interest rates low, stock markets do better than their long-term average. In contrast, when banks are consistently raising rates or keeping them high, stock markets perform worse than their long-term average.

How Can I Use This Information To Time the Stock Market?

• When central banks embark on a cycle of interest rates increases, you should not be fully invested in the stock market. It is probable that the stock market will not do as well as normally. You should hold money in reserve to buy stocks at lower prices. You should start buying stocks again when a cycle of interest rate cuts begins.
• When central banks are cutting interest rates, you should be fully invested in the stock market, provided stock prices are not falling. This is akin to the card counter placing big bets when the odds shift in his favor. You should stay fully invested until a cycle of interest rate increases resumes.

What is Technical Analysis?

Technical analysis (T.A.) has been around since at least the 1600s, when Japanese rice traders began using candlestick charts to track the market price of rice. The traders realized that certain patterns in their candlestick charts seemed to indicate that major price changes were imminent in the rice market. They tried to recognize the patterns that preceded large price movements.

Just as the rice traders did long ago, modern technical analysis uses a stock’s price history to decide whether it should be bought, held or sold. Often the trading volume – the number of shares that have been traded – is included in technical analysis. Here we are going to consider price history alone.

Technical analysts believe rising prices means buyers are bidding confidently, convinced the price will rise further. This type of buyer is termed a bull in market jargon. A lack of conviction on the part of bulls leads to falling or flat prices. When prices are consistently falling, bears are said to be in control of the market. Bears believe prices will fall and they are sellers.

A basic premise of technical analysis is that, if there is momentum in a stock-price – in other words, if its price has been trending upwards or downwards consistently over a period of time – the momentum will certainly reverse some time – but probably not in the short term. Therefore, if momentum is positive you should buy – positive momentum leads to rising prices. Similarly, if momentum is negative, you should sell – negative momentum leads to falling prices.

Does Stock Market Technical Analysis Work?

Firstly, it’s important to say that no reputable Technical Analyst would claim their methods are effective for every trade.

Some technical analysts look for a method that makes a profit on most trades. Making small profits on 60 to 70 percent of trades is possible. When these small profits are added up, they can be significant.

Other technical analysts employ methods that find fewer winning trades. Their strategy can still be profitable because they hold on to their winning stocks for as long as they continue to rise – leading to larger gains – while quickly offloading losing stocks, to minimize losses.

Proceed With Caution

Many T.A. methods do not work. Some methods are peddaled by modern-day snake-oil salesmen whose aim is to make their fortunes by selling dubious methods to a gullible public. The prospect of getting rich quick still seems to reel the suckers in.

John Mauldin reports that, in 1991, fund manager Gary Hirst began looking at all aspects of technical analysis. Hirst used a large research budget to investigate the effectiveness of various forms of technical analysis such as Elliot wave, stochastics and chart patterns. Hirst found no evidence that these methods outperformed a strategy of trading stocks at random times.

Amidst all the negatives, however, Hirst found a positive. Markets produce profitable trends.

Trend Following and Charts

Investingator’s in-house analysis of a variety of T.A. methods was not quite as dismissive as Hirst’s. We found that certain chart patterns were reasonably reliable as predictors of the beginning or end of a new trend. In fact Thomas Bulkowski has published the Encyclopedia of Chart Patterns. Bulkowski studied chart patterns used by stock traders in their decision making. Of the many patterns used, Bulkowski found several with failure rates of lower than ten percent.

Low failure-rate patterns included, for example, Ascending Triangles and Descending Triangles.

We also found other methods that seemed to yield a statistically significant positive return. However, they only yielded positive returns when applied to stocks that were already trending upwards. They added to the profits already available from buying upwardly trending stocks. The extra returns were, however, small.

In summary, there is abundant evidence that momentum / trend based technical strategies can be used successfully in stock-trading.

Other technical analysis methods can also be used profitably – we know traders who live comfortably on earnings from T.A. based stock-trading methods. Many, naturally enough, do not publicize their methods. There are, however, well-documented and enduring examples of successful T.A. based trading and investing.