Rules to Trade By

In this week’s commentary, I’ve put together a list of rules, quotes and thoughts that helped me develop my own investment framework. I hope they are able to provide you with valuable insight and help you along your path to creating an investment framework that represents your personal view of the financial markets.

 1.      The difference between the investor who year in and year out procures for himself a final net profit, and the one who is usually in the red, is not entirely a question of superior selection of stocks or superior timing. Rather, it is also a case of knowing how to capitalize successes and curtail failures.

2.      “Whoever controls the volume of money in our country is absolute master of all industry and commerce…and when you realize that the entire system is very easily controlled, one way or another, by few powerful men at the top, you will not have to be told how periods of inflation and depression originate.” – President James Garfield, 2 weeks before his assassination.

3.      First and foremost, an ability to establish a contentious premise outside the existing belief system, and have it go on and be adopted by the rest of the financial community.

4.      Perfection is achieved, not when there is nothing more to add, but when there is nothing left to take away.” ~Antoine de Saint-Exupéry

5.      Willingness and ability to hold funds uninvested while awaiting real opportunities is a key to success in the battle for investment survival.-

6.      In addition to many other contributing factors of inflation or deflation, a very great factor is the psychological. The fact that people think prices are going to advance or decline very much contributes to their movement, and the very momentum of the trend itself tends to perpetuate itself.

7.      Most people, especially investors, try to get a certain percentage return, and actually secure a minus yield when properly calculated over the years. Speculators risk less and have a better chance of getting something, in my opinion.

8.      Money cannot consistently be made trading every day or every week during the year.

9.      Markets are never wrong – opinions often are.

10.  Never average losses.

11.  Big movements take time to develop.

12.  It is much easier to watch a few than many.

13.  Trade like a mercenary guerrilla. We must fight on the winning side and be willing to change sides readily when one side has gained the upper hand.

14.  Capital comes in two varieties: Mental and that which is in your pocket or account. Of the two types of capital, the mental is the more important and expensive of the two. Holding to losing positions costs measurable sums of actual capital, but it costs immeasurable sums of mental capital.

15.  In bull markets we can only be long or neutral, and in bear markets we can only be short or neutral. That may seem self-evident; it is not, and it is a lesson learned too late by far too many.

16.  Try to trade the first day of a gap, for gaps usually indicate violent new action. We have come to respect "gaps" in our nearly thirty years of watching markets; when they happen (especially in stocks) they are usually very important.

17.  Trading runs in cycles: some good; most bad. Trade large and aggressively when trading well; trade small and modestly when trading poorly. In "good times," even errors are profitable; in "bad times" even the most well researched trades go awry. This is the nature of trading; accept it.

18.  To trade successfully, think like a fundamentalist; trade like a technician. It is imperative that we understand the fundamentals driving a trade, but also that we understand the market's technicals. When we do, then, and only then, can we or should we, trade.

19.  Respect and embrace the very normal 50-62% retracements that take prices back to major trends. If a trade is missed, wait patiently for the market to retrace.

20.  Understanding mass psychology is just as important as understanding fundamentals and economics. markets are driven by human beings making human errors and also making super-human insights.

21.  Be patient with winning trades; be enormously impatient with losing trades. Remember it is quite possible to make large sums trading/investing if we are "right" only 30% of the time, as long as our losses are small and our profits are large.

22.  Always keep a good part of your capital in a cash reserve. Never invest all your funds.

23.  There is nothing new on Wall Street. There can't be because speculation is as old as the hills. Whatever happens in the stock market today has happened before and will happen again, mostly due to human nature.

24.  Be patient and wait for the fat pitch.

25.  Be contrarian.

26.  Risk is the permanent loss of capital, never a number.

27.  Global macro is a willingness to opportunistically look at every idea that comes along, from micro situations to country specific situations, across every asset class and every country in the world. 

28.  If there is an instrument that will capture 80-90% of your thesis, why distract yourself with a bunch of positions?

29.  There is one true Macro trade, the price of money.  Everything else is a derivative of that.  The price of money is the 18 month-2 year interest rate because that is the rate corporations use to evaluate investment opportunities.

30.  Central banks control the price of money and drive everything with their central bank rate.

31.  Central banks monetary policy to get supply and demand moving in the economy, by encourageing people to move along the risk curve.

32.  Monetary policy is highly correlated among the G10.

33.  There is really only 1 central bank, US Fed.

34.  At most, there are only 3-4 macro trades in the world at any one time. Apart from the cost of capital, they are 1. What bonds are doing, 2. What equities are doing3. What the dollar is doing.

35.  The most important variables in Global macro are the economic conditions and how central banks respond to those conditions.

36.  Price action never lies.  Look for the shift in the way people are going to view a particular situation.

37.  A market is a simple information-discounting mechanism.

38.  Price moves are mainly driven by gov’t action and the underlying economy.

39.  75% of price movement occurs 10-15% of the time.  The rest is nothing but noise in the trading range.

40.  All markets can be understood with history 101, psychology 101 and economics 101.

41.  All major price cycles (lasting from months to years) are caused by 1 or 2 fundamental factors.  All other factors are irrelevant.  They can cause zigs and zags but they turn out to be just plain noise.

42.  It is not asset quality that determines investment risk.  The price of an asset determines its riskiness.  Since participants set security prices, its their behavior that creates most of the risk in investing.