Editor's note: This week, in place of our normal commentary, we've gathered some of our favorite trading-education pieces from our top analysts. These are the lessons we wish we'd had before we started trading... lessons many of us learned "the hard way." Whether you're already an experienced trader... or a novice just beginning to put money in the market... you'll find this series incredibly useful.
Monday, May 20, 2013
Stansberry & Associates: Brian, you claim "five magic words" are the secret to getting rich in the markets and through investments. You claim every rich investor or trader says these words over and over. Can you share those magic words?
Brian Hunt: Sure... The five magic words – and this works with real estate investing, small business investing, blue-chip stock investing, or even short-term trading – are: "How much can I lose?"
The rich, successful investor is always focused on how he can lose money on a deal, a stock, or an option position. He is always focused on risk. Once he has the risk taken care of, he can move on to the fun stuff... making money.
Almost everyone who is new to the markets or new to making investments is 100% about making money... the upside. They're always thinking about the big gains they'll make in the next Big Tech stock or currency trade or their uncle's new restaurant business.
They don't give a thought to how much they can lose if things don't work out as planned... if the best-case scenario doesn't play out. And the best-case scenario usually doesn't play out. Since the novice investor never plans for this situation, he gets killed.
I've found, through years of investing and trading my own money – and through years of hanging out with very successful businesspeople and great investors – that when presented with an idea, the great investor or trader reflexively asks early in the discussion, "How much can I lose?"
Like I say, this can be a real estate deal, a small business investment, a quick trade, a stock position, or a commodity investment. The concern is always, "How much can I lose? What happens if the best-case scenario doesn't pan out?"
S&A: It's along the lines of Warren Buffett's famous rules of successful investment. Rule one: Never lose money. Rule two: Never forget rule one.
Hunt: Right. Buffett is probably the greatest business analyst to ever live... the greatest capital allocator to ever live. He's worth over $50 billion because of his ability to analyze investments.
When they ask the old man his secret, he doesn't talk about the intricacies of balance sheets or cash flow analysis. The first thing he recommends to folks who want to make money in the market is to not lose money in the market. He's obsessed with finding out how much he could potentially lose on a stake. Once he's satisfied with that, he looks at what the upside is.
So Buffett is your great investor. Now take Paul Tudor Jones, an incredible trader with a net worth in the billions. His interview in the trading bible Market Wizards is the most important thing any new trader can read. His interview is filled with how he's obsessed with not losing money... with playing defense.
Tudor's famous quote is the trader's version of Buffett's investment quote. Tudor says the most important rule of trading is playing great defense, not offense.
If a new investor or trader taped Buffett's quote in a place he'd see it every day... and if he read Tudor Jones' interview once per month... and if he reflexively asks himself, "How much can I lose?" before investing a penny in anything, he'd be worlds ahead of most people out there. He'd set himself up for a lifetime of wealth.
S&A: OK, that covers the theory. How can we put "how much can I lose" into everyday practice?
Hunt: Well, if you're putting money into a startup business, a speculative stock, an option position, or anything else that is on the riskier end of the spectrum, the answer to "how much can I lose?" is usually, "Every last dollar."
While speculative situations can be tremendous wealth-generators, they're best played with small amounts of your overall portfolio. Or if you're a conservative investor, not played at all. Let's say you're buying a speculative gold-mining stock or a speculative tech company with just one potential "big hit" product.
With speculative positions, there is always the possibility that your money could evaporate. This is where the concept of position sizing comes into play. In a speculative situation, you're going to want to put just 0.5% or just 1% of your overall portfolio into that idea. That way, if the situation works out badly, you only lose a little bit of money. You certainly don't want to put 5% or 10% of your portfolio into a speculative position. That's way too big.
S&A: How about advice for conservative investors?
Hunt: I think conservative investors should stick to Warren Buffett-type investments... owning incredible companies with great brand names, like Johnson & Johnson or Coca-Cola. These are the safest, most stable companies in the world.
When you buy companies like this at cheap prices, when they are out of favor for some reason, it's very hard to lose money on them. They are such incredible profit generators that their share prices eventually rise and rise.
My friend and colleague Dan Ferris, who writes our Extreme Value advisory, provides advice on how and when to buy these dominant companies better than anyone in the business. He knows exactly what they are worth... and he watches them like a hawk to find the right buy-points for his readers.
If a conservative investor can buy a super world-dominating company like Johnson & Johnson or Coca-Cola or Intel for less than eight or 10 times its annual cash flow, it's very hard to lose money in them. Eight to 10 times cash flow is often a hard floor for share prices of elite businesses. They don't go down past that.
S&A: How about the concept of "replacement cost"? Do you think that's important in the quest to not lose money?
Hunt: A while back, I had lunch with a successful professional real-estate investor who raved about some of the values he found on the east coast of Florida.
The market was wrecked there. There are a lot of sellers who needed to dump right then and ask questions later... So he's found tons of properties that are selling for less than the cost it would take to build the structures if they weren't there in the first place. He's bought properties for less than that rock-bottom value... for less than replacement cost.
Since he is focusing on not losing money... and buying below replacement cost... it's going to be easy for him to make money on his properties. Mind you, he's not raving about price-appreciation potential. His eyes lit up because his downside was so well-protected.
That's the mindset the new investor needs to cultivate. He needs to realize the time to start raving is when he's found a situation where it's going to be difficult for him to lose a lot of money. The upside will take care of itself.
S&A: How about commodities? I know you like to trade commodity stocks.
Hunt: Oh, I love to trade commodity-related stocks... copper producers, oil-service companies, uranium, gold, silver, agriculture. They boom and bust like crazy. And you can make money both ways. I like to say they are "well behaved."
The key to not losing money – which leads to making terrific money – in commodity stocks is to focus your buying interest in commodities that have been blown out... that are down 60% or 80% from their high. Find commodities that have suffered brutal bear markets. The longer the bear market, the better. This is the time that the risk has been wrung out of them.
Every commodity has what's called a "production cost." This is how much it costs to produce a given unit of that commodity. It's similar to the concept of "replacement cost."
After a big bear market in a commodity, you'll often find it trading for below its replacement cost. Sentiment toward the asset will be so bad that nobody wants it. So producers get out of the business... and demand for that commodity increases because it is so cheap. This sows the seeds of a big bull market.
But to get back to covering your downside in commodities, focus on markets that have suffered a terrible selloff or bear market. In these situations, the answer to "how much can I lose?" is often, "Not much... It's already selling at rock-bottom levels."
You can certainly make money in commodities that have been trending higher for a long time, but the sure way to not lose money is to focus on the commodities that have absolutely been blown out.
Gold and gold stocks were a classic case of this in 2001. Gold and gold stocks were such bad investments for so long that everyone who bought in the 1980s or '90s had sold their holdings in disgust. They finally got so cheap and hated that they couldn't go any lower. Then they skyrocketed.
S&A: Good advice... Any parting shots?
Hunt: When you start out in this game, you're as bad as you're going to get. So take supertrader Bruce Kovner's advice and "undertrade."
Make really small bets to get the hang of things... to get the hang of handling your emotions. If you have $10,000 to get started, set aside $7,000 and trade with $3,000 for the first six or 12 months.
But even after going through a training period like this, it's tough to learn not to lose money unless you actually feel the pain of losing a lot of money. It took me touching several very hot stoves and suffering several big losses early on in my career before I learned this.
If I am a skilled trader and investor nowadays, it is only because I have made every boneheaded mistake you can think of and learned not to repeat it. I've learned that you can make great money in the market simply by not making stupid mistakes... by playing great defense.
S&A: Winning by not losing. It works for Buffett and Paul Tudor Jones... So it's probably worth focusing on. Thanks for your time.
Hunt: My pleasure.
A few years back, S&A Editor in Chief Brian Hunt produced a series on "the greatest things ever said about trading." Find a few choice quotes here...
An Old Wall Street Secret to Making Easy Trades
"Wall Street's graveyards are filled with men who were right too soon."
The Headline All Great Traders Hunt For
"Buy when there is blood in the streets."
The No. 1 Most Important Factor in Your Trading Success
"The realization that you are responsible for your results is the key to successful investing. Winners know they are responsible for their results; losers think they are not."
Volatility has died… "fear index" VIX is sitting near its lowest levels since 2007.
Fed policies are creating a new bank boom… financial sector fund XLF surges to a fresh four-year high.
U.S. automakers are breaking out… Ford and GM jump to two-year highs.
"Bad to less bad" rally for Best Buy… beaten-down electronics retailer soars 124% since the beginning of 2013.