Pub Landlord

Q; If we had no rules, where would we be?
A; France

Q; If we had too many rules, where would we be?
A; Germany.

And that is the start of just about every skit by Al Marray, aka the Pub Landlord, that I have ever seen. I think he should add to the repertoire;

Q; If we had too many rules, but we never obeyed them, where would we be?
A; Italy.

So, before I offend everyone in Europe, what kind of rules should I set up for my fund? And how often should I obey them?

The first rule is the big one; always survive. I plan to be running money until I retire, and I don’t plan to retire. So I have a primary rule; always cut. I always set a cut point in advance. And I never deviate from it, however often I’ve felt like an idiot cutting previous trades at the lows. I’m positively Germanic in my discipline.

Now it’s easiest to explain this rule by looking at its opposite; always double down (doubling up a losing trade). It’s a method that often works wonders. The problem is, on those rare occasions when it doesn’t work, when there is a genuine trend against you, you blow yourself up. Always cutting means that you never add to your losses, and while it may be deeply vexing at times, it at least guarantees that you stay in the game.

During my last gardening leave, unlike this one, I did no gardening. Instead I watched the cricket and read all of Warren Buffet’s letters. I then had a look at how the shares traded after he bought them. His best ever trade in a listed stock was to buy the Washington Post. When I looked, it was a 1000 bagger. What’s less well known is that the shares dropped 20% in the months after he bought them. That happens to be my limit for any thematic stock holding, and it shows that, if you follow any set of rules, you will miss some big opportunities.

My view, though, is that cutting pays out more. Dennis Gartman, the long time trader and florid letter writer, talks about financial and psychological capital. Cutting preserves your financial capital, no doubt. It also preserves your psychological capital. Cutting before a position rips a big hole in your portfolio stops your brain from exploding. I’ve been there on trades in the past and there is no way that it was a good thing. Either for me, or for my subsequent performance.

Now the next rules are much more Continental in outlook; they’re not so rigid, and they are designed to magnify, rather than constrain, talent. They help you to answer the ultimate b***stard money management interview question; what’s your edge?

Now, before I attempt to answer that for myself, likely later this week, I thought I’d bring in the big gun on this one; Puggy Wilson. He was the blue collar Texan who won the World Poker Championships in the early ‘70s, documented brilliantly in David Spanier’s ‘Total Poker’. Puggy looked like Budha, if you caught him in a certain light, and he put his trading rules down like a haiku;

Know yourself
Know how to manage your money
Know the right end of a 60:40 proposition.

So in much less elegant and economical a fashion, here’s my spin on each one.

Know yourself is about knowing how you’ll feel, and how you’ll behave, if your trading goes badly wrong, or, for that matter, fantastically right. A whole heap of literature identifies how people take more risk to win back what they’ve lost. And ‘The Psychology of Trading’ shows how people overtrade when they are frustrated – typically putting on big bets to trade small moves; making them much more vulnerable to random noise and to frittering away performance in trading costs. Brett Steenbarger wires himself up to a biofeedback machine and stops trading when it tells him he’s frustrated. Hard to see that catching-on on a city trading floor, which means it probably gives Steenbarger an edge.

The same thing happens to me. So I took Steenbarger’s advice when I was getting frustrated two or three weeks ago, and cut back my trading on my leveraged account, in order to focus on my long term thematic positions. That turned out to be exactly the right call.

The rule also applies to how you behave when you’re making big money. Nicholas Taleb describes the action of serotonin on the brain in his book ‘Fooled by Randomness’. When you’re up, you’re more open, more spontaneous, more attractive to women – more likely to ride your own luck. That works for me also, well, except maybe for the bit about being more attractive to women.

So what I do to guard against overconfidence is to run risk/reward models. That helps me identify when trends are mature, and when macro forces are acting to undermine them. It helps me get hedges up and running and look for major reversals.

Rule two is; know how to manage your money. For me that means the Germanic discipline of cutting that I outlined above. But it also means making sure that your bets are big enough to count – both ways.

In my thematic portfolio, my standard starting bet on a particular stock is 5% of the whole portfolio, sometimes doubling to 10% if all is going well. That sets up the opportunity for proper performance

I also apply the ‘big enough to hurt’ rule to the leveraged portfolio. If I am at full stretch I will have 10 positions on that could all hurt. Right now, I’m trading one.

And finally, rule three; know the right end of a 60:40 proposition. Now that, of course, is easier said than done. My own way is to do one or more of four things;
- Looking to see where I can compound high corporate returns by holding patiently.
- Looking for self-reinforcing macro cycles.
- Looking for what might trigger a regime change in those same cycles.
- Watching the other punters.

I’ll talk about these later this week, when I’ll write on how I’ve structured my portfolio to accentuate the positive, and edit out the average, in my trading life.