The Zurich Axioms By Max Gunther
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When the ship starts to sink, don’t pray. Jump.
The Second Axiom was all about what to do when things are going right. The Third Axiom is about saving yourself when they go wrong.
And they surely will go wrong. You can depend on it. You can expect that roughly half your speculative ventures will turn sour before you have reached your preplanned ending positions. Half your guesses about the future will be wrong. Half your judgments of economic forces will be inaccurate. Half the advice you hear will be bad.
Half your hopes are doomed never to be realized.
But cheer up. This doesn’t mean you are bound to lose a dollar for every dollar you gain. If that were true, the whole adventure would be pointless. It is true only of the inept. Successful gamblers and speculators handle things better. They forge ahead in large measure because they know what to do, and unhesitatingly do it, when the tide of events turns against them.
Knowing how to get out of a bad situation may be the rarest of all speculative gifts. It is rare because it is difficult to acquire. It takes courage and a kind of honesty with a cutting edge like a razor blade. It is an ability that separates the men and women from the boys and girls. Some say it is the most important of all the tools in a gambler’s or speculator’s kit.
One man who would agree with that statement is Martin Schwartz, a former securities analyst who now spends full time speculating in commodity futures. (Most full-timers prefer to call it “trading”, but we will stick to our own word.) In 1983, Schwartz increased his playing money by a spectacular 175 percent. That made him the winner of the U.S. Trading Championship, an annual contest sponsored by a Chicago commodity brokerage – and it also made him a lot wealthier. Asked how he achieved such nice results, Schwartz focused instantly on the one ability he felt to be essential. “I’ll tell you how I became a winner”, he told the New York Times, “I learned how to lose”.
You hear almost identical words around gambling casinos. Asked what makes a good poker player, Sherlock Feldman answered without hesitating, “Knowing when to fold.”
An amateur gambler hopes or prays the cards will fall his way, but a professional studies how he will save himself when they fall against him. That is probably the major difference between the two. It helps explain why a pro can expect to earn his living at the poker table, while an amateur (if playing against pros) can expect to get taken to the cleaner’s every time he plays.
The inability to jump quickly off a sinking ship has probably cost more speculators more money than any other failing, and has undoubtedly led to the spilling of more gallons of tears than any other kind of financial misfortune. “Getting stuck in a losing venture is the worst money pain there is”, says Susan Garner, who recently quit her job with the Chase Manhattan Bank in order to devote full time to speculation. She is successful now, but she wasn’t always. It took her time to learn the techniques – particularly to learn how to lose.
In one of her earliest ventures, she recalls, she paid $2,000 for a fractional interest in a small suburban office building. The building was situated in a somewhat sleepy community that seemed on the point of waking up. A major federal-state highway was scheduled to be built in the region, and the planned route took it along one border of the town. Because of the projected highway and certain other economic and geographic factors, everybody expected that the town would develop into a thriving commercial center. When that happens to a community, of course, real estate values often rise rapidly – including the value of office space. Susan Garner’s speculation looked promising.
But as often happens, the future was postponed. The highway project was hit by funding problems. A series of announcements spoke of longer and longer delays. At first the official word was that the project would be postponed for about a year. Then it was two or three years, then five years. Finally a state official found the courage to tell the truth: he honestly didn’t known when the highway would be built, if ever.
With each succeeding announcement, the fever of real estate speculation cooled a bit. There were no daily price quotations on Susan Garner’s little piece of a building, but she didn’t need precise numbers to tell her she was getting poorer. She thought of selling out.
“There were people who would have bought my share”, she says. “But I knew I’d have to sell at loss, and I couldn’t bring myself to it. After the first announcement of a one-year delay in the highway, I tried to tell myself everything would be okay if I just sat tight. This was a temporary setback – that’s what I kept saying. All I had to do was wait, and my share value would go back up.”
Then came the announcement of a two- or three- year delay. One of the bigger shareholders in the office building, a lawyer, now approached Susan Garner and offered her $1,500 for her share. She could not bear the thought of losing $500 – one fourth of her investment – and she turned him down. He raised his offer to $1,600. She still said no.
As the announced delays stretched toward infinity, the price fell steeply. The lawyer offered her $1,000. A little later he was down to $800. The lower the price dropped, the more tightly Susan Garner felt struck. “Now I wasn’t even hoping to get my $2,ooo back”, she says. “I was angry at myself for not taking $1,500 when I could have gotten it. I kept hoping the situation would improve and vindicate my judgment. The lower the price went, the more stubborn I got. I was damned if I going to sell my $2,000 share for a lousy $800!”
While her money was trapped in this souring venture, other speculations beckoned. She wanted to take a flier in antique furniture. She liked the look of the stock market. A friend wanted to sell, at a bargain price, an inherited album of nineteenth century postage stamps, and this attracted her too. But the trapped $2,000 was the bulk of her speculating capital. She could hardly make a move until she freed it.
“I finally decided”, she says, “that it was ridiculous to let money get frozen up like that.” She sold her share for $750.
And that was how Susan Garner learned the lesson of the Third Axiom. When the ship starts to sink, jump.
Note the wording: when it starts to sink. Don’t wait until it is half submerged. Don’t hope, don’t pray. Don’t cover your eyes and stand there trembling. Look around at what’s happening. Study the situation. Ask yourself whether the developing problem is likely to get fixed. Look for trustworthy and tangible evidence that improvement is on the way, and if you see none, take action without further delay. Calmly and deliberately before everybody else has started to panic, jump off the ship and save yourself.
This advice can be translated into numbers in the case of daily-trading entities such as stocks or commodity futures. Gerald Loeb’s rule of thumb was that you should sell whenever a stock’s price has retreated 10 t0 15 percent from the highest price at which you have held it, regardless of whether you then have gain or a loss. Frank Henry gave himself a bit more leeway and said 10 to 20 percent. Most seasoned speculators operate with very similar rules. In all cases, the idea is to cut losses early. You take small losses to protect yourself from big one.
To illustrate, let’s suppose you’ve bought some stock at $100 a share. The venture immediately turns sour, the price drops to $85. In this case the highest price at which you ever held the stock was the price at which you bought it: $100. You’re down 15 percent from that level, so the rules say you probably ought to sell. As long as you see no good evidence that some kind of improvement is in the works, get out.
Or let’s take a happier case. You buy the stock at $100 ,and it jumps to $120. You’re going to get rich, you think. Oh frabjous day! But then some unexpected trouble hits the company, and your stock sags back to $100. What should you do? You know the answer by now. In the absence of compelling reasons to think things will get better, sell.
But knowing the answer is only half the battle. There are three obstacles that get in people’s way when they are trying to carry out the precept of the Third Axiom. For some speculators, the obstacles are intimidatingly big. You must prepare yourself psychologically to face them. They can be overcome if you keep your cool.
The first obstacle is the fear of regret – substantially the same fear we looked at under the Second Axiom. In this case, what you fear is that a loser will turn into a winner after you’ve gone away.
It does happen, and it hurts. You’ve bought some gold at $400 an ounce, let’s say. It collapses to $350. Seeing no good reason to stick around, you decide to take your 12 percent loss and sell out. No sooner is the transaction completed than six new wars break out, four South American countries default on their international debt, the OPEC nations double the price of oil, all the world’s stock markets crash, and everybody with spare dollars is rushing for the protection of the yellow metal. The price zooms to $800. Ouch!
Yes, it hurts. It probably will happen to you sooner or later. There is no way to avoid it. But such sudden reversals of fortune do not happen often. More frequently, a situation that goes bad will stay bad, at least for a while. The problems that cause significant price drops in speculative entities – stocks, commodities, real estate – tend to be long-lived problems. They are slow to develop and slow to go away. More often than not, the correct course is to bail out when a price first develops an appreciable sag.
There are some situations in human life, it is true, in which it may seem wiser to wait out bad times. But that is seldom a wise course where your money is concerned. If you let it get stuck in a bad venture, and if the problems last, you can go for years without having the use of that money. It’s locked up when, instead, it should be out chasing gains for your in other, livelier ventures.
The second obstacle to implementation of the Third Axiom is the need to abandon part of an investment. This is inordinately painful to some. To console you, however, I can tell you that it gets less painful with practice.
You’re speculating in currencies, we’ll say, and you’ve put $5,000 into a bet on Italian lira. Your hunch has proved wrong, the exchange rates have turned against you, and your extractable capital has shrunk to $4,000. You probably ought to sell out as long as no definite promise of improvement is in sight. But if you do sell out, you abandon $1,000. That is what hurts.
It hurts some so much that they cannot do it. The instinct of the typical small-time speculator is to sit tight, hoping to get that $1,000 back someday. If you don’t conquer that instinct you may remain a small-time speculator – or become a bankrupt one day. The way to get that grand back is to pull your $4,000 out of the sagging venture and put it into a livelier one.
The inability to abandon part of an investment becomes twice as bad a problem if you speculate on margin – that is, use borrowed money to boost your leverage. Your speculative situation then comes to resemble the most exquisitely agonizing game in the world, poker.
It will be worthwhile to explore this resemblance briefly. Indeed, you will find it extremely rewarding to study the game of poker, if you aren’t already familiar with it. Get into some Friday-night neighborhood games, or organize some. Poker is designed to test some elements of human character to their very limits. You have much to learn from the game – about speculation and about yourself.
When you speculate on a cash basis – that is, when you don’t use any borrowed money – life is relatively simple. You buy some stock, let’s say. You pay cash on the barrelhead. You aren’t required to do more than make that single investment. If the stock’s price sinks and you fail to bail out, being unwilling to abandon whatever money you’ve lost, you aren’t asked to do anything. All that happens is that you sit and watch morosely while your wealth shrinks. Nobody asks you to throw more money into the venture.
Now consider poker. In a poker hand, you must keep adding to your investment if you want to stay in the game. You’re drawing to a flush, we’ll say. The odds are against you, the hand is a probable loser. But you’ve invested a lot of money in the pot so far and you can’t make yourself abandon it. Against your better judgment (and the teaching of the Third Axiom) you elect to stay.
This isn’t an ordinary cash-basis speculation, however. This is poker. If you stay, you pay. If you want to see the next card, you must buy it. The game requires that you continually invest new money to protect old money.
Speculation on margin produces similar agony. You buy some stock, borrowing a certain percentage of the price from your broker. The allowable percentage is determined by government regulations, stock-exchange rules, and individual brokerage policies. The stock is held by the broker as collateral for the loan. If the stock’s trading price drops, its value as collateral, obviously, will also drop. This can put you in automatic violation of the rules about margin percentages. You will then receive the dreaded “margin call” – a friendly but no-nonsense communication in which your broker offers you two hard choices: Either our come up with more cash to cover the discrepancy, or he sells you out.
You are in substantially the same position as the poker player. If you aren’t willing to abandon part of your instrument, then you must throw more money into the pot. The willingness to abandon is usually the more trustworthy response. If you don’t sense or can’t cultivate this willingness in yourself, speculation of any kid could be difficult for you, and speculation on margin could be disastrous.
The third obstacle to the Third Axiom’s implementation is the difficulty of admitting you were wrong. People differ widely in the ways they react to this problem. Some find it only a minor nuisance. Some find it the biggest obstacle of all. Women tend to overcome it more readily than men, older people more readily than younger. I don’t have any idea why this is so, and neither does anybody else, including those who say they do. Let’s leave it at this: it is a tall obstacle for many. If you feel it will get in your way, you should explore yourself and seek ways to handle it.
You make an investment it turns sour, you know you ought to get out. But in order to do that, you must admit you made a mistake. You must admit it to your broker or banker or whomever you’ve been dealing with, maybe to your spouse and other family members – and, usually worst of all, to yourself. You’ve got to stand there in front of a mirror, look yourself in the eye, and say, “I was wrong”.
For some, this is impossibly painful. The typical loser tries to avoid the pain, and as a result, repeatedly gets trapped in bad ventures. If he buys something whose price begins to sag, he hangs on in the hope that future events will vindicate his judgment. “This price drop is just temporary”, he tells himself – and maybe even believes it. “I was right to get into this speculation. It would be foolish to sell out just because of some initial bad luck. I’ll sit tight. Time will show how smart I am!”
Thus does he protect his ego. He have evaded the necessity of saying he was wrong. He can go on believing he is smart.
His bankbook will record the truth, however. Years from now, perhaps, that sagging investment will struggle back to the price at which he bought it or will even go higher, and then he will feel vindicated. “I was right all along!”, he will exult. But was he? During all those years while his money was stagnating, it could have been out working. He could have doubled it or better. Instead, he stands just about where he stood at the beginning of this dismal episode.
Refusing to be wrong is the wrongest response of them all.
The Zurich Axioms By Max Gunther
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