Secrets of Professional Speculation

Below are extracts from commentaries posted at www.speculative-investor.com between September and December of 2002. 

Secrets of Professional Stock Market Speculation

One of the best books we've ever read on stock market speculation was actually written about betting on horse races. The book is "Secrets of Professional Turf Betting" by Robert Bacon. It has been out of print for decades, but used copies can be obtained via www.barnesandnoble.com. 

Most people who bet on horse races not only lose money, they lose much more money than they should lose based on chance alone. What this means is that someone making purely random bets on horses, or an untrained chimpanzee betting on horses, will, over a long period of time, lose the track's 'take'. The 'take' is a fixed percentage, usually in the 10%-20% range, that is extracted by the track (or jockey club) out of the total amount of money bet on each race. The remaining 80%-90% is paid out to the winning bettors. In other words, if the track's take is, say, 15%, then someone who selects horses based on random guesses alone would, over a long period of time, be expected to lose an average of 15% of the amount of money they bet each race day. However, the average member of the betting public actually loses 33%-100% of the money they outlay over the course of each racing day. It is almost as if they are trying to lose!

While the vast majority of people lose money at the races, some betting professionals consistently win. These professional bettors generally do not have inside information or any resources that are not readily available to members of the public. Nor is it usual for them to be highly educated. So, how do they win? Since the public is usually so wrong that it manages to lose far more money than it should, it stands to reason that those who are able to consistently win do the opposite of what the public does. As Robert Bacon puts it, "These professionals win because they know the "inside" principle of beating the races, the same principle that must be used to beat any speculative game or business from which a legal 'take', house percentage, or brokerage fee is extracted. That principle is: 'Copper' [bet against] the public's ideas...at all times!" 

This principle certainly applies in the stock market and is the reason we spend a lot of time analysing sentiment indicators. If our analysis of sentiment indicators is 'on the mark' then we will know what the collective mind of the public is thinking and can, at the appropriate time, do the opposite. There is, of course, added complexity in the stock market, or any financial market for that matter, since there isn't a fixed pool of money that is distributed at fixed points in time based on a set of clearly-defined rules. There is, therefore, a critical timing element in the financial markets that is not present when betting on horses (as the speculators who 'shorted' absurdly-priced internet stocks during 1998 and 1999 discovered to their detriment).

In horse racing, betting against the public involves the identification of "overlays". These are situations where the odds assigned by the public (the odds at which a horse runs are determined by the amount of money bet on that horse relative to the amount of money bet on the other horses in the race) are longer than what the odds should be. In other words, where the risk/reward ratio is in favour of the bettor. For example, if a professional determines that the correct odds for a particular horse are 2:1 whereas the public's betting puts the horse at 10:1, then the professional has identified an "overlay" and may decide to bet on that horse. If the professional determines the correct odds to be 2:1 and the horse is quoted at 2:1 then the professional would certainly not bet on that horse because, in such a case, the likely upside and the likely downside are the same. 

This leads us to another important difference between the consistent losers (the public) and the consistent winners (the professionals). Most race-going members of the general public will bet on every race, whereas the professionals will only bet on those races in which they have identified an attractive overlay. This might result in the professional only betting on 2 or 3 races during a 10-race day. If there are no attractive overlays in any of the races then he/she will place no bets on that day. 

The principle of only putting money at risk in cases where there is an attractive overlay applies perfectly to stock market speculation. An "overlay" in the stock market would, for example, occur if the stock of a company is dramatically under-valued based on the cash that it is currently generating or is likely to generate in the future (the market value assigned by the public is low compared to the company's intrinsic value). In such a situation a long-term speculator (also known as a 'value investor') such as Warren Buffett might decide to buy the stock. He does so because he knows that the stock price will eventually return to its intrinsic value and he doesn't really mind how long he has to wait for this to happen. For a short-term speculator a suitable overlay might occur, for example, as a result of a period of panic selling that sets the stage for a sharp rebound. Whether you are a long-term speculator (investor) or a short-term speculator (trader), it is important not to act unless you can identify an attractive overlay, that is, unless the risk/reward is heavily in your favour. This means there will always be periods, sometimes lengthy periods, when you should do nothing. 

Another factor contributing to the public's losses in the game of horse racing, and in all speculative endeavours, is something called "switches". According to Robert Bacon it's not the races that beat the amateurs, it's the switches. Whereas the professionals develop a plan and stick to the plan the amateurs are continually changing (switching) such things as the types of bets they make, the amount they bet on each race, and the way they select horses. For example, an amateur might try Method A for a while and when it doesn't appear to be working switch to Method B. As soon as he switches to Method B, Method A starts to win. Not wanting to make the same mistake again he decides to stick with Method B, but Method A continues to win and Method B keeps losing. After a while he can't stand it any longer so he switches back to Method A, just before Method B hits a winning streak. 

Most speculators in the financial markets will have experienced the frustration wrought by switches, that is, they will at some point have been coaxed by a market to switch strategies at exactly the wrong time. One difference between the winners and the losers is that the winners have figured out a way to avoid the switches. An important part of this 'avoidance' is to only ever speculate in those instances when you have identified, via a thoroughly-tested method, an attractive overlay.

The Principle of Ever-Changing Cycles

According to Robert Bacon, "There is no danger of the public ever finding any key to the secret of winning. The crazy gambling urge and speculative hysteria that overcomes most players at the track makes that fact a certainty. But, if the public play ever did get wise to the facts of life, the principle of ever-changing cycles of results would move the form away from the public immediately."

In the financial markets, what works during one cycle tends not to work during the next cycle. Furthermore, the cycles inevitably change shortly after the public has figured out what is working and has bet heavily on the basis that what is working will continue to work. Taking one example, Warren Buffett accumulated a large stake in Coca Cola (KO) during the 1980s at an average price/earnings ratio of around 15. At the time he was doing his buying most Wall St analysts considered the stock to be over-priced because the company supposedly had no prospect of achieving above-average growth. Buffett completed his buying in the late-1980s and during the next 10 years KO's earnings and stock price grew rapidly. It's stock price actually grew far more rapidly than its earnings because Wall St analysts and the public fell in love with the stock and became willing to pay a lot more for each dollar of earnings. The analysts who hated the stock when its P/E ratio was in the 10-15 range rated it as a "strong buy" when the P/E ratio was over 40. The views of Wall St analysts, by the way, simply reflect the views of the public. In 1997-1998, just after the public had discovered this wonderful stock that was destined to increase in price by at least 20% every year, the stock price stopped rising. KO has not been a lousy investment over the past few years compared to many other stocks, but anyone who bought KO shares at any time since the beginning of 1997, and held onto those shares, almost certainly now has an unrealised loss. KO was a great investment at one time, but the public's discovery of this stock inevitably transformed it into a poor investment. 

The principle of ever-changing cycles doesn't just apply to individual stocks or groups of stocks, it applies to investment and trading methods. If you want to know what is not going to work during the current cycle, look at what worked extremely well during the last cycle. For example, the 'buy and hold' approach to stock market investing worked very well between 1982 and 2000 and there are few people today who don't believe that stocks, if bought and held for the long-term, will provide good returns. Unfortunately, most people only became thoroughly convinced that the 'buy and hold' approach was the right way to go during the final stage of the cycle, whereas the approach was only ever going to yield good results for those who bought during the early and middle stages. The current cycle will continue until the 'buy and hold' approach has been totally discredited and most of the long-term holders have sold. At that point a 'buy and hold' approach may once again be appropriate.

One of the most popular trading approaches during the final few years of the last decade was to buy a stock following an 'upside breakout' in the stock price and sell following a 'downside breakout'. It seemed so easy - just pick a tech or internet stock and when it moved above a trendline on a chart or made a new all-time high, buy it, wait for the price explosion that inevitably followed every upside breakout, then sell for a huge profit. Thousands of people thought they had discovered the key to getting rich quickly and quit their jobs to trade on the stock market. They didn't realise that what they were experiencing wasn't the way things normally worked or were going to work for very long. What they were experiencing was the sort of short-lived cycle that occurs only a few times per century. However, the fact that this 'breakout method' worked so well for a while will mean that many people will continue to use it for years to come, even though the results will generally be poor. In fact, it is inevitable that the various momentum-based trading methods that seemed to work like magic during the late-1990s will not yield good returns during the current cycle. (By the way, a relatively small number of people are still able to make good profits every year using a breakout approach (buying upside breakouts and selling downside breakouts). Their success, however, is based much more on their money management ability (their ability to know when to take profits and when to take losses) than on the breakout method itself.)

In summary, what worked during the last cycle is not going to work this cycle. Furthermore, what is currently working won't work indefinitely - it will only work until enough people discover it. At that point, the principle of ever-changing cycles will come into effect.

The Information Age versus the Principle of Ever-Changing Cycles

A question that we've received several times over the past year from readers of our 'stuff' goes something like this: "With the general public now having ready access to far more information than in the past, won't the so-called 'dumb money' make better investment decisions and be less likely to behave in a herd-like manner?"

We've always been somewhat amused by the above question because the recent stock market mania was clearly one of the greatest examples ever of the investing public losing its senses and accepting fantasy as fact. Even the most cursory observation of the goings-on of the past 5 years tells us that the Information Age has not brought about an improvement in the ability of the public to make the right investment decisions. After all, there were record flows of money into equity funds at the bubble peak during the first quarter of 2000 and there were significant flows of money out of equity funds when the market was bottoming during July-October of this year. And based on past experience much greater out-flows will occur when prices drop below this year's low. For all the information that people had access to they managed to embrace ideas that they really should have perceived as absurd. As has always been the case throughout history and always will be the case, they simply got carried away with rising prices and visions of great wealth.

Although the experiences of the past few years provide some empirical evidence that the availability of more information has not increased the investment acumen of the public, it is worth exploring why this is so.

One reason, of course, is that a high percentage of the information to which the public is exposed is wrong, either by accident or by design. So while most people have a lot more information than they had in the past their decisions might, if anything, tend to be even less correct because much of that information is inaccurate. In other words, bad information is potentially more damaging than the absence of information. It is quality of information, not quantity of information, which is important. Thanks to the Internet, high-quality information is now more readily available to the average investor than it has been in the past. But unfortunately, most people have no way of differentiating the good information from the bad or of filtering out the small amount of useful information from the daily information deluge.

Another reason is that the people who are responsible for providing information to the investing public, even if they happen to have the best of intentions, are subject to the same herd-like behaviour as everyone else. This can be clearly seen in the weekly survey of investment newsletter writers conducted by Investors' Intelligence. Most newsletter writers are independent and don't have a vested interest in getting their readers to buy when they should be selling or to sell when they should be buying, yet these investment advisors are invariably wrong at major turning points. As a group they tend to become progressively more bullish as prices rise and progressively more bearish as prices fall. As such they are always extremely bullish at major peaks (great selling opportunities) and extremely bearish at major bottoms (great buying opportunities).

The performance of investment advisors, as a group, highlights a third reason why having more information won't prevent the public from making the investment mistakes it has always made in the past. The people who write investment newsletters generally spend a lot more time gathering and analysing information on the financial markets than the average investor, yet as mentioned above the newsletter writers are invariably wrong at important turning points (some will be right, but more than half will usually be wrong). For example, at the beginning of the great 1995-2000 stock bull-market more than 50% of the investment advisors surveyed by Investors' Intelligence were bearish. The advisors only started to become bullish when the market started to rally, and the higher the prices moved the more bullish they became. As such, it isn't really the quantity or the quality of information that matters when looking at the investment performance of any large group. Some people are able to separate themselves from the investment herd and make decisions based on an objective assessment of the available evidence, but most, including the majority of supposedly well-informed advisors, will simply react to changes in prices.

There is, however, a fourth and even more fundamental reason why more information will never stop the public from ending up on the wrong side of the market, irrespective of how accurate the information was when it was first digested by the public or the public's ability to interpret information. This reason is covered in the following extract from Robert Bacon's "Secrets of Professional Turf Betting" (just substitute the phrase "stock market" for the words "races" and "racing" in this extract):

"The collective "mind" of the public imagines that if it could only once find the "combination" for beating the races, it would be all set for life. The public wants to hit on some simple key, shown by numbers in the past performances, and use this key to get richer and richer as racing goes on. The public believes that if it could only once find that past performance key, its troubles would be over.

But that is not the way racing is at all. There is no danger of the public ever finding any key to the secret of winning. The crazy gambling urge and the speculative hysteria that overcomes most players at the track makes that fact a certainty. But, if the public play ever did get wise to the facts of life, the principle of ever-changing cycles of results would move the form away from the public immediately." [Emphasis added]

The reason "the form", as Robert Bacon puts it, will always move away from the public is that when the public becomes convinced of something and bets accordingly it worsens the odds (it lessens the probability of success). 

Trends in the stock market continue until the public becomes a 'true believer' in the trend. In the real world, where most of the information accessed by the public is unhelpful, it often takes the public a long time to become a true believer. Then, by the time it becomes committed to the trend its own buying has pushed prices to such extremes that the probability of further gains is low and the risk of large losses is high. However, even in an idealised world in which the bulk of the information absorbed by the public was accurate and in which the public had a greater ability to correctly interpret information, the weight of the public's buying would still turn what might initially have been favourable odds into unfavourable odds. The public would still find itself on the wrong side of the market at major turning points, it's just that those turning points would occur with greater frequency.

In a world where most of the information thrust at the public was helpful and where the public's ability to objectively analyse information had been magically enhanced, no investment would stay popular for long. However, we don't think there is any danger of reaching the point where even 50% of the information used by the public to make investment decisions is genuinely helpful. And there is certainly no danger that objective analysis will ever replace emotion as the main driver of the public's investment decisions. As such, it will continue to take the public many years to recognise major trend changes and there will continue to be plenty of opportunities for 'contrarians' to buy well in advance of the public and to sell once the public eventually, and inevitably, becomes a believer.

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