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
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.
From the perspective of a stock market
speculator the most important chapter in Robert Bacon's book is the one
that deals with the "principle of ever-changing cycles".
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.
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
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
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."
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
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