The 6 Rules of Investing: How to Scientifically Increase Your Luck
Everybody wants to make money. The question is how? Fergus Cullen talks through his 6 essential ideas for positioning yourself to get lucky in your investing.
“I attribute my trading success to: 50% asymmetry & 50% luck. The rest is talent and insight.” - Fergus Cullen
The basic premise is that if you simply avoid all the standard pitfalls in the market, you are positioned to create wealth through your investing activities.
- Asymmetry: Limit your losses and let your winners run.
- Risk: The position is the stop loss, the fattest margin of safety possible. You need to understand your current environment, and since there is always risk, you need to take risks you “understand.” You must know yourself and the emotional risk. Scale.
- Edge: You need to have a defined edge in the market. Know your turf.
- Conviction: Conviction is critical as a trader. If you don't have absolute conviction, any rule will simply not be effective.
- Incentives: One of the most important things to understand. You need to understand specifically how a company, and in particular, its management team is being financially incentivized.
- Cyclicality/History: The fact that markets always move in cycles.
This article is going to explain each of these in detail and provide a clear understanding of how to apply these set of rules to any market to increase your portfolio and profits.
The first part of the system is asymmetry, also known as optionality or positive skew.
Asymmetry is when you have a limited downside in order to have an unlimited upside.
“The goal in investing is asymmetry: to expose yourself to return in a way that doesn’t expose you commensurately to risk, and to participate in gains when the market rises to a greater extent than you participate in losses when it falls.” - Howard Marks
You control the risk by limiting the amount you put into any one position. This is using proper position sizing. You have to allow for some drawdowns, but when you get winners, let them run as long as possible. You don't actually have to be smart if you have optionality because things are weighted in your favour. Cullen believes that many investors trim the profits from a multi-bagger investment too early.
Optionality is back-loaded, which makes it difficult to manage in a portfolio because of the longer time frame. Much like compounding, it never shows up early on. Generally speaking, the payoff with optionality is in the later years of an investment.
Peter Lynch, the renowned investor, said his average hold period was 2-3 years of sideways movement before his stock picks took off.
“Selling your winners and holding your losers is like cutting the flowers and watering the weeds.” - Peter Lynch
With this scenario, you can often experience volatility, and even some decent drawdowns before everything comes together in the span of a few months, and you find yourself up 3-4-5x.
Magnitude vs. Win-Loss Ratio
The next point with asymmetry is magnitude vs win-loss ratio.
This may sound counter-intuitive, but in the markets, your win-loss ratio is not important. If you don't understand trading, you could have a great win-loss ratio, but one steep loss can take away months of profit overnight.
With trading, you should always be thinking about the magnitude of your wins and losses. How can you milk the winners for all they are worth? How long can you ride the profits? This is contrary to what many amateur traders believe because it goes against the rule of taking your initial capital off the table when a position doubles, thereby creating a risk-free position.
Cullen adds that you should also consider adding to the position if you like the way the management is executing.
Right-Tail vs. Left-Tail
In trading, there is the concept of the right-tail vs the left-tail. Everybody loves the idea of the left-tail risk, which is the idea of the Black Swan, popularized by Nassim Taleb; namely that you can be cleaned out by some unforeseen circumstance.
This “left-field” event captures our attention because we are hardwired to be looking for danger from an evolutionary sense.
However, the opportunity cost of the right-tail can be a lot higher than the left-tail if you're practising correct position sizing.
Cullen gives an example from his own portfolio. He had 3% of his portfolio weighted in offshore drillers. 2 of them went bankrupt, but the other is going to gain a 5X return, that's break-even. But in another experimental section of your portfolio, a similarly sized 3% position, a win with great magnitude ended up growing to nearly a quarter of his entire portfolio.
And that’s an illustration of magnitude and the bigger opportunity cost.
A great book for aspiring traders is "Fooled By Randomness" by Nassim Taleb. One aspect that tends to be broadly overlooked is how much luck is involved in any investment. Try to stay humble and on the side of "I got lucky." This helps to stop your ego from getting involved, which is important as any professional investor will attest.
Other rules Cullen adheres by is that after having a decent win in the 6-figures, he will park that capital and not enter any new positions for a minimum 3-6 months. Wins result in inflated egos, which any trader knows can be dangerous.
How to Identify Breakouts
One of the few trading signals that Cullen pays a lot of attention to is a breakout. Whole trading systems are based around this premise of trend-following. If you've ever read about “the Turtles” and their trend-following strategy, all they did was look for breakouts and then having strict risk management to support those positions.
The Turtles were an experiment in the 1980s started by a couple of commodity traders, Richard Dennis and William Eckhardt. Dennis had a theory that anybody could trade successfully if they followed a series of specific rules, while Eckhardt thought their success was less “transferable.” So Dennis put out a newspaper ad and found 14 suitable candidates to test their theory.
According to former turtle Russell Sands, the original students that Richard Dennis personally trained earned more than $175 million in only five years, proving that anyone without trading experience can learn to trade successfully. You can download the previously secret rules that The Turtles followed here.
The basic tenet of the system is that it is a trend-following system.
Price movement tends to follow a stock that has broken out of a sideways trading range. The longer it's been in the trading range, the more powerful it is when it starts to move.
The first thing to do is to look at the main competitors and identify if the breakout is sector-wide. If not, there could be reasons for that.
Second, try to figure out what is driving it. Are there any fundamentals that have changed? You have to understand if this is being driven by fundamentals - and that's where the principle of conviction comes in. Do you understand what's driving the upswing, or is it just a pump-and-dump?8
The book, “The Art of Execution” by Lee Freeman-Shor is a true story about a fund manager who managed a group of fund managers for decades. He tells the story that after working with dozens of hedge fund managers, it was only the rare manager who could let the trade ride and resist taking the profits. The majority of his returns were made this way, but most people’s psychology prevents them from riding a winner properly.
Position size is the stop loss.
This is at odds with what many investors are taught. With too many stop losses there is a very very real possibility of missing the move entirely.
Investors like to limit losses because setting stop losses makes people believe they are controlling the risk, but at some point, you need to accept volatility. Volatility is the opportunity to capture profits.
In addition to correct position sizing, Cullen looks for other safety margins such as large amounts of cash, restructurings that eliminate debt, or large free cash flow. These all help insulate against negative surprises, like COVID.
Understanding The Current Environment
Take risks that you understand. If you are told that the investment is high return with low risk, it is fundamental to understand where the risk is hidden so that you can position size correctly and not be taken off guard. If you don’t see a risk, you just don’t know where it is hiding.
“We must strive to understand the implications of what’s going on around us. When others are recklessly confident and buying aggressively, we should be highly cautious; when others are frightened into action or panic selling, we should become aggressive.” - Howard Marks, Co-founder and Co-chairman of Oaktree Capital Management
A good example of this is naked puts, which seem like nice smooth returns until the market delivers all the risk to you at once.
A naked put is an options strategy where the investor sells a put option without having a short position in the underlying security in the anticipation of capturing the option premium. Naked puts have limited upside, but carry the risk of holding the asset even if the stock plummets in value.
Basket Case Risk
The “emotional basket case” risk originates from Stanley Druckenmiller in the Tech Boom.
Known as possibly the best trader in the world, he explained that he got caught up in the tech boom despite knowing better. So the possibility of getting caught up in the mania is real. Therefore it’s important to have a defined exit plan with immovable goalposts.
Investing should be an emotionless process based on decision-making on facts and numbers. However, there is a real risk from deviating from the hard truth of the numbers due to cognitive bias. There are several types of cognitive biases traders should be aware of; the most common one is called confirmation bias. Confirmation bias is when you seek out information that aligns with your existing beliefs and actively ignoring information that counters your beliefs.
An example could be if you are already long on a particular stock and ignore new information or news coming out about that stock, or perhaps overlooking the fact of subsequent quarters of lower and lower profits.
As an investor, if you catch yourself imagining what to do with the profits, you have emotionalized the money and you are not in the headspace to make decisions.
Think in terms of percentages not dollars, or material things. This is crucial in keeping level headed.
According to Fergus Cullen, scaling is his number one tool for overcoming hindsight and anchoring bias (relying too much on pre-existing information when making decisions). The idea is that you can slowly scale out of a position as it rolls up to protect you against binary outcomes.
Edge is when you understand that you are not going to compete with hedge funds. Investing is a zero-sum game; you can’t go into the big liquid stocks and compete with institutional traders. If you go where the “big boys” can’t go, you get an advantage.
Looking at small illiquid names with poor data, no analysts, and where banks earn no fees - that’s your hunting ground. Small investors have a distinct advantage for this reason.
Know where you have an advantage.
Another edge is that of risk embarrassment.
As an institutional investor, you cannot go to your board and explain why you put money into a company and it went bankrupt - you have career risk, but personally you can have your own risk analysis on something like this.
Other things to recognize is that you can have patience - something will happen, just sit back and let time pass. Hedge funds aren’t able to do that.
There is a great study, "God would get fired as an active manager," which had the premise that if God could look forward 5 years and pick the top 10 highest performing stocks, God would still get fired as an active manager because the volatility would be too great. Some of these stocks would have seen 50% drawdowns.
Again, you always need an exit plan. Many people will attach to the “hold-for-life” mantra and a vital part of trading is understanding when a trade has run its course and it’s time to exit.
“If you want superior returns, find an inefficient and illiquid market and work every day to be one of the best investors in that market.” - Ian Cassell, MicroCap Investor
Cullen states that everyone should aspire to find sub $200M companies, try and understand them as well as possible, and build conviction in them.
You can copy trades but you can’t copy conviction. Conviction is the unshakeable belief you have in your decision based on solid fundamental research. And you know you have conviction when you can hold through periods of volatility.
“Volatility is the price you pay for performance.” - Bill Miller, American investor, fund manager, and philanthropist
You need to have the stomach for volatility. In the book, “The Art of Execution”, winning traders would always add in a drawdown while losers would put their heads in the sand.
Over the years, Lee Freeman-Shor would cut his managers by the ones who lacked understanding of their stocks and didn't add to them. It's a fallacy that you will time the bottom so when you are presented with dip opportunities, that’s the time to add to those positions.
Another aspect of conviction is understanding; don't get into investing in a sector until you have over a year's worth of knowledge. By gathering the information, you will have seen if there's seasonality to it or cycles and you've understood the moving parts, the players, and the variables. Of course, you will find exceptional cases, but it would be in the very rare case where you think that the benefit of that exception far outweighs any rules that have been set.
You can't copy somebody else's conviction.You won’t have conviction unless you understand the reason behind it.
This is key. Always check executive compensation. You are set up for success if your incentives are aligned
Charlie Munger (vice chairman of Berkshire Hathaway) says,
“Never, ever, think about something else when you should be thinking about the power of incentives.”
If management has got a high percentage of the company, they're incentivized to take the company where you want it to go.
When deciding to invest in a company, see how management is compensated. Read all the filings to see if they have higher options and share allocations at higher prices or are they actually issuing themselves bonuses as they bounce along the bottom?
Pay attention to the language, especially in the 10-K Report. What are they saying?
Do they say: We don't pay ourselves a salary, or we pay ourselves a very modest salary, or our salaries are in line with what the remuneration committee have decided, or they're in line with industry norms?
Also, what about director’s fees? A director’s fee is one of many ways they can describe payments to themselves, or rather not describe payments to themselves. This could be things from a company car and other perks which go in the GNA under other labels. There are other forms of options, warrants, etc. Check the details. t could look like they're picking up $6,000/month, but the truth is they're actually costing the company nearer $30,000.
Another thing to keep in mind is that some CEO's are given an increase in salaries to buy shares in the open market. If you were on a normal salary you would not be able to, or willing to buy in the open market, but it's good optics and they may have persuaded the company to pay the salaries as they are.
The Upton Sinclair quote, "It is difficult to get a man to understand something when his salary depends upon his not understanding it." This is something to pay attention to. Where you've got the opportunity to speak with the consultant involved. The consultant is going to tell you what you want to hear 9 times out of 10.
Promotion Vs Execution
Sometimes you can go in on a set of assumptions and find out the management has different aims. If that’s the case, never expect management to tell you where things actually stand because it's not in their best interests.
There are two types of people; those who think in terms of cyclicality and those who think in terms of linear exploration.
This is important to understand because as we progress in a bull market, everyone moves towards linear exploration but it is those people who usually end up being the victims.
As Paul Singer said, “It’s best to think of financial markets as examples of mass human behavior."
Human psychology drives everything. As markets continue to climb, people believe the latest narrative that justifies everything continuing as is. When you're making money, you'll be inclined to want to believe it.
It is crucial that you don’t fall into this pattern of thinking.
You should always have your basic exit plan and not deviate from it.
Do the responsible thing and not be involved in that last blow off top; you've got to watch other people get rich and know that these things don't end well. It’s the history and cyclicality mix of knowing what's happened before.
If you look at a long enough time frame, everything always goes through cycles. We had peaks in financial assets or resources and it usually rotates to real resources or commodities.
Remember inflation in the 70’s. Nowadays, people make decisions based on assumptions that we will never see inflation like that again, and by making those decisions they make the system fragile and when inflation shows up we get a similar result as we had last time around.
If you look at a long enough time frame, it's people essentially repeating their behaviour and when they’ve forgotten the past, they will repeat it again.
“Rule number one: most things will prove to be cyclical. Rule number two: some of the greatest opportunities for gain and loss come when other people forget rule number one.” - Howard Marks
Okay, so what next?
Can you confidently say that you have positioned yourself to get lucky? If not, re-read this article and take a look at how each point can be transferred to your current investments.
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