Taming the Lion — Richard Farleigh

I have many beliefs that went against conventional wisdom, some of which included:

  • Markets tend to underreact, not overreact.
  • Big, obvious ideas offer great opportunities.
  • it is safe to invest with a consensus view.
  • Contrarian trading is usually irrational.
  • It is best to enter and exit the sharemarket at the right times instead of always staying invested.
  • Price trends are well known but underutilised.
  • Chartists are just astrologers.
  • Investment and trading are increasingly similar.

Chapter 1 – Markets

The most common mistake is to assume that investment success is easy.

The starting point must be that market prices are normally right, and that any opportunities can only be found by identifying their cause and understanding how they work.

I believe that in all markets:

  • any genuine opportunity needs to be based on a sound observation
  • big ideas offer big opportunities
  • prices take time to absorb information
  • prices go further than generally expected
  • prices move in trends
  • crisis situations and panic buying and selling occur from time to time
  • investing requires  a sensible approach to risk management
  • analysis requires recognition of both the bullish and the bearish arguments; a cheklist is very useful
  • ‘experts’ are often wrong, and the media oversell how easy it is to make money.

My mistakes

I had no experience and I did all the wrong things:

  • I started with positions that were way too big.
  • I stopped and started a new strategy every few days.
  • I have no long-term view.
  • I didn’t  really understand what was driving the market.
  • I grabbed profits as soon as I could and stayed with losing positions.
  • I listened to the views of other people who probably had no idea either, including brokers and people with fancy charts.

Even now, when I make investments, I have a fear of the markets, and perhaps an underlying scepticism of my ability to outwit them. However, I am convinced that over the years, the fear I first experienced at that time has saved me a lot of money, and allowed me to stay in the business of trading.

I want you to have that same level of respect. I want to convince you that the market can be a horrible place where your money can just disappear very quickly. You’re throwing dice, tossing coins, whatever. There are no certainties and you don’t know what you’re up against.

When you buy or sell in the market you are hoping that the current market price is wrong, that the super-computer is wrong. Now stop for a moment and think how incredible that would be.

So start with a degree of caution. Be like a lion tamer. The lion can be tamed, but only by maintaining a healthy fear of the lion.

I often think of the market as an opponent, a living being to outwit and defeat.

Luckily for us, however, the markets are not always efficient. The most likely reasons that a market fails to operate efficiently are that:

  • All the relevant information is not equally available to all buyers and sellers. An example would be a bargain in the property market that occurs when too few buyers are aware of the opportunity.
  • The buyers and sellers all have the relevant information but do not sufficiently understand the implications of that information.

I was effectively backing market fundamentals versus the government. The fact that even governments, with all their muscle, cannot reverse the market has always impressed me.

Listen and read very critically.

Chapter 2 – comparative advantages

  • patterns and anomalies [vulture]
  • Markets are slow to react to big picture changes
  • Small companies offer more opportunities.
  • Markets go further than generally expected.
  • Markets move in underlying trends

To outperform the market you need a comparative advantage.

My views were based purely on fundamentals. I had no interest in price charts or all the talk in the market about who was buying or selling. I simply talked to economists and made my own opinion.

The process of being forced to identify a comparative advantage, in retrospect, was the best thing that could have happened to me as a trader. It meant that I never had the temptation or ability to slip into ad hoc gambling in the markets. My trading had to be based on some sort logic and discipline.

If you believe you have an advantage, be very clear what it is. Write it down.

Everybody is a hero in a bull market! Psychologists have identified that it is human nature to attribute our wins to our skill, and our losses to our bad luck. Don’t fall for this trap. a rising tide lifts all boats, even the rusty ones. Now some luck is fine, as long as the recipient doesn’t suddenly think they’re Warren Buffett and expect to keep backing the winners. As prices went higher and higher, they increased their investment sizes, so that when the crash came they had far more money at risk than they would have imagined just a year earlier. It ended badly. Profits tempted them in, and losses forced them out.

Never stray from your comparative advantages

For investors to stray from their comparative advantages can also be foolhardy. But occasionally I have allowed myself to stray away from using these advantages, and to do silly trades or investments where I have no advantage. This sometimes happens after a particularly good run of profits when I’ve left overconfident. It is very, very easy to do.

So, having very clearly identified your comparative advantage, you must continually remain certain that all trades and risky investments fit the criteria. Continually filter every decision with that in mind.

Test the advantage over time and make changes slowly

Quick success can also be dangerous. [你以为的天堂往往是地狱,洛克菲勒]

four different types of advantage:

  1. information: face to face meeting are important; third-party opinion, central banks, fund managers, World Health Organisation about SARS. [calm – egg price in Walmart]
  2. original analysis
  3. brokers and bankers have extra information and free insurance
  4. understanding of market behaviour. A flurry of  IPOs and mergers is known to signal the top of sharemarkets; price-sales ratios are a better indicator of future price performance.

Chapter 3 – risk

Over a period of time, even the best investors will inevitably suffer losses. Unfortunately, even good ideas can lose money and bad ideas can sometimes make money. There is inevitably a high degree of chance or luck involved. The most important thing is to manage the risks and to ‘stay in the game’. Investors need to think about how far a price can move in the wrong direction. They also need to diversify, be able to cut losing positions and withstand the stress involved.

if you’ve lost money on an investment, ask yourself questions such as:

  • were you pursuing a genuine opportunity?
  • Did you understand how the market usually works?
  • Did you back a big idea or market anomaly that you had identified?
  • was the potential reward worth the risk?

Wild swings and losses  are uncomfortable, but they may offer the best rewards.

Opportunities may be found in areas that others find uncomfortable. (Others don’t like. Unloved)

For good risk management, the most important thing for me is to always have a rough idea of how much money I could lose if the markets move against me, and I should be able to withstand that loss if necessary.

No market is too risky if the position is not too big.

With the right approach you should be able to do what I used to advise traders to do , and that is to ‘stay in the game’. Do not take too much risk.

(Crocodile Dundee is a fantastic movie. It somehow managed to capture the best of the Aussie spirit and sense of humour.)

I learnt that the hospitality sector is not really a place to expect to make money. It is probably subsidised by investors who are attracted by the lifestyle it can offer. It is fun to walk into your own restaurant or club and hobnob with the customers –  but many investors in the sector take a lot of risk and most fail.

[Always ask] Did you take a lot risk to make a profit?

The risk-taking elements of trading require self-belief and genuine confidence. This is particularly important to handle losses. On the other hand, a big ego is a negative because markets can’t be fooled by bravado.

Good traders are almost always aware of the world around them. Many are news junkies and love following the developments in domestic and global politics.

The ability to use the information … an ability to simplify a complicated subject has always impressed me.

You also need to enjoy what you do. … A level of optimism like this is important. There is a book by Dr Martin Seligman, Learned Optimism, which relates the level of a person’s optimism to their success.

My former boss at Bankers Trust, Bruce Hogan, has a great way of describing how trading pressure increases with the amount at risk. He describes the job as akin to walking a tightrope: it’s a lot harder to do the higher you are off the ground. … Under stress, one error leads to another.

Stopping out is the hardest trade. No-one likes to give up hope. But it is essential in these circumstances.

‘The market can remain irrational much longer than you can remain solvent.’

have a stop loss in you mind when you put on a trade and if the price hits the stop-loss level, always cut if:

  • the loss is threatening to be destructive
  • you are confused about what is going on
  • the fundamentals are moving against you.

Chapter 4 – patterns and anomalies

I have spent my professional life looking for patterns and anomalies.

A good idea can often point to more than one type of investment.

Crisis situations almost always provide opportunities to those investors who can remain calm and who have kept some powder dry.

a falling price triggers more panic selling than it does bargain-based buying. … Even though holding on may be a great trade, they simply cannot take the risk.  …  ignoring their heartfelt pleas not to do so.  … try to consider many different opportunities and don’t necessarily jump at the first one you see. In a genuine crisis, there will be no shortage of ideas.

Short-term interest rates will tend toward the inflation rate plus the economic growth rate.

The economy pushes shares and property in generally the same direction, but with property, the reaction takes longer. (There are always exceptions to rules)

property may be the easiest market

  1. Property prices often lag stock prices
  2. There are not many false trends in property prices
  3. No tax on capital gains on people’s own homes.

chartists are the astrologers of the markets. They use a pseudo-science.

Chapter 5 – big ideas

The big ideas cause big but slow changes in many markets (the big falls in inflation, technological innovation, emerging economies and China’s appetite for raw materials are just a few)

Investors should look for these big ideas and ignore anything that is too obscure

A useful way for those investors to keep an eye on the economy is by a simple checklist of the positives and negatives.

Markets are slow to react to structural influences. Without precedent. Tough to forecast and measure.

Big ideas: china rises, eu fall; Nano; [data; AI]

img_0964

An investor should definitely not try to pick the turns in the market. The idea is almost the opposite: allow some broad consensus to build in the market and invest after the price begins to move. (This style of investing is key to these 100 Strategies and i will develop it further later on.) [?]

Chapter 6 – small companies

There is a greater chance that they are mispriced in the market because there is a big variation in their quality, they are often involved with new products and they are not as widely followed by analysts and investors.

For a small company, the competence of the management is the most important feature. Other things investors need to look at are, of course, the company’s products and markets and its ability to handle growth.

Checklist for small companies:

  1. management
  2. valuation
  3. initial comparative advantage
  4. sustainability
  5. adoption of product
  6. ability to handle growth
  7. route to exit and cash resources
  8. other shareholders
  9. due diligence.

Chapter 7 – price behaviour

the market takes its time to react to big ideas and big changes. All the way along, people are sceptical and they don’t expect the price move to continue, so investors  need to expect the unexpected. They shouldn’t cut winning positions too early, and they should accept that the old price levels are history.

I frequently hear or read comments that suggest a market has gone to far, and that a price is unsustainable. … We need something more logical and reliable.

Hindsight and overconfidence

in retrospect the financial markets can seem quite simple. … we forget that at the time, most of us were very uncertain about what was going to happen.

By buying put and call options simultaneously, I have been able to make profits, not have a clue about which way the price was going, but by simply knowing that it would move significantly one way or the other.

The pattern inspired the expression, ‘Up by the fire stairs, down by the elevator shaft’ to describe the asymmetry of the Australian dollar in the 1980s, when Australian interest rates were relatively high.

if there is a favourable announcement and the market doesn’t rally, it can be a sell signal. Vice versa.

Chapter 8 – The understanding and use of trends in prices

These price trends are a gift! A market that has moved higher is more likely to continue moving higher than to suddenly reverse.

There are solid reasons why trends exist and will persist in the future. Market information spreads gradually, and the reaction is delayed by inertia and scepticism. Economic cycles also help prices move in trends.

Chapter 9 – market timing

So it is not a good idea – unless there is market panic – to buy into falling markets. Being a contrarian means fighting against trends and not acknowledging that markets can go further than expected. … add to winning trades, not losing trades

Sticking with winning trades for as long as possible is the only way to make big wins.

Chapter 10 – avoiding temptation

they have the discipline to know when there are no genuine opportunities and not to take excessive risks.

with a passive portfolio, management and brokerage fees should be kept to a minimum.

sometimes the best trade is no trade at all.

Negotiation is an art. It is true that you get what you negotiate, not what you deserve.

—————–

Richard: Peakhurst – chronic shyness and reluctance to speak – teacher Jan Walker – he was a ghost in class and his self-esteem was not great. He was not doing  well in English, but he was far ahead in mathematics – One of a kind: The story of bankers trust australia 1969-1999, Gideon Haigh – described Richard as ‘one of the most fascinating characters.’

Markets tended to overreact in the short term and underreact in the long term.

“when it didn’t go according to expectations, his disciplines getting out were intense. Even when Richard made losses, I was always impressed with the rigour of his post-mortems. Was it a bad decision? Or was it actually still a good risk-return decision where something of a lower probability happened?”

By 1993 Richard was in his early 30s and earning a seven-figure sum as the star trader.

war was too risky for a bet and i had cashed in my chips –  I was out of the market.

Investment can be nerve-racking and exciting. Even when there is confusion everywhere, it is possible to find ways to succeed by using logic and by understanding how markets work.