sline was busy, or, worst of all, they were engaging in an activity they were unwilling to interrupt by indelicately answering the telephone?
During the GameYou have picked your spot, you have decided how much risk to take, you havelaid plans for every possible scenario, you have enough in reserve to keep youfrom going under, and you have your equipment and backup plan in order.Now you have to play the match; and in my book, the first blow is nine-tenths ofthe game.Win the First PointOn the court: In squash, the accepted strategy used to be to save the best, mostpowerful serves for the last few points of the game. My way was to hit the hardserve for points at the start, thus getting off to a lead that my opponent couldnot overcome. Doing so can lower an opponent’s self-confidence and encourage him to take risks to catch up.In the market: To reduce the chances of starting out with an immediate loss,consider using limit orders. For example, you might buy at 0.25 percent belowthe bid and sell at 0.25 percent above the asked. Or buy 5 percent below the current market price. I used to like to place my buys at 1/8 above the round numberand sell at 1/8 below, a tested method for profit when I wrote on the subject inthe 1960s with M.F.M. Osborne, the Pasteur of the field. However, fast-movingday traders tell me that these days, this strategy is naïve, and they have ways ofmaking fixed-rule followers of the old school like me eat my own rules.Maintain a Strong Base of OperationsOn the court: Other things being equal, the best position in all games seemsto be the center. Being in the center minimizes the longest distance you have
286 Practical Speculationto travel to hit an opponent’s shot. I am not graceful, and when someonewatched me play for the first time I would invariably hear “That’s Niederhoffer?” sotto voce in the stands. But after the game, it would be, “He’s not evensweating.”In the market: Maintain a financial position that lets you maneuver easilyinto good opportunities. Take a lesson from chess master Bobby Fischer,whose favorite proverb was, “I never want to get in a position where I can’tput my hand around all my pieces.” A hand can fit around 10 or 15 stocks,and that is enough to achieve all the reasonable benefits that diversificationcan provide. This does not conflict with investing in index funds, where lowcosts, diversification, and the long-term forward movement of the marketwork in your favor.Do Not Create CrisesOn the court: If you have the edge, do not take risks. Do not force your opponent to hit good shots. If you force him into a crisis, he may rise to the occasion and come up with a winning shot. For example, if I were to hit a dropshot, my opponent could lunge and hit a very hard shot that I might not beable to return. The same thing holds in poker. If you are a better player thanyour opponent, the last thing you want is to play him a hand where you bothhave all your chips in but you have a very small edge. He just might draw thelucky card.In the market: Never put all your chips on one thing, no matter how good.Failure could keep you out of the market, and there is always an edge for youin the market if you buy and hold, derive your own method, or follow one ofours. Once you have an edge, maintain it and accumulate steady profits.Rome Was Not Built in a DayOn the court: Play your points one at a time. Do not go for the total win withone shot; games are not designed that way, and trying to do so puts you toomuch on the defense. Break your opponent’s game down bit by bit. First trythe forehand, then the backhand, then the net. Ultimately, you will find aweak spot, and your chance to put him away will arise.In the market: The mouse with one hole is quickly cornered. Do not committoo great a percentage of your assets to one situation. A profit from stocks is
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good. So is a profit from mutual funds, and do not forget the friendly bondmarket.
Hit Them on the Half-VolleyOn the court: The best time to hit the ball is on the half-volley, when it is juststarting to bounce up from the court. The technique works because it lets youtake maximum advantage of the ball’s momentum. Your opponent is not ableto read your next move well, and has less time to recover. My squash rival,Sharif Khan, held a plus record over me because he followed this method, eventhough he often made five times as many errors as I did. Rene Lacoste, mastertennis tactician and businessman, wrote that when he hit every shot on thehalf-volley, his play improved 40 points a set. Today, Andre Agassi owes muchsuccess to such shots.In the market: After a big down day, come right in the nextday to pick up a line of stocks. When the market starts moving up, the shorts will not have time to recover. A test we ranin December 2001 showed that the last 30 times the stockmarket dropped 2 percent or more in a day and then openedlower, the average change from that open to the next openwas up 0.5 percent, with an average variability of 0.25 percent. (But beware the ever-changing cycles. We strongly recommend thatyou test any patterns mentioned in this book before acting on them.)
Come Up FrontOn the court: The least-used weapon in racquet games is to go up front. At thenet, you can hit much sharper angles and force your opponent to run faster andfarther. Too many players spend 99 percent of their time perfecting groundstrokes and just 1 percent of their time on the net game. In fact, the best way forthe average player to improve is to develop a net game, as the benefits and rateof improvement are much better there.In the market: Train yourself to react instantaneously to opportunities.That will give you the greatest chance of making a fast profit. But be surethat you do not follow the herd in trying to react to a news announcement, asthe big boys, the market boys, and top predators are likely to get there aheadof you.
288 Practical SpeculationAttack on Both SidesOn the court: Create pressure on both sides. Good players often attack on oneside and then the other. By forcing the opponent to defend on both sides, youcan often move in for the finish.In the market: An initial rise is often followed by a decline that gives way inturn to a final rise. On the 193 occasions in 1994–2001 that S&P 500 futureswere up from close to 11 A.M. and down from 11 A.M. to 1 P.M., the expectedmove from 1 P.M. to the close was 0.2 percent, with a variability of about halfas much and a batting average of .530.Be Aware of Changing CyclesOn the court: Between games, your opponent will adjust his strategy to yourplay. In tennis, if you have been staying back on the baseline after your serve,he will expect you to keep doing that, so surprise him by coming up to the net.(But don’t change during the middle of a game if you are winning.) TomWiswell, a longtime world checkers champion, once said: “The wise playercan see the handwriting on the wall before there is any.”In the market: After trend-following has worked for a while, be prepared toreverse. After reversalists like me have had their day, be prepared for a majortrend. The winners in one month are the losers next month, according to astudy I made of trend-following funds versus reversal fundsduring the 1990s. The average difference in performance was4 percent.Pick Up the PaceOn the court: At the beginning of a game, when your opponent is not yetwarmed up, slow drop shots are often effective. Near the end of the match,however, your opponent will be faster on his feet; so make sure all your shotsare much harder and faster than at the beginning.In the market: Reversing is usually grand at the beginning of months or years,but beware of reversing at the end. From the end of 1989 through 2000, a risein S&P 500 futures over the first 11 months of the year has been followed by anaverage change in December of 4 percent. If there was a loss over the first 11months, the expected December move was just 2 percent. At the start of theyear, however, industry groups tend to reverse direction, as professionals
“His shots were not always brilliant, but he patiently waited out long rallies . . .”
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290 Practical Speculationregroup and reallocate to capture all the easy money made by the public during the previous year.
The EndgameOn the court: Whenever I was ahead in a squash game, I liked to imagine thatthe score was against me by my margin of victory. Near the end of a match, I redoubled my energy and never hit slow shots. The opponent is always at a do-ordie stage at that point, and will run his hardest to catch anything without pace.En garde: Jamie Melcher, a former Olympic fencer who now runs BalestraCapital in Manhattan, said he became more cautious about finishing gamesafter losing a number of early matches. As he matured, he said, “I would fencedefensively, determined not to lose a single point, rather than trying to winpoints. This shift in attitude enabled me to win those bouts almost every time.”In the market: The idea reconciling these apparently conflicting pieces of advicemight be to avoid undue risks when you are ahead. This thought is consistentwith the idea of taking gains after a good run in the market. An extraordinarilywise old rule says, “Never underestimate your opponent.” The market might beconsidered the toughest opponent of all. It certainly has been for us.Laurel and I followed our own advice in 2001 by taking profits on severalportfolios after short holding periods ranging from one to three months. Webought a group of beaten-up Internet stocks in late December 2000 and soldthem about a month later after doubling our money. Before the summer crashof 2001, we sold various groups of volatile stocks we had recommended at thestart of the year. In November 2001, we sold a portfolio of below-$5, high ValueLine-ranked stocks, for a 20 percent monthly gain. At the start of December2001, we mopped up a 21 percent profit on a biotechnology portfolio with insider buying, recommended October 25, 2001, to readers of our column.Mopping up by taking profits may have drawbacks. As noted, most of usfind it difficult to make two timing decisions—buy and sell—that both haveabove-average expectations. If academics are right about a 10 percent annualupward drift with random movements from all previous paths of pricechange, you will not be participating when you are out of the market. However, it is always wise to have a cushion while waiting for the market to offeranother chance for an edge. As my chess teacher, Art Bisguier, likes to say:“Do to them before they do to you.” Therefore, we were delighted to accept 20percent short-term gains, regardless of the wisdom of the academics.
15
THE FINE ART OFBARGAINING FORAN EDGE
The handshakes are followed by shouting, the shoutingby insults, the insults by impudence and more insults, shouting, and handshakes until the business is finished.—Joseph De La Vega, Confusion de Confusiones (describing the Amsterdambourse of 1688)1
TRADERS!• Do you have an inordinate tendency to sell at the low of the day and buyat the high?• Do you find yourself behind the eight ball in many of your trades fiveminutes after you get a fill?• Do you ever wonder why the average price you pay is always higherthan the average price for the day and the average price you sell at is always lower?291
292 Practical Speculation• Do you find that the trades you feel most certain of and that you havemost of your chips in are the ones that turn out to be the greatestdisasters?• Have you ever, at the end of a day or a week, thrown up your hands indisgust and shouted, “Damn my broker!”If the answer is “yes” to two or more of these questions, then please readon. You are a candidate for the Kennerhoffer School of Bargaining.Almost everything that happens in life is a negotiation. It starts when oneperson induces interest in another person. They meet and begin a processthat moves them both in the direction of the other side.The most important thing in any negotiation is to create a sense of urgency in the other side that is greater than your own. The purest example ofthis would be the nineteenth-century art of cornering stocks practiced by operators like Jay Gould. Quiet accumulation would be followed bydiscreet tips to the press; the manipulators would unload at the topand the public would be left with plummeting shares. Today, apiece of information hits the market electronically; traders jockey for positionand finally reach a stopping point, a meeting of the minds.To gain insight into negotiating, the directors of the KennerhofferSchool of Bargaining took a train trip to the Wharton School of Business inPhiladelphia to visit Professor Richard Shell, director of the Executive Negotiation Workshop. Shell described the common mistakes people make innegotiating:• They talk rather than listen.• They are unclear about their goals.• They think about minimizing risk more than maximizing opportunity.• They assume that negotiating is inherently unethical and manipulative.His advice:• Always be willing to ask, respectfully, for a better price.• Practice negotiating in everyday life.• Learn about the hidden patterns in the negotiating process so youcan get past the caricatures associated with negotiators and apply yourintelligence.On a practical level, he said, the first mistake in negotiating is to quote aprice first. The second is saying yes immediately. To illustrate the point,Shell told the tale of a businessman kidnapped in Mexico. The kidnappers
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demanded $1 million from his family. The family agreed to pay. An exchangewas arranged, after which the kidnappers immediately rekidnapped the manand demanded another $1 million for his release. This time, the family hireda professional negotiator, who offered $25,000. Eventually, the two sides settled at $250,000, and the businessman was freed.“People often expect to bargain. When they do, and the other side says yesright away, the one who quoted the initial price may feel regret,” Shell said.“When bargaining is done well, people can be very satisfied with even a lousydeal; if it has been set up poorly, they will feel unsatisfied even though theydid very well.”If the other party fears being worse off if the deal does not go through,that translates into leverage for you. The prospect of loss need not be only material; the fear of loss in self-esteem or reputation can be equally leverageenhancing. In the stock market, the speculator does well to keep in mind thatthe movements of a stock are designed to show attractiveness and scarcity topotential buyers.The day after the October 1987 crash, Shell’s late father, a retired MarineCorps general, came home from his job as the head of the Virginia MilitaryInstitute and called his broker. He assessed the panic selling going on andconcluded the situation was not as severe as other crises he had endured during war and depression. He calmly placed orders. As a buy-and-hold investor,he was rewarded with large gains as the market recovered and went on togreater heights.Professor Shell, while emphasizing that he is no expert on stock marketbargains, sees the keys to speculation as “having disciplined goals, definedlimits and understanding of the market, and a fearless willingness to makecommitments when others are faltering.” Not to be forgotten, he adds, is theimportance of “keeping your spouse from cutting off your access to funds.”He hastens to add, however, that in his case the wife knows best—she is ajournalist and the former managing editor of Inc. magazine.Shell often sees loss aversion, the irrational quirk that keeps investorsfrom selling their losers, come up in bargaining. A $5 bill auction illustratesthe principle. A group of people has the chance to bid for a $5 bill. The bidding may start at 10 cents. When it gets to $4.99 and $5, everybody tends todrop out except for two people; the usual closing price is $12. “Both sides arewilling to go much further than is rational because of unwillingness to giveup their investment.”Which brings us to the first lesson at the Kennerhoffer School ofBargaining.
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Watch Your CostsVic’s former partner, Steve Wisdom, uses the following technique whenbuying a car. “The way to beat car dealers, I learned many years ago, is toshow up looking indigent, then fanatically beat down the purchase pricewhile appearing indifferent/uncomprehending of the finance angle. Dealerswill assume they can sell you the car for no margin and make it up onthe back end by putting you ‘on the chart’ (i.e., expensive financing). Thenshow up the next day in normal clothes, take out your checkbook and buythe car for cash.”Steve’s method can be directly applied to the market. A similar techniquehas been adopted successfully by George Soros, who, to hear him tell it, hasnever had a successful trade in the market. When Vic used to trade for him,Soros would bemoan his mistakes every day. At the end of each year, at theirannual tennis game, Vic would ask, “How bad was it?” Soros would sheepishly smile and murmur something like, “Oh, we were up 87 percent.”In all candor, Vic has never had a satisfactory day of trading either. If Vicmakes money on a particular day, it is never enough; he should have tradedmore heavily. If he loses money, it is even more terrible because he has sixkids to support.The point is, always let your counterparts know about your bad trades.Perhaps they will accommodate with you with a better fill next time, just tokeep you in the game. More important, if they feel that you are in the chips,they may not be able to resist the all-too-human tendency to endeavor to relieve you of some of the overplus thereof, as they used to say in the nineteenthcentury.Someone once asked J. Paul Getty, the richest man in the world in the1960s, why he installed a pay phone in his London home. He answered that abusinessman makes a few cents on every dollar of revenue, on average, afterpaying suppliers, employees, taxes, and debt holders. If he gets in the habit ofpaying 10 cents more than he receives for each item, he will quickly go out ofbusiness. Not only will he lose everything, but a few hundred thousand employees and suppliers also will be out of work. Like most people, Getty foundit hard to behave differently in his personal life than he did in his business. Sohe ran his personal affairs in a businesslike way and did not pay out an inordinate amount.The world’s richest people today—Buffett, Gates, and Soros—seem to follow a similar path. If they find it useful to be economical in their activities, itis probably good for the rest of us.
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In stock trading, the biggest mistake people make is paying an extra 10cents or 25 cents out of every dollar in revenue they take in. Time after timeVic has had some manager working for him who loses 100 percent of capital.Invariably, the trades of such managers are highly profitable—before commissions and bid-asked spreads. What happens is that the market and theirown money management outmaneuver them. They take in $1, but they payout $1.10. If they trade often enough, that can be significant by the end of theyear, and unfortunately most people do that.Vic has been a relatively active trader for years. During that time, he estimates, he has made well over half a million trades, and has never bought orsold at the market. He always buys at a limit a few ticks below the current bidprice and sells a few ticks above the current offer price. Try it, especially onthe electronic markets, and see if you do not start out with a better feeling.
Pick Your Time and PlaceYou will get a better price if the car dealer wants to meet a month-end quota orwin a prize, and is hungry for a sale. One of the most successful speculators ofour generation, Mr. P himself, often featured in the columns of our editor,Jon Markman, has kindly shared for the benefit of our readers his patentedmethod of buying a Jag on the cheap. He waits until 5 P.M. on Christmas Eve.Then he goes into the showroom:“You must be very tired tonight.” (To initiate a query here is key.)“No, in fact, you’re the first customer I’ve had.” (The dealer’s downfall.)“What’s your best price on that silver model?”“Forty-five.”“Oh my, I’m afraid 35 is it for me. Goodbye.” (Walks toward door.)“Just a minute. I haven’t sold one all day. It’s yours.”“Very good. I need the keys right now. That’s the very car my wife wanted,and she needs it tonight as a special surprise.” (Had the dealer known that inadvance, Mr. P would have had to pay the full price.)Similar opportunities often come up in markets. The bonds have an inordinate tendency to rise at the end of the month, and on days that futures expire. After all the bulls have evaporated, there is often the opportunity toprovide liquidity to the bears at the end of the day.Our anecdotes illustrate two fundamental laws of bargaining that the academics have locked into. When a buyer and seller have room to maneuver tocomplete a trade, who is going to get the better deal? Whoever is more patient
296 Practical Speculationand is willing to take more risk of the deal falling apart. By watching your costsand waiting until the key moment, you make the other side impatient, and thusget the edge. By downplaying your success, you show awareness of your ownfallibility and willingness to let the deal fall apart. These principles are well covered by Theodore C. Bergstrom in an upcoming article for the Journal of Economic Literature, “Economics in a Family Way,”2 available now on google.com,as well as by such books as Bargaining Theory with Applications by AbhinayMuthoo,3 and The Strategy of Conflict by Thomas C. Scheling.4When we write our columns, our editors are always after us to tell readerswhat stocks to buy right now. This is an error, as a close reading of the firstlesson indicates. We often feel we are in the position of King Canute, theViking conqueror of 1,000 years ago whose noblemen demanded that he usehis considerable powers to do something about the poor harvest. Canute objected that just because he had conquered England that did not mean he wasomnipotent, but the nobles would not listen. So he had his throne brought tothe seashore and commanded the tide to stop coming in. As waves lappedover his feet, the nobles presumably got the point.Even on days when we possess the wisdom and resolve of Canute, oureditors demand that we improve the harvest. We therefore came up with apractical application of the principles of bargaining, using IBM as the example. The advantage of choosing a bellwether like IBM is that a large numberof competing market makers are always offering quotes, with the happy result that the typical bid-asked spread is very narrow, perhaps a penny. Beingable to get in and out for 1/100 of a percent minimizes the grind of payingexcessive costs—that inevitable albatross of excessive frivolity on the costside alluded to earlier.What happens when you buy at the close of a day in which IBM declines3 percent and hold two days? It seldom occurs, but over the past decade it happened enough times to give a significant sample, both from a practical andstatistical standpoint.In fact, a 3 percent drop in IBM occurs a little more frequently than oncea month. Table 15.1 shows the average expectation and the number of tradesyou make per year by varying your filter.The results show that you make 0.6 percent after a 3 percent drop, and 1.6percent after a 5 percent drop. You lose about a third of the time. The variability is highly unlikely to have occurred through chance variation alone, about 1in 500.Making 0.6 percent in two days in 8 to 12 months will not make you a Getty,but it is a good start. Before too long, such trades could amount to some seriousmoney—at least enough to pay for your next lesson at the Kennerhoffer School
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Average Profit per Trade after Big Daily Drops in IBM
IBM Trade
After 3% Drop
After 5% Drop
Percent change after 2 daysApproximate number of occurrences
0.6%Once a month
1.6%Once a quarter
Source: Niederhoffer Investments.
of Bargaining, especially since it is free. The value of watching your costs andpicking your times is illustrated. Such trades will make you less hungry.
Keep a Doleful MienTo the question, “How do you do?” Beethoven would often answer, “As well as apoor musician can do.”Norman Lebrecht, The Book of Musical Anecdotes5
Vic’s friend and mentor, Steve “Hobo” Keeley, has a technique that applies toall situations. When buying a product, he invariably puts on a doleful expression and after looking the purveyor in the eye, sighs, “Look, we’re both Godfearing people. How much do you need over cost on this?” Or, “What’s yourbest dealer price on this?”The important thing to remember is that you do not have to take the firstprice quoted.Duncan Coker, an investor friend of ours who has had occasion to bargain with real experts—Third World merchants—says his greatest challengeis getting his opening bid low enough.“I often think I will insult the seller going in too low, but this is not thecase,” Coker reports. “Once when I was looking at rugs in Turkey I went inwith an opening offer half the price I was willing to pay. After many mint teas,we settled somewhere in the middle. Later, a Turkish friend told me that thecorrect opening price was one-tenth of my offer.”Do not worry about offending the seller, or in the stocks bazaar, the market maker. After all, even a transaction below average cost may benefit a sellerwith excess inventory, as the Generation X economist N. Gregory Mankiw observes in Principles of Microeconomics.6
Information Is ValuableCoker’s tale illustrates the truth that not everyone has all the information necessary to make decisions. Information is scarce, and a cost arises in acquiring
298 Practical Speculationit, whether it is direct, is the subscription fee for an investment advisory service, is the opportunity cost of taking the time to read a book like this or obtaina few extra quotes on a car.Bargaining received serious attention from George Stigler, who won theNobel Prize in Economics in 1982 for his 1961 paper on the subject.7 Stigler’spathbreaking theory, in a nutshell, is that consumers should seek informationup to the point that the expected marginal benefits from additional search areequal to or less than the marginal cost. Say it costs you $100 in time and transport to visit a car dealer. Compare the additional reductions you get each timeyou visit a new dealer. When the average of the last two reductions is below$100, then stop searching. Stigler also developed a formula forestimating expected high and low prices based on the assumption that prices would follow the uniform distribution of equallydivided ones to sixes that you get when you throw a single die.Stigler’s paper set off an explosion of interest in the role of information ineconomics that continued for decades. In 2001, the theory of asymmetric information gained three economists the Nobel Prize. It also gained us a 20 percent profit on a group of biotech stocks that we chose because of inside buyingby corporate officers and directors. We reasoned that these insiders must havehad information that outweighed the overwhelmingly bad odds of winningapproval for their product from the FDA.It happens that George Stigler’s son, Stephen M. Stigler, is a friend andmentor of ours. We thought it appropriate to ask Steve whether any of his father’s practical techniques of bargaining had helped him. He wrote that heemployed an effective strategy on his last car-buying trip by taking his wife,son, and daughter along. “My son did the bargaining. He was ready to walk ifthey didn’t come down. My wife and daughter were along to choose modeland color. I was paying, but not until my son gave the nod. The salesmen,managers, and so on, didn’t know who to sell to. We got the car, but they werestill muttering as we left.”
Sex and Bargains Do Not MixOne of Vic’s traders, Patrick Boyle, in his previous career as a hotelier, says herarely admitted to a customer that more than one room was available even ifhalf the hotel was empty. His first price quote was much higher than hethought the customer would accept. “Sometimes the person would pay, and ifthey wouldn’t, they were much happier when the price dropped,” Boyle says.
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“Often I would have customers in the exact same types of rooms, some paying$40, some paying $400.“The greatest mistake people could make was to come in during busy season and say, ‘Please tell me you have a room.’ That automatically tacked anextra $75 on to their room rate. The only bigger mistake was for a young guy tocome in with his new girlfriend. He would never want to appear cheap by bargaining, and that was always worth $100.”Boyle also took advantage of the attractive properties of round numbers,well known to stock traders. “Usually people looking for a room have a pricein mind, for example $200 per night. If you priced rooms a little above roundnumbers like that you could increase profitability, because they would happilypay $210 rather than drive around any more.”Those lessons—the flexibility of price, the undesirability of being eager,and the exercise of care around numbers—are all eminently applicable to buying stocks.“It is important,” Boyle concludes,” to always be friendly. No one wants toreduce the price for someone they dislike.”Remember that it is a free society, and it is not shameful for people to sayat what price under the quoted one they would buy.
16
AN AMIABLE IDIOT INTHE BIOTECHNOLOGYREVOLUTION
The ability to manipulate the genetic codesof living things set off an unprecedented industrial convergence: farms, doctors, drug makers, chemical processors,computer and communications companies, energy companiesand many other commercial enterprises will be drawn intowhat promises to be the largest industry in the world.—Juan Enriques and Ray A. Goldberg, Har vard Business Review(March–April 2000)1
Vic’s 10-year-old daughter Kira talking:“Daddy, tell me a story. About great heroes and what happens to themtoday.”“Very good. You’ve been hearing in school about the heroic exploits inmythology: how Perseus had to cut off Medusa’s head, how Theseus killed the301
302 Practical SpeculationMinotaur, and how Jason sailed to capture the Golden Fleece. Jason had towork like a demon to get it from King Aetes.”“That’s right. First he had to build the Argo with 50 oars. Then he had toround up Hercules and 49 other heroes to stand a chance.”“And then, they had to overcome the water nymphs, the harpies, theclashing islands, the fire-breathing bulls, the armed men who sprang up fromdragon’s teeth, the dragon itself, King Aetes’ pursuing army, Medea’s brother,the sirens, the rock-throwing giant. And Jason had a broken heart from seeinghis father and mother slain on