Livermore had only written one book right before he died: How to Trade in Stocks: The Livermore Formula for Combining Time Element and Price (Livermore, 1940). One key message of the book is that the market is always right. Many investors make the fatal assumption that they could be smarter than the market, when in fact the market is often smarter than them. To illustrate this, Livermore gave a very interesting example.
After the breakout of the Second World War, the U.S. stock market was very bullish and many shares were selling at new high prices. Many industries were enjoying a great run―except the steel companies. They were unable to overcome a peak which they had reached in September 1939. At the time, no one could give a valid explanation for it, but the steel companies kept lagging. It was not until the middle of January 1940, four months later, that the public was given the facts. It was announced that, during that time, the English Government had disposed of over 100,000 shares of U.S. Steel, and in addition Canada had sold 20,000 shares. When that announcement was made, the prices of the steel companies had already fallen much from their highs, whereas the prices of other industries only wobbled a little.
This incident proves the futile effort of trying to find a good “reason” to buy or sell a given company or industry. If you have to wait till the reason to be given to you, then you will have missed the proper time to act! The only “reason” which an investor should ever want to be pointed out to him is the action of the market itself. Whenever the market does not act in the way that you think it should, it is enough reason for you to change your opinion immediately. Remember, there is always a reason for the market acting the way it does, but you are very unlikely to become acquainted with that reason until later, when it is too late to act on it profitably.
Another major mistake in investing is to buy cheap securities just because they are considered “great companies”. Many so-called “buy and hold” investors often hold onto losing positions for no other reason than that their shares have been paid for. They tell themselves, “I buy securities for an investment. If they go down, eventually they will come back up.”
Livermore pointed out that no companies, however large and famous, are safe enough to be held forever. In 1920s, it was considered that investing in railway companies were even safer than depositing money in a bank. Many of them were selling above $200 a share, and all were paying good dividends. About forty years later, in 1940, many of those companies were selling below one dollar. Therefore, great “investments” tumble, and with them the fortunes of so-called “long-term” investors.
When it comes to stock selection, Livermore followed one golden principle: buy the strongest companies in the strongest industries, and conversely, sell the weakest companies in the weakest industries. Avoid buying the weak industries entirely, particularly the lowly priced companies without a firm financial foundation, because when a declining movement does set in, these weak securities are the first to go, and recover with the greatest difficulty. Instead of buying slow-moving blue chips which usually go nowhere, it is better to buy the market leaders of sound fundamentals. These are usually the strongest companies in the strongest industries, which will go up the fastest and farthest in a bull market, and hence from which to derive the greatest profits.
Still, conditions change all the time. Even companies with the strongest growth will slow down one day. No matter how great these “investments” look when they were bought, constantly changing conditions in the economy will bring these companies a new set of challenges that would jeopardise their earning capacity, and sink into oblivion by either going into receivership or struggling to make ends meet for years.
Therefore, a good investor has to maintain a flexible mind by adjusting his plan if things are not going the way he expected. If you are walking along on a railway track, and you see a train coming towards you at full speed, it is foolish to keep walking and hope that it will be fine. Instead, get out of the track immediately, and you can always jump back after it has passed. The same goes in the stock market.
This principle of jumping out when you are wrong is easy to understand, but many investors actually do the opposite. Suppose you buy a security at $50, and the next day it falls to $48 and gives you a two-dollar loss. Normal you would not fear that the next day it would drop a few dollars more. No, you would regard it as a temporary reaction, and convince yourself that the next day it would recover its loss. Yet it is the time that you should be worried, because the two-dollar loss could be followed by two more the next day, or possibly five or ten within the next week or two. That is when you should be decisive and close out your position.
On the other hand, let’s say you buy another security also at $50, and the next day it has a quick run up to $52. Normally you would immediately worry that if you don’t sell immediately, the next day you may see your two-dollar profit fade away, so you will usually get out of your position for a small profit. However, it is exactly the time to keep your impulse in check. Why should you worry about a two-dollar profit which you did not have one day before? If it can go up two dollars today, you might go five more tomorrow, and perhaps ten within a week. As long as the market action does not worry you, do not be in a hurry to take a profit. Have faith in your conviction and stay with it, and let it develop into a very large profit.
In order to succeed in the stock market, one must maintain a proper perspective of the market by keeping an eye on the big picture, and only allow oneself to act when the conditions are favourable. Livermore recalled an investor who lived in the mountains of California and he always received this quotes three days old. He did not trade very often and only called his broker in San Francisco a few times a year. Yet, despite his extreme isolation from the market, he was able to draw abundant amount of funds consistently from the market.
When he was asked how he was able to do it, the investor explained:
“Real movements do not end the day they start. It takes time to complete the end of a genuine movement. By being up in the mountains I am in a position to give these movements all the time they need. But a day comes when I get some prices out of the paper and put them down in my records. I notice the prices are not conforming to the same pattern of movements that has been apparent for some time. Right then I make up my mind. I go to town and get busy!”
Every trader is possessed with an impatience for constant activity, but good opportunities do not come by every day, so a good investor must have the patience to await the high probability setups to occur. Livermore also commented that, whenever he had the patience to wait for the market to arrive at a pivotal point before he started to trade, he always made money in his operations. Incidentally, every time he lost patience and failed to await the pivotal points and fiddled around for some easy profits in the meantime, he would lose money.
At one point in his life, Livermore was very bullish on cotton. It was hanging around twelve cents, running up and down within a moderate range. He was so convinced that this judgment was correct that he did not wait for a proper time to enter the market. He bought fifty thousand bales. It moved up, but as soon as he stopped buying, it began to settle back to where it was. Livermore got out of his position and it stopped going down.
Sometime later, Livermore thought this time he had got closer to the proper time, so he bought again. The same thing happened: he bid it up, only to see it going down when he stopped. He did this several times until it costed him a lot of money, and he finally quit in disgust. However, not very long after he was done with it, cotton began to go up and never stopped until it got to a price which would have meant a killing for Livermore―if he hadn’t been in such a great hurry to start.
This experience taught Livermore a very important rule. In a narrow market, when prices are not getting anywhere, there is no sense in trying to anticipate what the next big movement is going to be up or down. The thing to do is to watch the market to determine the limits of the prices, and make up your mind that you will not take an interest until the price breaks through the limit in either direction. An investor must never argue with the market or ask it for reasons or explanations. Such practice does not pay dividends in the long term.
Lastly, there is one very important skill in successful speculation which was considered by Livermore as the hardest to learn. It is the patience to sit with the long-term trend and resist the temptation of taking profits too early until the trend is over. He famously remarked:
“It was the change in my own attitude toward the game that was of supreme importance to me. It taught me, little by little, the essential difference between betting on fluctuations and anticipating inevitable advances and declines, between gambling and speculating. I think it was a long step forward in my trading education… that the big money was not in the individual fluctuations but in the main movements that is, not in reading the tape but in sizing up the entire market and its trend.
“And right here let me say one thing: After spending many years in Wall Street and after making and losing millions of dollars I want to tell you this: It never was my thinking that made the big money for me. It always was my sitting. Got that? My sitting tight! It is no trick at all to be right on the market. You always find lots of early bulls in bull markets and early bears in bear markets. I’ve known many men who were right at exactly the right time, and began buying or selling stocks when prices were at the very level which should show the greatest profit. And their experience invariably matched mine, that is, they made no real money out of it. Men who can both be right and sit tight are uncommon. I found it one of the hardest things to learn. But it is only after a stock operator has firmly grasped this that he can make big money. It is literally true that millions come easier to a trader after he knows how to trade than hundreds did in the days of his ignorance.”
Even though Livermore suffered from mental problems in the final years of his life, and sadly ended up killing himself, he still left behind a lot of wisdom which could be translated into millions of profit in the market through correct application. I definitely recommend his writings to those who are interested in making money in the market.
Reference:
Lefèvre, E. (1923). Reminiscences of a Stock Operator. New York: George H. Doran Company.
Livermore, J. L. (1940). How to Trade in Stocks: The Livermore Formula for combining time element and price. New York: Duell, Sloan & Pierce.
Lefèvre, E. (1923). Reminiscences of a Stock Operator. New York: George H. Doran Company.
Livermore, J. L. (1940). How to Trade in Stocks: The Livermore Formula for combining time element and price. New York: Duell, Sloan & Pierce.
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