Chapter 2
Warren Buffett
Warren Buffett says that your two best ways to succeed financially is to increase your earning power or to own a great business. He says that the best doctor, lawyer, plumber, contractor and so on will always be able to earn from their industry. It is hard to become the best at anything. But with study and practice you can become good at investing in businesses. The easiest way to do this is with single stocks.
The 80/20 Rule
The safest way to trade a core satellite strategy is to keep eighty percent of your stock market capital in your core investment and twenty percent in your satellite investment. If your satellite ratio goes higher be aware that your portfolio has become much riskier.
Single Stocks as Satellite
If you look at any given year you will see that some stocks returned hundreds or thousands of percent returns. These stocks are rare but they give off certain signals when they begin to rise. Here are the signals…
Momentum
When I was a doctoral student at the University of South Carolina I had to read countless research papers in finance. One paper in particular is responsible for making me a stock market millionaire. This was the work by professor Sheridan Titman at the University of Texas at Austin. He published a paper in the Journal of Finance with Narasimahn Jegadeesh entitled Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency in 1993 in the journal of finance.
This paper shows that an investor could get double digit returns buying stocks that are trending upward. It also showed that stocks that trend downward have to be sold. I told you before that the S&P 500 returns 9% per year. This paper explained to me why Warren Buffett averages nearly 20% per year. He buys stocks that trend upward.
I realized then and there that I needed to master reading stock charts so that I could see which stocks are trending upward and which are trending downwards. This was the day my life changed for the better as a stock investor and call options trader.
Volume
I discovered an important research paper by finance professor Yakov Amihud in 2002 in The Journal of Financial Markets entitled Illiquidity and Stock Returns: cross-section and time-series effects. He showed that illiquidity precedes high returns. His illiquidity measure interacts with price trend and share volume.
This was a jaw dropper for me. It meant that I had to learn not just how to read the price trend in the upper part of a stock chart. I also had to learn how to read the daily volume bars at the bottom of the chart.
Price and Volume
Another paper that proved to me that I was on the right path was published in 2000 in the Journal of Finance by professors Lee and Swaminithan at Cornell and Stanford Universities. The title of the paper is Price Momentum and Trading Volume.
They showed a low and high price and volume cycle in the charts that was not just high yield but highly statistically significant. This was another sign post that was on the road to success in the stock market.
Daily, Weekly, and Monthly Price Charts
Price charts have an upper part and a lower part. In the upper part the daily change in prices can be displayed as bar charts or candlesticks. The easiest to read are the open, high, low, and close charts. These allow you to see how the auction process on the stock exchanges unfolds throughout the day in a compact shorthand graphic. The bottom of the chart shows the total volume for the day.
I normally check my charts and record the daily market update for the Stock Market Trading channel in the morning. This is because volume is a lagging indicator. I don’t get to see the true volume until after it opens the next day. I spend most of my time looking at daily charts. But anytime I find a new stock up trending on a burst of volume I make sure to look at the weekly and monthly price charts as well. You will be amazed to discover that many charts that have a good daily pattern look horrible on a weekly and monthly chart.
Always start with the chart to see how prices and trading volumes change over time. Most people do the opposite. They listen to the news and try to predict price changes. There is far too much irrelevant news to make the news tradable. The chart, however, ALWAYS tells you the truth. If you know that there is a big up or down move in a particular stock or index then when you pay attention to the news you are far more likely to piece the puzzle together hours or even a few days after the move. News is useful only in the rear mirror looking backward in time. If it doesn’t make the market move then the news piece is unimportant. Or as Jimmy Buffett signs it, “important, useless information!”
Portfolio Concentration
A big secret to the success of the most profitable fund managers today is portfolio concentration. There are many portfolio theories. The most known and taught is the capital asset pricing model called CAPM. This model is based on diversification research by Harry Markowitz and Eugene Fama at the University of Chicago. Both men earned Nobel prizes for their work.
The concept is extremely simple. In buying a large basket of stocks the investor is protected from a major loss on any single investment. The idea behind CAPM is that the investor should buy the market portfolio which is theoretically every investment on Earth. This is not practical so the actual application of CAPM involves buying an index.
The most common index used is the S&P 500. This is an indexed fund in an employer sponsored 401k that tracks the S&P 500. It is VFIAX in my wife’s 401k. There are big disadvantages to indexed mutual funds. They only allow you to buy or sell at the end of the day and they do not have options.
For investors who have self directed accounts the most common fully diversified instrument is the spider SPDR S&P 500 exchange traded fund ETF. And this is the best option for your core portfolio when you are building wealth.
However there exists another much lesser known arcane theory of portfolio management based on a Friedman Savage utility curve. This research gave rise to a portfolio model of concentration by Markowitz as well as prospect theory by Israeli psychology professors Daniel Khaneman and Amos Tversky. Each received Nobel prizes in economics for this body of academic work.
Mohnish Pabrai learned from Warren Buffett and holds no more than 10 Stocks that are the best he can find. Warren Buffett tends to hold just 5 Stocks that are the best he sees in the market. Charlie Munger invests in just 3 stocks and is the partner of Warren Buffett. There are many others who attribute their success to portfolio concentration and you can read about them in the book Market Wizards by Jack Schwager.
A concentrated satellite portfolio of either shares or calls is an aggressive way to build wealth. Combining a core and a satellite portfolio gives an investor the best of both worlds, wealth protection on one side and possible high yields on the other. By restricting your satellite portfolio to no more than 20% of your initial portfolio you protect yourself from getting wiped out in single shares of stock or call options.
Kelly Betting
Prospect Theory also uses the math of The Kelly Size Formula developed by a Bell labs engineer working together with one of the most famous professors of statistics. The theory of portfolio concentration says to buy more of an asset the more assurance you have that it will rise. A number of the best known investors concentrate their portfolio.
Nikolas Darvas
Nikolas Darvas wrote a book in the 1950s entitled How I Made $2,000,000 in the Stock Market. I kept reading about it in bestselling stock investing books such as Market Wizards by Jack Schwager. Jack interviewed some of the biggest names on Wall Street back in the nineties when they were smaller. Guys like Paul Tudor Jones. Anyway, one of these market wizards highly recommended the book by Nikolas Darvas so I bought How I Made $2,000,000 in the Stock Market and read it.
The hair went up on my arms when I discovered that this Hungarian economist who was also a world renowned professional dancer made millions trading the stock market with momentum, trend, and volume just as these recent studies have recommended. This gave me even more faith that I had discovered the right path in the stock market that gave me the best shot at making money.
The Disappearance of the Universe
Years ago my friend Van Tharp was recommending to his Super Traders the book A Course In Miracles. I bought the book and started reading it. It was a very strange book. It seemed to be a mix of Christianity and Buddhism. Van said it was good for getting the ego out of the way to trade better. It was like reading Greek. I had to stop reading it because I was getting nowhere with it and was in the middle of my PhD studies.
My now deceased mom was a huge fan of the psychologist and spiritualist Wayne Dyer. Nobody would go with her to the big Hay House New Age conference in Las Vegas. She was stressed out because they wanted her to sign up for workshops in advance. She shouted at me to do it so I picked two random workshops quickly from the list of conference side events. The first workshop was utterly useless about indigenous spirit guides by a guy who did not seem to know what he talked about. But the other workshop I picked was by Gary Reynard talking about his new book The Disappearance of the Universe. I bought his book and discovered that it explained A Course in Miracles.
Thanks to Gary’s book I now understand A Course in Miracles. In Disappearance of the Universe two ascended masters appear in Gary Renard’s living room to impart wisdom. Hey, I warned you this stuff is strange. Gary is also a stock and options trader. His ascended masters tell him that he will get better returns with a trend following system. Albeit strange, this was further confirmation that my trend following system made sense.