The Seven Secrets of Successful Speculation

Written by Nicholas Vardy, CFA

Thursday, 05 September 2013 01:00

"Speculation" has an image problem.

Index fund pioneer John Bogle recently wrote a book on "The Clash of Cultures: Investing
versus Speculation," where he trashed the idea of trying to make money by doing anything else
besides investing in an index investment fund (presumably from the Vanguard firm that he
founded).

And if you are an investor, he is right.

I invest in many Vanguard Index funds on behalf of my clients at my firm Global Guru Capital.

At the same time, I offer my newsletter subscribers regular speculative opportunities in my

trading services, Bull Market Alert and Triple Digit Trader.

Unlike John Bogle, I think you can be both an investor and a speculator and be profitable
doing both.

First, let's define our terms.

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The Seven Secrets of Successful Speculation

Written by Nicholas Vardy, CFA
Thursday, 05 September 2013 01:00

Speculation is the rapid trading of financial instruments of all types in the hope of big short-term
gains.

Investing is buying shares for long-term future financial return.

Today, you'll find thousands of articles and dozens of books lauding the long-term "investment"
approach of the world's #1 investor Warren Buffett.

But you'll find relatively few on "speculation" the approach of many hedge funds and
exemplified by the world's #1 speculator, George Soros.

With that, below are the "Seven Secrets of Successful Speculation," as I set them out at a
recent Money Show presentation in San Francisco. You can download the presentation by
clicking here.

And you can see an actual recording of the presentation on the Moneyshow.com website, by
clicking here.

Secret #1: Accurate Predictions Have Nothing to Do With Successful Speculation

As Nils Bohr, the Nobel Prize-winning physicist observed:

"Prediction is hard, especially about the future."

It sure is.

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The Seven Secrets of Successful Speculation

Written by Nicholas Vardy, CFA
Thursday, 05 September 2013 01:00

A whole new discipline of modern finance has emerged over the past 50 years dedicated to the
idea that economists and business school professors can explain the rhyme and reason behind
daily stock market gyrations.

Despite these many efforts, even Nobel Prize-winning efforts, the disciples of modern finance
have been remarkably unsuccessful.

My favorite story involves Stanford Professor Bill Sharpe:

In 1987, a reporter asked him to explain the stock-market crash.

His response?

"It's weird."

His mother called him on the phone to berate him:

"Fifteen years of education, three advanced degrees, and all you can say is, 'It's weird?'"

Sharpe went on to win the Nobel Prize in Economics in 1990.

Contrast that with the "street smart" approach of speculator George Soros, who has said:

"My approach works not by making valid predictions but by allowing me to correct false ones."

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The Seven Secrets of Successful Speculation

Written by Nicholas Vardy, CFA
Thursday, 05 September 2013 01:00

That's a surprising even shocking conclusion.

The #1 speculator in history does not attribute his success to his ability to predict the future
movements of financial markets.

His secret is his willingness to admit and correct his mistakes.

Secret #2: Risk Control is Job #1

Managing risk is the real secret behind winning and staying in the game of speculation.

As Bruce Kovner put it:

"In real estate, the key is location, location, location. With money management, the key is risk
control, risk control, risk control."

And, again, that means focusing on what to do when things go wrong.

As Alan Raphael, one of George Soros' deputies put it many years ago:

"When George is wrong, he gets the hell out. He doesn't say, 'I'm right, they're wrong.' He says,
'I'm wrong,' and he gets out, because if you have a bad position on, it eats you away. All you do
is think about it-at night, at your home. It consumes you. Your eye is off the ball completely. This
is a tough business. If it were easy, meter maids would be
doing it."

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The Seven Secrets of Successful Speculation

Written by Nicholas Vardy, CFA
Thursday, 05 September 2013 01:00

Hedge fund managers who ignore this key insight inevitably blow up their portfolios.

Former Soros fund manager Viktor Neiderhoffer ignored these lessons repeatedly and his
investments blew up no fewer than three times.

His creditors literally came to his house and took away his furniture.

Secret #3: Size Matters

Bet size is the single most important (measurable) aspect of successful speculation.

Poker players seem to know this instinctively. If they are dealt a bad hand, they throw in their
cards quickly. If they are given a good hand, they up their bets.

No wonder they tend to make the best traders.

The impact of bet size is hard to quantify.

But trading coach Van Tharp has said that bet size accounts for 60% of your trading success.
Exits account for 30%, while your actual bet or prediction accounts for merely 10%.

You see this in George Soros' biggest trading successes. Just prior to September 16, 1992, the
day Soros "broke the Bank of England," he famously chided his deputy Stan Druckenmiller for
his small position, telling him, "It takes courage to be a pig!"

Thanks to Soros' upping his bet, he made $1 billion in a single day.

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The Seven Secrets of Successful Speculation

Written by Nicholas Vardy, CFA
Thursday, 05 September 2013 01:00

Secret #4: Successful Speculation is 100% Psychology

Psychology is by far the single most underrated aspect of trading.

You'll be surprised to learn that just as 7 tall basketball players have an advantage over their 5
10" counterparts, most successful speculators have a certain personality type.

Specifically, studies have shown that 55% of successful traders are INTJs (Introverted,
Intuitive,Thinking, Judging) on the Myers-Briggs scale.

Yet INTJs make up only 1% to 2% of the general population.

Physical attributes play a role also. As John Coates of Cambridge University has shown, if you
got a high dose of testosterone in your mother's womb, your ring finger is longer than your index
finger.

Coates' studies have shown that "not only did traders with long ring fingers make on average six
times more money, they survived more years in a cut-throat world which weeded out the weak
and unprofitable."

Secret #5: Think Differently

It pays to think against the herd.

Hedge fund great Michael Steinhardt talks of "variant perception" a perception about a
market that is a variant from the consensus.

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The Seven Secrets of Successful Speculation

Written by Nicholas Vardy, CFA
Thursday, 05 September 2013 01:00

That's the kind of insight that allowed even a value investor like John Templeton to make $80
million by shorting Internet stocks in 1999.

He called it "the easiest money I ever made."

Secret #6: Successful Speculation is a Mess or a Work of Art

Successful speculation is a messy, messy business.

As one Soros colleague put it:

"[Soros is] the first one to tell you that sometimes his actions... look like the most rookie, odd-lot,
wrong way kind of thing, selling at the lows, and buying at the highs. But it's much easier to
understand in light of his avowed mission: to be able to come and fight another day. He says: "I
don't want to wake up broke."

Bruce Kovner uses a more elegant metaphor of composing a piece of art.

"This is a complex game we are in and the edges are subtle. It's not so much about being right
all the time but rather about being able to adapt and find a strategy that works. I'm wrong a lot.
While the analogy may be pushing it, you can think of a painter painting many brush strokes. He
can be wrong a lot; no one stroke is right or wrong. We are constantly painting a picture."

No matter which metaphor you choose, those big profits come at the price of big ups and
downs.

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The Seven Secrets of Successful Speculation

Written by Nicholas Vardy, CFA
Thursday, 05 September 2013 01:00

And the process ain't pretty.

Secret #7: Market Analysis Has Nothing to Do With Successful Speculation

The final secret of successful speculation is really the same as Secret #1.

Fans of George Soros laud him for his remarkable insights into the market.

As Barton Biggs wrote of Soros' attempt to explain his secrets in "The Alchemy of Finance:"

[This] is a seminal investment book... it should be read, underlined, and thought out page-by
page, concept by-idea. He's the best pure investor ever... probably the finest analyst of the
world in our time."

Yet, Soros' own son Robert, had a different view.

"My father will sit down and give you theories to explain why he does this or that. But I
remember seeing it as a kid and thinking, Jesus Christ, at least half of this is bullshit, I mean,
you know the reason he changes his position in the market or whatever is because his back
starts killing him. It has nothing to do with reason. He literally goes into a spasm, and it's his
early warning sign."

Yet again, Soros' secret is his willingness to admit and correct his mistakes.

So there you have it...

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The Seven Secrets of Successful Speculation

Written by Nicholas Vardy, CFA
Thursday, 05 September 2013 01:00

Learn and put into practice these secrets and you'll have an edge over 99% of traders in
the financial markets.

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