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Data for chart courtesy: Daily Graphs Figure 2.1 The stock market mini-crash of October 13,1989. In a single day, the Dow Industrial dropped 191 points, the second largest drop in history. On the same day, the Transportation index finished over

78 points, sparked by the UAL financing problem.

Assume for the moment that savings is required for growth, and that this is true not just in a specific case such as buying a house, but for all individuals and groups engaged in economic activity -that it is a principle. What does this tell you in terms of the markets? The answer is "Plenty!" It tells you, for example, that leveraged buyouts cant go on forever, especially when the stock market is at peak levels. A corporation with debt far exceeding the value of its cash reserves and liquid assets is espec ially jeopardized in a general economic decline (a recession or depression). Such a company is totally dependent on future income or additional credit availability for its economic survival. In an economic downturn, a highly leveraged company would be hit with both decreased sales and increased credit costs. Its survival, its potential for future profitability, and therefore its value as a potential investment would be questionable if you consider the risk as well as the potential reward.

Similarly, the principle can be applied to evaluating the economy as a whole. If growth requires

savings, then the producers of a nation must create more wealth than is aggregately consumed and invest the balance to produce goods and services in the future. When the federal government continually operates at a deficit, it is financing todays programs at the expense of tomorrows products. Only one of two possibilities exists. Either (1) Americans will produce so much more in the future that the government will be able to confiscate a portion of what would have been their savings to pay for the debt and still leave enough for investment; or (2) there will be a decrease in growth, or rate of growth, as the government taxes or inflates away the existing wealth of producers. More importantly, if the government attempts to continue operating at a deficit, the attempt to spend what does not exist will eventually lead to financial disaster-a severe bear market.

Whether you agree at this point with the truth or falsehood of the princ iple in this example isnt the point. The example illustrates how one sentence, one bit of knowledge, leads to a whole chain of reasoning and conclusions. What initially seems enormously complex is made relatively simple by understanding the underlying principle.

In any endeavor, making good decisions requires the development of essential knowledge such that every observation can be related to the fundamental ideas governing the cause-and-effect relationships involved. In the financial markets, this means d iscovering the principles of price movements and price trends. It means understanding the nature of markets in general and defining the distinguishing characteristics that separate one market from the next.

To develop this knowledge requires a constant process of relating concrete events to abstract ideas and vice versa, projecting the long term based on an analysis of todays events, and understanding todays events according to the same ideas applied in the context of both recent and past history. I call this process thinking in principles, or thinking in essentials.

It is one thing to say that you should think in principles; it is quite another to identify those principles. In reading books and magazines ab out the financial world, you can find almost as many opinions as you can find "experts," and many of them will be diametrically opposite. Part of the reason for this is a problem of definitions. Consider some of the terms that we hear every day: bull marke t, bear market, trend, depression, recession, recovery, inflation, value, price, risVreward, relative strength, and asset allocation, just to name a few. Most people in the financial world would recognize these teens, but few would actually be able to define them precisely. But defining them isnt just an abstract exercise; it is an essential step to understanding the markets and identifying the principles that govern them.

For the remainder of this book, Im going to present the essentials neces sary to understand the markets and profit from the knowledge-the principles of speculation that youll need to be a successful market player.

If you read about many of the great traders in history, youll find that a very large percentage of them blew out (lost all their money) at least once, and some of them blew out two or three times in their career. Add to this the fact that only abut 5% of commodity traders make money, and you have to wonder. "Whats going on here"

There are many reasons why people lose money in the market,, but one huge and easily avoided mistake is putting too much capital at risk in a single positionbetting it all. The mistake arises because people dont set forth a business philos for themselves before making a trade in the markets.

My objective as a trader has always been to obtain and maintain the freedom secured by financial independence: consequently, my goal has been to make money consistently, month in and month out, year after year. I have always approached m \ career as a business, and a prudent businessman wants to first corer his Overhead each month and then concentrate on achieving a stead% growth in earnings. Rather than striving for the big hit. I protect capital first and work for consistent retum. and take more aggressive risk with a portion of profits. Not accidentally, the big hits still come along; but they come alone without excessive risk.

Translated into more businesslike terms. I base my business philosophy on three principles, listed here in order of importance: preservation of capital, consistent profitability, and the pursuit of superior retums. These principals are basic in the sense that they underlie and guide all of m \ market decisions. Each principle carries a different weight in my speculative strategy, and they e% olve from one to the other. That is. preservation of capital leads to consistent profits, which make pursuit of superior retums possible.


Preservation of capital is the comerstone of ms business philosophy. This mean that, in considering any potential market involvement, risk is my prime concem.

Before asking "What potential profit can I realize?", I first ask, "What potential loss can I suffer?" In terms of lisVreward, the maximum acceptable ratio is 1:3, the measurement of which I will discuss in this chapter and in Chapter 11. When the lisVeward of remaining in any market is poor, I go into cash, regardless of the contemporary wisdom. Consequently, I dont concem myself with "outperforming the averages." I work for absolute not relative retums.

In my terms, money isnt green . . . its either black or white. Black and white have come to be associated with false or tme, wrong or right, bad or good. In ethical terms, most of society has been taught that "there are no blacks and whites-there is only gray": gray-the mixed and contradictory-the lack of absolutes. But on a ledger sheet, there are nothing but absolutes: 2 + 2 is always 4, and 2 - 6 is always -4! Yet, in a subtle way, the modem investor has been taught to accept gray by the money management community. He is encouraged to rejoice if his account goes down only 10% when the averages are down 20%-after all, he has outperformed the averages by 10%! This is B.S., plain and simple.

There is one, and only one, valid question for an investor to ask: "Have I made money?" The best insurance that the answer will always be "Yes!" is to consistently speculate or invest only when the od ds are decidedly in your favor, which means keeping risk at a minimum. For example, if all your indicators lead you to conclude that the long-term trend in the stock market (or soybeans, or cmde oil, and so on) is approaching a top, at least for the intermediate term, then why put your portfolio at risk by being 100% invested on the long side? Why attempt to gain a few more percentage points over the T -bill yield when

Business Philosophy for Consistent Success

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