In two previous articles, we discussed some of the lasting investing and trading insights of Jesse L. Livermore, the legendary pre-World War II stock operator who made (and lost) huge fortunes trading in a stock market that was far more wild – and less regulated – than the one we know today. It is a testament to his sagacity that so many of his observations continue to have relevance today, despite our living in a radically different world.
In this research note, we discuss still further insights from the so-called "Great Bear of Wall Street," who made his greatest fortunes shorting the devastating market crashes of 1907 and 1929. Specifically, we look at his two core tenets for trading as one’s positions rise and fall.
Do not lose your position in a rising market
When one’s portfolio is taking off and certain securities go on an upward tear, there is often an increasing psychological pressure to take profits. But that can be unwise, as Livermore was quick to point out:
“As long as the stock is acting right and the market is right: do not be in a hurry to take a profit.”
This is sage advice, especially when it comes to a stock in which you have great confidence and is moving in the direction dictated by your fundamental analysis and expectations. This is especially true of deep-value plays, where the market is often mispricing a security due to erroneous information or expectations. In these cases, pessimism can feed pessimism. But when reality sets in (as it inevitably does), it often does so quickly. Thus, if you are positioned to benefit from a climb when a market realization occurs, only consider exiting if the pendulum swings so far in the other direction that your valuation projections are fully busted.
In a broader sense, it is dangerous – and costly – to bail out of a rising stock due to discomfort or the itch to books profits. Riding the exuberance allows you to benefit fully from your foresight and not leave money on the table.
Always cut your losses when things turn against you
Just as you should be cautious not to lose your position in a rising market, Livermore was equally clear about the importance of cutting losses when things go the opposite way:
“Speculators insure themselves against large losses by taking the first small loss.”
It is human nature to avoid harsh truths, especially when that truth is you made a wrong call. When you take a position in a stock and its price begins to deteriorate thanks to an underlying shift in the thesis, investors should cut their losses quickly in order to avoid the big losses likely to follow. Of course, there are times when the market punishes a stock unfairly, overreacting or underreacting to news or other exogenous factors. In such cases, holding may be wise. But it is also important to recognize that you can be wrong about a stock or a company’s trajectory. In such cases, it is crucial to let reason prevail and not submit to the psychological crutch of denying reality in order to balm your ego.
It is only natural to be defensive about one’s positions since it reflects one’s judgment. But the greatest test of judgment comes from the ability to revise one’s thesis in the case of new information and act accordingly. Of course, that means avoiding the most extreme damaging psychological response: doubling down.
Listen to reason, not your feelings
Human beings have long been governed by strong emotions, often to their detriment. Livermore was a proponent of the idea that all of human action throughout history, and thus the behavior of the market, is governed by “greed, fear, ignorance and hope.” These emotions run strong in the stock market and, if you can keep your cool while others panic or become overly exuberant, it is possible to profit from others’ less structured thinking.
No one is right all the time. But by allowing your profits to run and your losses to be curbed swiftly, you can make sure your correct calls provide maximum benefits and your poor ones cause minimum pain.
Disclosure: I/We own no stocks discussed in this article.
