Haribon’s Blog

How AIG’s Collapse Began a Global Run on the Banks
By Porter Stansberry
October 4, 2008

Something very strange is happening in the financial markets. And I can show you what it is and what it means…

If September didn’t give you enough to worry about, consider what will happen to real estate prices as unemployment grows steadily over the next several months. As bad as things are now, they’ll get much worse.

They’ll get worse for the obvious reason: because more people will default on their mortgages. But they’ll also remain depressed for far longer than anyone expects, for a reason most people will never understand.

What follows is one of the real secrets to September’s stock market collapse. Once you understand what really happened last month, the events to come will be much clearer to you…

Every great bull market has similar characteristics. The speculation must – at the beginning – start with a reasonably good idea. Using long-term mortgages to pay for homes is a good idea, with a few important caveats.

Some of these limitations are obvious to any intelligent observer… like the need for a substantial down payment, the verification of income, an independent appraisal, etc. But human nature dictates that, given enough time and the right incentives, any endeavor will be corrupted. This is one of the two critical elements of a bubble. What was once a good idea becomes a farce. You already know all the stories of how this happened in the housing market, where loans were eventually given without fixed rates, without income verification, without down payments, and without legitimate appraisals.

As bad as these practices were, they would not have created a global financial panic without the second, more critical element. For things to get really out of control, the farce must evolve further… into fraud.

And this is where AIG comes into the story.

Around the world, banks must comply with what are known as Basel II regulations. These regulations determine how much capital a bank must maintain in reserve. The rules are based on the quality of the bank’s loan book. The riskier the loans a bank owns, the more capital it must keep in reserve. Bank managers naturally seek to employ as much leverage as they can, especially when interest rates are low, to maximize profits. AIG appeared to offer banks a way to get around the Basel rules, via unregulated insurance contracts, known as credit default swaps.

Here’s how it worked: Say you’re a major European bank… You have a surplus of deposits, because in Europe people actually still bother to save money. You’re looking for something to maximize the spread between what you must pay for deposits and what you’re able to earn lending. You want it to be safe and reliable, but also pay the highest possible annual interest. You know you could buy a portfolio of high-yielding subprime mortgages. But doing so will limit the amount of leverage you can employ, which will limit returns.

So rather than rule out having any high-yielding securities in your portfolio, you simply call up the friendly AIG broker you met at a conference in London last year.
“What would it cost me to insure this subprime security?” you inquire. The broker, who is selling a five-year policy (but who will be paid a bonus annually), says, “Not too much.” After all, the historical loss rates on American mortgages is close to zilch.

Using incredibly sophisticated computer models, he agrees to guarantee the subprime security you’re buying against default for five years for say, 2% of face value.

Although AIG’s credit default swaps were really insurance contracts, they weren’t regulated. That meant AIG didn’t have to put up any capital as collateral on its swaps, as long as it maintained a triple-A credit rating. There was no real capital cost to selling these swaps; there was no limit. And thanks to what’s called “mark-to-market” accounting, AIG could book the profit from a five-year credit default swap as soon as the contract was sold, based on the expected default rate.

Whatever the computer said AIG was likely to make on the deal, the accountants would write down as actual profit. The broker who sold the swap would be paid a bonus at the end of the first year – long before the actual profit on the contract was made.

With this structure in place, the European bank was able to assure its regulators it was holding only triple-A credits, instead of a bunch of subprime “toxic waste.” The bank could leverage itself to the full extent allowable under Basel II. AIG could book hundreds of millions in “profit” each year, without having to pony up billions in collateral.

It was a fraud. AIG never any capital to back up the insurance it sold. And the profits it booked never materialized. The default rate on mortgage securities underwritten in 2005, 2006, and 2007 turned out to be multiples higher than expected. And they continue to increase. In some cases, the securities the banks claimed were triple A have ended up being worth less than $0.15 on the dollar.

Even so, it all worked for years. Banks leveraged deposits to the hilt. Wall Street packaged and sold dumb mortgages as securities. And AIG sold credit default swaps without bothering to collateralize the risk. An enormous amount of capital was created out of thin air and tossed into global real estate markets.

On September 15, all of the major credit-rating agencies downgraded AIG – the world’s largest insurance company. At issue were the soaring losses in its credit default swaps. The first big writeoff came in the fourth quarter of 2007, when AIG reported an $11 billion charge. It was able to raise capital once, to repair the damage. But the losses kept growing. The moment the downgrade came, AIG was forced to come up with tens of billions of additional collateral, immediately. This was on top of the billions it owed to its trading partners. It didn’t have the money. The world’s largest insurance company was bankrupt.

The dominoes fell over immediately. Lehman Brothers failed on the same day. Merrill was sold to Bank of America. The Fed stepped in and agreed to lend AIG $85 billion to facilitate an orderly sell off of its assets in exchange for essentially all the company’s equity.

Most people never understood how AIG was the linchpin to the entire system. And there’s one more secret yet to come out…

AIG’s largest trading partner wasn’t a nameless European bank. It was Goldman Sachs.

I’d wondered for years how Goldman avoided the kind of huge mortgage-related writedowns that plagued all the other investment banks. And now we know: Goldman hedged its exposure via credit default swaps with AIG. Sources inside Goldman say the company’s exposure to AIG exceeded $20 billion, meaning the moment AIG was downgraded, Goldman had to begin marking down the value of its assets. And the moment AIG went bankrupt, Goldman lost $20 billion. Goldman immediately sought out Warren Buffett to raise $5 billion of additional capital, which also helped it raise another $5 billion via a public offering.

The collapse of the credit default swap market also meant the investment banks – all of them – had no way to borrow money, because no one would insure their obligations.

To fund their daily operations, they’ve become totally reliant on the Federal Reserve, which has allowed them to formally become commercial banks. To date, banks, insurance firms, and investment banks have borrowed $348 billion from the Federal Reserve – nearly all of this lending took place following AIG’s failure. Things are so bad at the investment banks, the Fed had to change the rules to allow Merrill, Morgan Stanley, and Goldman the ability to use equities as collateral for these loans, an unprecedented step.

The mainstream press hasn’t reported this either: A provision in the $700 billion bailout bill permits the Fed to pay interest on the collateral it’s holding, which is simply a way to funnel taxpayer dollars directly into the investment banks.

Why do you need to know all of these details? First, you must understand that without the government’s actions, the collapse of AIG could have caused every major bank in the world to fail.

Second, without the credit default swap market, there’s no way banks can report the true state of their assets – they’d all be in default of Basel II. That’s why the government will push through a measure that requires the suspension of mark-to-market accounting. Essentially, banks will be allowed to pretend they have far higher-quality loans than they actually do. AIG can’t cover for them anymore.

And third, and most importantly, without the huge fraud perpetrated by AIG, the mortgage bubble could have never grown as large as it did. Yes, other factors contributed, like the role of Fannie and Freddie in particular. But the key to enabling the huge global growth in credit during the last decade can be tied directly to AIG’s sale of credit default swaps without collateral. That was the barn door. And it was left open for nearly a decade.

There’s no way to replace this massive credit-building machine, which makes me very skeptical of the government’s bailout plan. Quite simply, we can’t replace the credit that existed in the world before September 15 because it didn’t deserve to be there in the first place. While the government can, and certainly will, paper over the gaping holes left by this enormous credit collapse, it can’t actually replace the trust and credit that existed… because it was a fraud.

And that leads me to believe the coming economic contraction will be longer and deeper than most people understand.

You might find this strange… but this is great news for those who understand what’s going on. Knowing why the economy is shrinking and knowing it’s not going to rebound quickly gives you a huge advantage over most investors, who don’t understand what’s happening and can’t plan to take advantage of it.

How can you take advantage? First, make sure you have at least 10% of your net worth in precious metals. I prefer gold bullion. World governments’ gigantic liabilities will vastly decrease the value of paper currencies.

Second, I can tell you we’re either at or approaching a moment of maximum pessimism in the markets. These kinds of panics give you the chance to buy world-class businesses incredibly cheaply. A few worth mentioning are ExxonMobil, Intel, and Microsoft. I have several stocks like these in the portfolio of my Investment Advisory.

Third, if you’re comfortable short selling stocks (betting they’ll fall in price), now is the time to be doing it… simply as a hedge against further declines.

Keep the fraud of AIG in mind when you form your investment plan for the coming years. By following these three strategies, you’ll survive and prosper while most investors sit back and wonder what the hell is going on.

Good investing,

Porter Stansberry

What went wrong with the storied investment-banking firm is a warning for all of Wall Street.
By Allan Sloan and Roddy Boyd
Last Updated: September 15, 2008: 8:13 AM EDT

(Fortune Magazine) — The sad fate of Lehman Brothers is a cautionary tale of what’s gone wrong with Wall Street.

Lehman ended up on the financial scrapheap because it played – and ultimately lost – a dangerous game involving high-stakes bets and huge borrowings. The firm’s reported profits grew nicely through last year. But to keep its profits growing, Lehman was taking on more and more risk.

Lehman (LEH, Fortune 500) borrowed too much money, put too much of it into deals of dubious quality, and then insisted for months that all was well when it was apparent that all wasn’t well. Monday’s bankruptcy filing is a sad end for a firm once regarded as prudent and well managed.

The saddest thing of all is that decades ago Dick Fuld, now Lehman’s CEO, bitterly opposed having the firm do big, aggressive deals with its own capital. But as we said in July, during one of Lehman’s recurring crises, Fuld’s decision to do the risky things that he opposed in the 1980s hurt Lehman badly.

Back then, Fuld’s trading faction from the old Lehman Brothers was struggling against the firm’s banker faction, led by Steve Schwarzman and Pete Peterson.

The bankers wanted the firm to use its own capital to do deals. The traders opposed it.

The trader-banker war so weakened Lehman that it sold out to American Express (AXP, Fortune 500) in 1984. Fuld, a Lehman lifer, stayed on, while Schwarzman and Peterson went off to found the Blackstone Group (BX) and become billionaires.

In 1994, AmEx, giving up its “financial supermarket” strategy, spun off a small, undercapitalized firm called Lehman Brothers, with Fuld as CEO. (That’s why, despite what you read, Lehman wasn’t a 158-year-old firm; it was a 14-year-old firm with a 158-year-old name.) Lehman’s leverage – borrowings relative to capital – grew and grew, even as other firms were cutting back as the credit crunch worsened.

For example, last October, with the real estate collapse well underway, Lehman (in partnership with the Tishman Speyer real estate firm) paid a whopping $22.2 billion to do a leveraged buyout of a big apartment developer, Archstone. Losses on the deal began to surface almost immediately. Alas, we can’t give you Fuld’s take on all this; he’s declined to talk with us for months.

Lehman looked as if it would be able to survive more or less intact after the Federal Reserve Board announced in March that it would make huge loans available to eligible investment banks. This came shortly after the Fed and the Treasury forced a fire sale of Bear Stearns, and let it be known that the timing was no coincidence.

But Lehman never fully regained the market’s confidence, Fed and Treasury support notwithstanding.

That leads us to a second Wall Street lesson from Lehman: that the Fed and Treasury can no longer control events as they once could.

http://money.cnn.com/2008/09/12/news/companies/sloan_lehman.fortune/index.htm?postversion=2008091508

As the clock ticks down, workers file out of a Times Square skyscraper carrying what they can.
By Andy Serwer, managing editor
Last Updated: September 15, 2008: 7:27 AM EDT

NEW YORK (Fortune) — The last hours, minutes really, of one the world’s largest investment banks make for a pretty unusual spectacle.

I’m standing outside Lehman Brothers (LEH, Fortune 500) headquarters on 7th Ave and 50th street in New York City, watching Lehman Brothers die.

Employees, some in suits, others in casual clothes, are filing out with all they can carry as time runs out.

They are walking down the sidewalk past police barricades as scores of New Yorkers and tourists gawk, some asking, “Which star is coming out?” – not knowing what’s going on.

A big cop issues the standard “keep moving” line to those of us who stop to gaze. He tells the crowd, “Go home. There is no one famous coming out. You are looking at a whole bunch of people who just lost their jobs.”

Some of the people behind the barricades are loved ones – their faces distraught, their cars waiting to pick up their significant others and their boxes. One banker carries out a pair of green Lehman umbrellas, a paltry trophy.

Few parting employees are in a mood to talk – either they’re still adhering to CEO Dick Fuld’s tight-lipped, ‘We’re all in this together’ policy or they’re just exhausted and in major pain.

“No comment,” is the standard line. A TV producer tries in vain to get interviews. I managed to ask one guy how he felt: “Look at all of us with boxes,” he said with a grimace. “What do you think?”

As the night wears on, dozens of younger workers start coming out of the building. One yells, ‘Jackals,” not knowing that the crowd is made up mostly of relatives or clueless onlookers. A pair of employees walk out carrying orchids.

Six months earlier and five blocks away, a similar scene played out as Bear Stearns collapsed. Tonight I’m wondering how many more crash and burn nights like this Wall Street, the markets and our economy can take.

http://money.cnn.com/2008/09/14/news/companies/lehman_workers.fortune/index.htm?postversion=2008091507

TRADERS MINDSETS

It has been theorized that your state of mind will dictate your trading methods. Experts in the field of trading psychology have pinpointed three main states of mind and how each has a direct effect on a trader’s profitability.

These three mind states are “having”, “doing” and “being”. Psychologists have noted that those new to trading start with a “having” state of mind. As they gain more experience, they move on to a “doing” state of mind. The pinnacle of profitability occurs when a trader moves into the last and final “being” frame of mind.

The “Having” Mind Set

A novice trader may focus primarily on profits. In this “having” state of mind, they are out of sync with the markets. They are blinded by their obsession to obtain the all mighty dollar and what it can afford them. Trading is not viewed as a job that must be mastered, but as a vehicle to escape from a world of mediocrity.

Many traders are in the business to make money, as well as they should be. However, if they are blinded by greed, they tend to take uncalculated risks. Looking at the potential payoff without carefully calculating market trends and other factors is a recipe for disaster.

It is impossible to graduate to a high performance level when you concentrate on “having” instead of how the game is won. If you trade in a “having” frame of mind, you may become frustrated when profits are not immediately forthcoming. With frustration comes a lack of focus. Without the ability to focus, you cannot gain knowledge from your experience on the trading field.

Other negative consequences of this mindset are feelings of frustration and anger. Frustration stemming from a lack of expected profits and anger directed at oneself or the market in general. These adverse emotions will only cause further decline in profitability. Without witnessing gains from one’s efforts, an individual may not give their best and may be tempted to “throw in the towel”.

The “Doing” State of Mind

If an individual continues on to trade another day, they will eventually move from a “having” to a “doing” state of mind. Learning that there is more to trading than the amassing of money, a trader will turn their focus on learning new methods of trading and what does and doesn’t work.

This state of mind is still primarily centered on how to turn a profit. Although a “doing” mind state is essential to becoming a seasoned adept trader, the main focus is still short of the mark. It is crucial to know what works and what doesn’t. However, a skilled trader will tell you there is more to the business then choosing one method and using it arbitrarily to make trades across the board.

Becoming a trader of means requires not only a winning attitude, but also a fine honing of trading skills. To develop these skills, you must make trades using various methods under a wide spectrum of market conditions. Only then can you develop the needed intuition to master the art of trading.

Pinnacle of Profitability: The “Being” State of Mind

A successful trader almost instinctively knows how to make a trade using the best method available for the current market trend and/or condition. This ability does not occur overnight. It is only accomplished through perseverance, knowledge of various trading methods and learning which one works given a particular market condition.

No trade is ever a “sure thing”. However, a profitable synchronicity almost naturally occurs when you are faced with a potential trade, have a feel for the current market trends and conditions, and utilize the method best suited for a potential payoff. This “being” state of mind ultimately lends itself to long-term success in the high stakes of trading.

By William Eckhart

• “If a betting game among a certain number of participants is played long enough, eventually one player will have all the money. If there is any skill involved, it will accelerate the process of concentrating all the stakes in a few hands. Something like this happens in the market. There is a persistent overall tendency for equity to flow from the many to the few. In the long run, the majority loses. The implication for the trader is that to win you have to act like the minority. If you bring normal human habits and tendencies to trading, you’ll gravitate toward the majority and inevitably lose.”

• “It’s much easier to learn what you should do in trading than to do it. Good systems tend to violate normal human tendencies.”

• “One common adage on this subject that is completely wrongheaded is: you can’t go broke taking profits. That’s precisely how many traders do go broke. While amateurs go broke by taking large losses, professionals go broke by taking small profits. The problem in a nutshell is that human nature does not operate to maximize gain but rather to maximize the chance of gain. The desire to maximize the number of winning trades (or minimize the number of losing trades) works against the trader. The success rate of trades is the least important performance statistic and may even be inversely related to performance.”

• “The people who survive avoid snowball scenarios in which bad trades cause them to become emotionally destabilized and make more bad trades. They are also able to feel the pain of losing. If you don’t feel the pain of a loss, then you’re in the same position as those unfortunate people who have no pain sensors. If they leave their hand on a hot stove, it will burn off. There is no way to survive in the world without pain. Similarly, in the markets, if the losses don’t hurt, your financial survival is tenuous.”

• “I know of a few multimillionaires who started trading with inherited wealth. In each case, they lost it all because they didn’t feel the pain when they were losing. In those formative first few years of trading, they felt they could afford to lose. You’re much better off going into the market on a shoestring, feeling that you can’t afford to lose. I’d rather bet on somebody starting out with a few thousand dollars than on somebody who came in with millions.”

• “In many ways, large profits are even more insidious than large losses in terms of emotional destabilization. I think it’s important not to be emotionally attached to large profits. I’ve certainly made some of my worst trades after long periods of winning. When you’re on a big winning streak, there’s a temptation to think that you’re doing something special, which will allow you to continue to propel yourself upward. You start to think that you can afford to make shoddy decisions. You can imagine what happens next. As a general rule, losses make you strong and profits make you weak.”

• “If you’re playing for emotional satisfaction, you’re bound to lose, because what feels good is often the wrong thing to do. Richard Dennis used to say, somewhat facetiously, “If it feels good, don’t do it.” In fact, one rule we taught the Turtles was: When all the criteria are in balance, do the thing you least want to do. You have to decide early on whether you’re playing for the fun or for the success. Whether you measure it in money or in some other way, to win at trading you have to be playing for the success.”

• “Trading is also highly addictive. When
behavioral psychologists have compared the relative addictiveness of various reinforcement schedules, they found that intermittent reinforcement – positive and negative dispensed randomly (for example, the rat doesn’t know whether it will get pleasure or pain when it hits the bar) – is the most addictive alternative of all, more addictive than positive reinforcement only. Intermittent reinforcement describes the experience of the compulsive gambler as well as the future trader. The difference is that, just perhaps, the trader can make money.” However, as with most affective aspects of trading, its addictiveness constantly threatens ruin. Addictiveness is the reason why so many players who make fortunes leave the game broke.”

• “Don’t think about what the market’s going to do; you have absolutely no control over that. Think about what you’re going to do if it gets there. In particular, you should spend no time at all thinking about those rosy scenarios in which the market goes your way, since in those situations, there’s nothing more for you to do. Focus instead on those things you want least to happen and on what your response will be.”

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If you don’t think these principles are true, you haven’t been trading very long. Print these out and refer to them often.

Gerald M. Loeb was a highly successful trader who wrote the classics “The Battle For Investment Survival” and “The Battle For Stock Market Profits.”

Loeb’s Trading Tactics:

• The market is a battlefield. Make sure you are on the winning side
• You must trade with the actions of the market and not simply by how you might think the market should trade
• Knowledge through experience is one trait that separates successful stock market speculators from everyone else
• To do well in short-term trading, it takes full-time attention and dedication
• Exploit all new trends quickly and aggressively
• The best traders are usually psychologists. The worst are usually accountants
• Stocks act like human beings and go through the same stages and phases as people do, including infancy, growth, maturity, and decline. The key in trading is to be able to recognize which stage the stock is in and to take advantage of that opportunity
• Successful traders are intelligent, they understand human psychology, they practice pure objectivity, and they have natural quickness
• To succeed in trading you must
1) aim high,
2) control the risks, and
3) be unafraid to keep uninvested reserves and be patient
• The stock market is more an art than a science and far more complex than most people understand
• It takes considerable amount of self-control to trade well
• The more experienced and successful you become, the less you should diversify
• Big money is always made in the market’s leaders
• The best stocks will always seem overpriced to the majority of investors
• Resist the urge and temptation to change your strategy for each and every different market cycle
• Traders should always close a trade when good reasons exist to do so
• Tops in stocks usually occur when the advance in price stalls as volume or activity increases, or if the prices decline and the activity increases
• A sell signal occurs when a stock rises sharply on big volume but ends the day at no gain or at a loss
• Every new market cycle produces a new list of fresh leaders
• Pyramid your buys – start with an initial position and then add to it only if the trade moves in your favor
• Stocks are always way overvalued in a bull market and way undervalued in a bear market
• Expectation, not the news itself, is what moves the market
• What everyone else knows is not worth knowing
• Three basis elements should be considered when evaluating a stock -
1) quality (fundamentals, liquidity, management),
2) price, and
3) trend (the most important)
• Always sell when you start patting yourself on the back for being smarter than the market

By Larry Schneider
http://www.tradingmarkets.com/.site/stocks/how_to/articles/-76372.cfm

No one likes to lose money. Ever. But the veteran trader knows there are two kinds of losses. Those caused by being on the wrong side of the market (because the seasoned trader knows the market is always right) and those caused by doing something dumb and avoidable. Taking losses is a part of trading and successful traders will employ money management to control their losing trades. We shrug off the losers and move on to the next trade. We know no one can control market forces. But losing money through our own actions – actions we can control but failed to – ahhh! That is an entirely different matter and we have no one but ourselves to blame.

After more than thirty years in brokerage firm management, I’ve compiled a short list of commonly made mistakes.

Did I want to Buy or Sell?

The first mistake on my list is entering a Buy (or a Sell) ticket when the intention was to enter a Sell (or a Buy) ticket. This usually comes on liquidating, not upon initiating a position and more commonly occurs when the trader is Short. I call this having a stock market mentality; since the normal action for securities traders is to be Long a position which gets liquidated with a Sell order. As a result, we too often see traders that are holding Shorts try to close themselves out with (drum roll please) – another Sell order. But futures traders are Short as often (or at least as easily) as they are Long. So let me repeat myself. Close out a Long position with a Sell order and close out a Short position with a Buy order.

Failing to enter or to cancel a GTC (Open) Order:

In the good old days, you had to call your broker to place a GTC. Then, usually once a week, you’d receive a call from your broker reminding you that the GTC was still in force. Today, we enter our GTCs with the click of a mouse. Trade errors? You bet! Errors are created by a trader receiving a fill from a GTC order he had completely forgotten about, or believing that a GTC was in place, when there was none. Can you imagine how angry you’d have been, if on March 24 (when June gold was trading at $920) you said, “I’ll short gold on the next bounce back to $959.00″ and then failed to enter a GTC sell order for $959.00?

Forgetting where your positions are-

IBM is IBM and it doesn’t matter which stock exchange executed your order. But futures contracts are not fungible. A COMEX gold position can only be offset with a liquidating order sent to the COMEX. I have seen too many traders get long COMEX gold (or silver) and then enter the liquidating sell order for CBOT gold (or silver). The result is two positions which have to be unwound simultaneously, and even then there is considerable risk if one contract has far less liquidity (ie greater bid/offer spreads) than the other. And on the subject, don’t make the mistake of confusing full-size with mini-sized contracts. There are, at present, about a dozen mini-sized contracts available. If you are short mini-Corn or mini-Crude Oil, be sure to liquidate the mini contract.

Taking Your Eye off the Clock

Thanks to electronic trading platforms, most futures contracts are open almost 24 hours a day. But not for an expiring contract on the last trading day! There’s nothing more frustrating than placing a liquidating order, only to be told, “TLMC” (too late, market closed). To illustrate: The closing bell for CME Group grains, treasuries and meats on the Last Trading Day for the expiring contract, rings at Noon (Chicago); but CME e-mini stock indices close at 8:30 am on the Last Trading Day. Fail to get out of your June e-mini position on June 20 and you’ll only be subject to one more mark-to-market – between the June 20 closing bell and the June 20 Special Settlement Price. But if you hold a position in May Corn and you sleep through the Noon closing bell on May 14 you’ll be in the position of having to receive or make delivery of 5,000 bushels of #2 yellow corn!

Tom Gentile, Profit Strategies.com
April 7, 2008
http://www.optionetics.com/market/articles/19312

Watching kids grow up is amazing. The processes we all take for granted were once major challenges for all of us. And what really impresses me is how they seem to take to most things like a fish to water—first looking at each new endeavor, then assessing it, and finally accomplishing it. Thinking about a recent trip to the ice rink, I realized that his learning process had some profound lessons for us as traders.

First, he is single-minded and on purpose. Though falling down a lot, he realized that ice skating was possible, and he chose to go everywhere on those skates. Unless there was some tight crowd he couldn’t get through, he was up trying to skate

Second, he is unstoppable. If someone or some object got in his way, he would just skate around them. He would skate not only the way everyone else skated, but even against the crowd, scaring most of them. Not because he was or wasn’t supposed to, but just because he could.

Third, he is failure-proof. When he started off, he fell down every few feet. He realized, however, that all he had to do was to get up, and he could be off on his skates again. Getting up became easy, and falling down became less frequent. Even when he fell in a way that would cause me to wince, he just stood right up, because getting up after falling down had become second nature for him.

And you know this is a proven Success Formula. In some form or another we all learned this lesson growing up.

How Does This Apply To Investing?

First, Be Single-minded and On-purpose. To do this you have to have a goal. For example, “I’m going to increase my wealth by $1 million by getting a trading plan and following through on that plan.” And you have to have a plan to reach your goal—i.e., “I’m going to get good at process of calendar spreads, or straddles, or the forex markets.” Keep your focus on that goal.

Second, Be Unstoppable. If some challenge comes up, figure out a way around it. If you’re having trouble getting fills, don’t whine. Evaluate why, improve your execution skills or try something else—perhaps a new broker.

Third, Be Failure-proof. Remember challenges. “Falling down” is part of the process. Get up and keep on going. In time, the getting up will become easy and second nature, and the challenges will become less frequent. Knowledge in this business without application is like worrying about falling down so much that you never try to skate. Get out there and start doing it!

Tom Gentile
Chief Strategist
Profit Strategies Group, Inc.

http://traderfeed.blogspot.com/2008/04/few-trading-psychology-observations.html

* From working with developing traders, I’d say that 90% don’t/can’t sustain the process of keeping a substantive journal. Among the group that does journal, well over 90% of the entries are about themselves and their P/L. I almost never see journal entries devoted to figuring out markets.

* A sizable proportion of traders who have been having problems are trading methods and patterns that used to work, but are no longer operative. The inability to change with changing markets affects traders intraday (when volume/volatility/trend patterns shift) and over longer time frames (when intermarket patterns shift).

* It’s a common observation that traders fail because they don’t stick to their plans. My experience is different. Traders develop plans and trade patterns that simply don’t work; they’re based on randomness. When the patterns don’t work, traders become frustrated and abandon their plans. So it looks like lack of discipline causes trading failure. But planning doesn’t create success; sound planning does. Sticking to plans based on randomness is no virtue.

* I mentioned in my book an important law of performance: In every performance field of note–from Olympic athletics to Broadway–performers spend more time in practice than in formal performance. That is how expertise develops. The ratio of “practice” time (time spent on markets outside of trading) to trading time is a worthwhile indicator of a trader’s prospective success.

* Among the predictors of trading success, a “passion for trading” is grossly overrated. The successful traders have a passion for markets, which is very different from a passion for trading. Indeed, a passion for trading in the absence of passion for markets is a fair definition of addiction.

* Some traders habitually look for tops in a rising market and bottoms in a falling one. There’s much to be said for countertrend methods, but not when the need to be right exceeds the need to make money.

* An underrated element in trading success is mental flexibility: the ability to shift views and perceptions as new data enter the marketplace. It takes a certain lack of ego to form a strong view and then modify it in the face of new evidence.

* A trader I spoke with recently told me he was going to trade more aggressively by putting on more trades. Trading more frequently is not necessarily trading more aggressively, and it certainly isn’t necessarily trading prudently. Trading more aggressively means allocating more risk capital to particular (sound) trade ideas. A considerable portion of traders would benefit from trading less frequently *and* more aggressively.

* Nice litmus test for any website devoted to trading education, coaching, and the like: If the site spends more time promoting the person than promoting ideas, you have a good sense for the site’s priorities. Caveat emptor.

* Many traders fail because they’re focused on what the market *should* be doing, rather than on what it *is* doing. The stock market leads, not follows, economic fundamentals. Some of the best investment opportunities occur when markets are looking past news, positive or negative.

* Success in trading requires the capacity for personal investment. Too many traders close out their efforts, along with their positions, at the end of the day.

I find two things striking about a large number of active traders:

1) They’re not prepared for failure – If trading doesn’t work out for them, they don’t have clear backup plans (and trading doesn’t naturally lead to other careers);

2) They’re not prepared for success – If trading does work out for them, how will they accumulate wealth over time and ensure their financial future?

In some ways, the latter problem is just as acute as the first. Making money, holding onto money, and accumulating wealth are very different things. Just because traders make money doesn’t mean they know how to deploy that money wisely to build wealth. Indeed, I’ve seen many sad outcomes among those who have retained a trading mindset with respect to financial planning.

If traders are going to build a financial future, they need to think like investors. And that’s not easy to do, when all your financial decision-making has been on the short term.

Fortunately, there are some valuable resources available to help traders make the transition to becoming personal money managers. Here are a few that have come to my attention of late:

1) The Disciplined Investor by Andrew Horowitz – This very accessible book is excellent for those needing an investment primer. Horowitz doesn’t cover the full gamut of financial planning (insurance, estate planning, wills), but rather focuses on the range of wealth enhancement and wealth preservation opportunities via stock market investing, mutual funds, and annuities. He begins with “creating a discipline”, offers background on quantitative, technical, and fundamental investment strategies, and launches into important material on risk management. It’s clearly written and not at all intimidating for investment newbies. Andrew also maintains a blog and conducts frequent podcasts on investment themes.

2) Create Your Own ETF Hedge Fund by David Fry – This is a valuable introduction to the world of exchange-traded funds (ETFs), which are rapidly putting a variety of investment options–from bonds to stocks to currencies and commodities–in the hands of traders. Fry is the founder of the ETF Digest site, which tracks various ETF portfolios and includes weekly podcasts related to investment in ETFs. Fry’s central thesis is that individual investors can replicate common and successful hedge fund strategies, from long/short equities to profiting from global macro themes. At the end of the book, he offers sample portfolios designed to meet a variety of investor needs. The book is very practical and quite clearly written.

3) The ETF Book by Richard A. Ferri – Ferri’s book is a detailed look at the exchange-traded fund universe, covering various styles and choices among ETFs and then examining portfolio management options for ETF investors. A particularly worthwhile segment of the text applies different ETF strategies to investors in various phases of their life cycle. Ferri covers both passive and active portfolio strategies and offers clear, illustrative sample portfolios. If you’re ever wondering which ETFs are available for particular kinds of investment, this book pretty well covers the gamut in a way that is not overly technical. Ferri has also written on asset allocation–an extremely important theme among investors.

What are some general lessons from these books that traders can draw upon in becoming more astute investors? These come to mind:

* You can’t invest what you don’t save – An investment plan starts with a cogent savings plan.

* Know your objectives – It’s important to get a return on your capital, and it’s important to ensure the return *of* your capital. Your investment strategy should be tailored to your risk tolerance, and that should reflect where you’re at with respect to child bearing, retirement, etc.

* Know your alternatives – With a vast array of mutual funds, annuities, and exchange-traded funds, there are many ways of investing nationally, internationally, in stocks, and in other asset classes.

* Diversify, diversify, diversify – Even the greatest investments (think residential real estate of the last decade, or equities in China) can lose money quickly. Placing eggs in many baskets and ensuring that those baskets are not highly correlated in returns produces superior risk-adjusted returns over time.

You work for your profits; it’s important to ensure that they work for you. The average savings rate in the U.S. has recently become negative; people are spending more than they earn. They have assumed that the rising values of their homes would fund their retirements. With the recent housing decline, that assumption will be called into question for quite a few of those folks. For them, retirement is a potential train wreck on the horizon.

That doesn’t have to be you. Saving money and making it work for you in a carefully planned manner can ensure that earnings today become tomorrow’s wealth of a lifetime.