The Speculator
9 tactics for investors and generals
The stakes may not be as high, but the combat on Wall Street can be just as fierce. Here are a few things we've learned that might help when trading stocks or trading fire.
By Victor Niederhoffer and Laurel Kenner

"In war, everything is uncertain, and the calculations have to be made with variable quantities."
-- Karl von Clausewitz, "On War"

The market, like war, is hell. Reversals of fortune, the joy of victory and horrible disasters mark the battle for investment survival each day. The flexibility required to negotiate such uncertain terrain is emphasized by military strategists such as Karl von Clausewitz, who wrote the fundamental training manual for commanders, and Liddell Hart, mentioned in our column last week.


U.S. commanders, too, strive for flexibility. "If you take the most capable forces in the world, you equip them with the right kind of equipment and you put them in motion with a very flexible plan, the outcome is not in doubt," Gen. Tommy Franks said in a March 27 interview with Infinity Broadcasting.

If only that were always true in the market. Since the turn of the century, even investors who possessed good equipment, the right amount of reserves and the flexibility to take necessary risks feel like battle-scarred veterans after watching favorite stocks like Enron (ENRNQ, news, msgs), WorldCom Group (WCOEQ, news, msgs), Global Crossing (GBLXQ, news, msgs) and many of the Nasdaq 100 plummet 50% and more. Take a look at the Nasdaq-100 casualty list from Dec. 31, 1999 through March 31, 2003:

And those are just the surviving companies, since the list is based on the existing Nasdaq-100. Some 1999 members, such as At Home (ATHMQ, news, msgs) and Metromedia Fiber (MFNXQ, news, msgs), were delisted. Vitesse Semiconductor (VTSS, news, msgs), -96%, was removed from the index. The average return on the still-breathing stocks is -73%. What a reversal of the 1990s, when most of us felt like victorious commanders as the average stock gained 15% a year and the Nasdaq 100 members returned twice that much. In the market as in war, overconfidence can be deadly.

Last week, we wrote about what traders can learn from war strategists. This week, as the market's fortunes were buffeted by shifting political winds and battlefield developments, we asked ourselves if generals might learn something from traders. You can learn much about a thing by seeing how it's affected by something else. War, of course, is more terrible than the market in that not just fortunes but lives are at stake.

Furthermore, our own connection with armed combat is slim; Laurel was an aerospace reporter for five years, and Vic once came close to accepting a job as assistant squash coach at the Naval Academy in Annapolis. Nevertheless, we are anything but novices in the battle for investment survival. We have read most of the classics on war, and we notice quite a few common areas of education. Perhaps our hard-won insights from trading will help investors and soldiers alike win their respective battles.

Risk and reward are uncertain
Market: The goal is to survive and grow wealthier in a field governed by uncertainty. The guiding principle here is that the greater the non-diversifiable risk, the greater the return. Investment strategy must combine risk and return in the most conducive way to reach the goal. Once a strategy is selected, tactics determine the best way to choose investments that can achieve the desired return with the least risk. To prepare for the unknown, traders sometimes adopt a wider range of likely outcomes of the tactics employed -- a more “diffuse prior,” in the language of Bayesian statistics.

War: Fighters perform similar calculations. Strategy determines which assets -- equipment, men and materiel -- should be used to maximize the gains of victory and minimize the risk of loss. Tactics determine which assets to use in which way at what time. Most of the second-guessing about U.S. strategy in Iraq boils down to whether more troops should have been in place at the start. The most painful lesson we’ve learned in the market is that surviving and winning require sufficient force, which is to say cash. In war, force can mean ships, aircraft, missiles, bombs, bullets, rifles, body armor, food, water, gas, troops, information satellites, and political goodwill -- but at the top of the list, again, is cash. Niall Ferguson, in "The Cash Nexus", quotes an adviser to Louis XII before the monarch’s 1499 invasion of Italy: “What your Majesty needs is money, more money, money all the time.”

Technology doesn’t win alone
Market: Vic can’t count the times he has seen the most sophisticated computer systems, Fourier series, artificial intelligence, genetic algorithms and chaos analysis used to assemble “unbeatable” trading strategies, only to go bust in a few months.

War: No less a personage than Norman Schwarzkopf, commander of the 1991 Gulf War, has criticized Defense Secretary Donald Rumsfeld for relying too much on air power and high technology and dismissing the concerns of the Army. James Lackey, a Florida trader who served in a tank unit during the 1991 Gulf War, succinctly summed up this point of view: “To be too dependent on technology on a battlefield is deadly. … An individual rifleman is quite a threat in a war.”

Staring at the monitor doesn’t help
Market: Traders who change tactics with every squiggle on the live price chart will soon find that commissions have eaten up their profits.

War: With 500 war correspondents reporting from very limited vantage points, it’s easy to get a distorted picture of our overall progress.

The political environment is important
Market: Government policy changes can devastate individual portfolios. You can have all the earnings in the world, but if a Roosevelt inveighs against “malefactors of great wealth,” if a Kennedy decides to protect against steel price increases, if a Nixon imposes price controls, if a Carter goes after “windfall profits,” stocks won’t go up. Conversely, take the Berlin Wall down and you get the 1990s’ 300% advance.

War: As of Monday, President Bush’s approval rating in the United States was at 66%, according to a pollster interviewed on MSNBC. But so many things would be easier if world opinion were on our side. Deployment was substantially delayed because Turkey refused allied troops border access, and fear that the war will create “100 bin Ladens,” as Egypt’s president put it Monday, has kept others from providing even humanitarian aid.

Timing is everything
Market: Our book “Practical Speculation” has many examples showing the importance of proper timing.

War: Waiting until the weather is right, e.g., when the moon is down or the sandstorms aren’t blowing, can mean the difference between success and failure. Our favorite fighting commander is Jack Aubrey, a fictional hero modeled on the 19th century British naval commander Thomas Cochrane. Aubrey timed an attack so that his ship would gain the weather gage. In other words, Aubrey wanted to be upwind of the enemy. That let him maneuver freely while, at the same time, blocking the enemy’s wind. Jumping in too quickly can lead to overexposure just as surely as a “right-but-early” trade.

Hubris is deadly
Market: The ancient Greeks believed that hubris -- outrageous arrogance -- causes a terrible blindness that eventually leads to the hubristic destruction.

War: Rumsfeld, Schwarzkopf told the Washington Post, “almost seems to be enjoying” being constantly on TV. Underestimating the enemy and leaving supply lines and the rear guard vulnerable while the main body of troops rushed on to Baghdad seems to be a case of hubris.

There is never just one
Market: The first earnings restatement and the first derivatives blowup are just the tip of the iceberg.

War: Threats are not limited to Iraq, or even to the Mideast. North Korea continues to threaten its neighbors. Farther afield, terrorist camps have proliferated in Colombia. (Japan and Colombia both support the U.S. invasion of Iraq.)

Optimism and pessimism are often exaggerated
Market: Plenty of truth is in the truism that the public sells low and buys high.
War: Despair and ebullience are equal enemies.

In a crisis, everything can go wrong at once
Market: Gold, bonds, oil and beans all got killed two weeks ago. Vic got killed in October 1997, when baht-ulism spread from Thailand through emerging markets everywhere and seeped into the United States. In 1998, the strategy of international diversification got killed when all the world’s stock markets plunged together.

War: In the heat of battle, tanks run out of gas; supply lines are hard to defend at night and sand gets in the sights.

Every trader knows that no trade is finished until it is closed out. Too often, a bad trade is allowed to fall into the abyss as the stock goes down in an endless spiral. We won’t soon forget the collapse of the telecoms or the bankruptcies of Enron, Global Crossing, Kmart (KMRTQ, news, msgs) and -- as our critics never tire of reminding us -- our onetime stock recommendation, WorldCom. On the other side, trades that begin well -- like buying gold or oil futures in early 2003 -- are often not closed in time to lock in a gain, as the trader succumbs to hope that the price will ascend to the moon. Clausewitz calls the corresponding principle in the military the principle of continuity: If any time is lost without good reason, the attacker takes a loss.

It is much harder to trade and fight in the real world than on paper. A trader knows that the ultimate responsibility for success or failure lies with him or her alone. Not with a faulty machine, not with bad advice, not with sickness or family crisis.

Although war is a cooperative venture, everyone from the commander in chief to the lowest-ranking soldier is responsible for doing his or her individual best. We wish the alliance troops success.

Final Note:
Visit our Web site to read more insights on war and trading from Gulf War vet James Lackey and others. We are always glad to hear from you; send comments, thoughts, criticisms and praise to us by e-mail..

At the time of publication, Victor Niederhoffer and Laurel Kenner did not own shares of any of the equities mentioned in this column.