Charlie Munger's 10 Rules for Investment Success

By Morgan Housel December 13, 2007

Those of you lucky enough to attend a Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) annual shareholder meeting have undoubtedly heard Charlie Munger say, "I have nothing to add."

In reality, the guy has quite a bit to add. Thankfully for us, Munger is almost as forthcoming with his investment thoughts as his pal Warren Buffett. In his must-read book, Poor Charlie's Almanac, Munger puts forth a 10-step checklist that even the most inexperienced investors could benefit from.

1. Measure risk
All investment evaluations should begin by measuring risk, especially reputational.

It's crucially important to understand that from time to time, your investments won't turn out the way you wanted. To protect your portfolio, don't set yourself up for complete failure in the first place. Giving yourself a large margin of safety, avoiding people of questionable character, and only taking on risk when you can be sure you'll be satisfactorily rewarded are all steps in the right direction. Companies like Chipotle (NYSE: CMG) might have perfectly bright futures, but when their shares are priced for perfection, they might nonetheless prove too risky for savvy investors.

2. Be independent
Only in fairy tales are emperors told they're naked.

With stockbrokers often rewarded for activity, not successful investments, it's critically important to make sure you believe that what you're doing is right. Chasing others' opinions may seem logical, but investors like Munger and Buffett often succeed by going against the grain. Big Berkshire investments such as Coca-Cola (NYSE: KO), and more recently Petrochina (NYSE: PTR), were largely ignored by the masses when they were first made.

3. Prepare ahead
The only way to win is to work, work, work, and hope to have a few insights.

It shouldn't surprise you that the best investments aren't the ones we typically read about in the paper. The diamonds in the rough are out there, but finding them requires effort. Buffett reads thousands of annual reports to cultivate ideas -- even if he only comes up with a few candidates each year. Munger advocates a constant curiosity for nearly everything in life. If you never stop asking the "whys" in what you do, you won't have trouble staying motivated.

4. Have intellectual humility
Acknowledging what you don't know is the dawning of wisdom.

Perhaps most crucially to Berkshire's success, its leaders never stray away from their comfort zones. In investing, a clear idea of what the business will look like in the future counts most. If you struggle to comprehend what the business does today, you might as well be throwing darts. While companies like Google (Nasdaq: GOOG) and Boston Scientific (NYSE: BSX) are certainly titans in their own right today, they might look drastically different in five to 10 years.

5. Analyze rigorously
Use effective checklists to minimize errors and omissions.

The numbers don't lie. When researching investments, Buffett and Munger like to try to estimate the security's worth before they even look at its price. They are businessmen, not stock-market junkies. They focus their brainpower on the value of businesses, not convoluted economic forecasts or intricate market-timing techniques. Munger is incredibly brilliant, but the analytical rigor of his investment decisions is based around simplicity, not complexity.

6. Allocate assets wisely
Proper allocation of capital is an investor's No. 1 job.

In the early days of Munger's investment partnership, he held very few securities. When good ideas came, he poured significant capital into them; otherwise, he simply enjoyed the California sun. The amount of money employed in each of your investments should relate directly to its attractiveness. When you find a great investment, don't be afraid to bet big on it.

7. Have patience
Resist the natural human bias to act.

Munger said it best himself: "Half of Warren's time is sitting on his ass and reading; the other half is spent talking on the phone or in person to a highly gifted person that he trusts and trust him." While it can be tempting to jump in and out of the market, true fortunes are made from big commitments in quality companies, held indefinitely. When you're done with that, find a hobby. Spending all day watching stock tickers won't do you much good.

8. Be decisive
When proper circumstances present themselves, act with decisiveness and conviction.

This also goes back to not following the herd. When others are jubilant, you should be scared, and vice versa. Don't let others' emotions sway you; the market masses should help you find opportunities in their absence, not guide you down their own path to mediocrity.

9. Be ready for change
Accept unremovable complexity.

Investing success requires us to accept inevitable changes. Munger and Buffett hated railroads for decades, but as the times changed, they threw their old thoughts out the door and invested billions. The world around us won't always conform to our preferences and prejudices, and sometimes our best ideas will prove incorrect. If you aren't willing to roll with a changing market, you may find yourself fighting a lost cause.

10. Stay focused
Keep it simple and remember what you set out to do.

In chasing little, unimportant things, we often overlook huge and critical factors. But by keeping it simple, we can fixate on what really matters: buying good companies at a good price, and holding them until they're fully priced.

Charlie Munger often gets overshadowed by his more famous partner, but don't assume that's any reflection of Munger's own genius. He's undoubtedly been a guiding light for Buffett himself, and by any count, he should go down as one of the greatest investors of all time.

Useful Investment Links

Welcome to the world of stock investing. Before you start investing or trading please spend sometimes reading the following articles, it will help you to become a better investor or trader.


"Don't invest in or buy products you don't fully understand. Don't try to out-smart the market. Investment is about adopting a disciplined aproach based on your strategy and risk appetite. It is not about listening to rumours or timing the market." -- Anonymous


Investing
http://www.investmentu.com/research/timelessrules.html

http://starones.blogspot.com/2008/03/contrarian-investing.html

http://starones.blogspot.com/2008/03/templetons-10-investment-principles.html

http://starones.blogspot.com/2009/07/rules-of-trading-and-investing.html

http://starones.blogspot.com/2009/07/importance-of-risk-management.html

http://starones.blogspot.com/2008/10/eight-pearls-of-investment-wisdom-for.html

http://starones.blogspot.com/2008/03/when-you-to-sell-your-stocks.html

http://starones.blogspot.com/2008/06/warren-buffetts-stock-portfolio.html


Trading
http://starones.blogspot.com/2008/03/secrets-for-profiting-in-bull-or-bear.html

http://starones.blogspot.com/2008/07/high-probability-trading-take-steps-to.html

http://starones.blogspot.com/2008/03/ganns-24-never-failing-rules.html

http://starones.blogspot.com/2008/03/how-and-when-to-sell-stocks-short.html

http://starones.blogspot.com/2008/03/how-to-make-money-in-stocks-william-j.html

http://starones.blogspot.com/2008/03/9-deadly-trading-mistakes.html

http://starones.blogspot.com/2008/03/study-guide-for-come-into-my-trading.html

http://starones.blogspot.com/2008/03/stock-market-rules.html

http://starones.blogspot.com/2008/03/richard-rhodess-trading-rules.html

http://starones.blogspot.com/2008/03/trend-following-trading-turtle-trading.html

http://starones.blogspot.com/2008/03/technical-analysis-power-tools-for.html

http://onlypill.tripod.com/toolsofthetrade/id7.html

http://www.rb-trading.com/begin.html

http://www.swing-trade-stocks.com/

http://www.dtjr.com (Chinese)


ADX: The Trend Strength Indicator
http://www.investopedia.com/articles/trading/07/adx-trend-indicator.asp

Capturing Trend Days
http://www.traderslog.com/capturing-trend-days.htm

Momentum Trading with Discipline
http://www.investopedia.com/articles/trading/03/092403.asp

Selling Strategy
http://www.stockhouse.com/help_technical.asp?subitem=euphoria

Spotting Breadouts
http://www.investopedia.com/articles/technical/04/032404.asp

Ten Steps to Building a Winning Trading Plan
http://www.investopedia.com/articles/trading/04/042104.asp

WHAT makes someone a great investor?

Published November 17, 2007

Reading this won't make you great

Mark Sellers, founder of a Chicago-based hedge fund, argues that the best investors are born with particular psychological traits that others can never learn

By TEH HOOI LING
SENIOR CORRESPONDENT

WHAT makes someone a great investor? It's something you have to be born with, said Mark Sellers, founder and managing member of Sellers Capital LLC, a long/short equity hedge fund based in Chicago.

Apparently, it's not about your IQ, the education you've had, the books you've read, or the experience you've accumulated. 'If it's experience, then all the great money managers would have their best years in their 60s and 70s and 80s, and we know that's not true,' he said in a speech to a class of Harvard MBA students.

Intelligence and learning are obviously necessary too, and are sources of competitive advantage for an investor, but there are structural assets some possess that cannot be copied or learnt by others. 'They have to do with psychology and psychology is hard wired into your brain. It's part of you. You can't do much to change it even if you read a lot of books on the subject,' said Mr Sellers.

He said that there are seven traits great investors share that are true sources of advantage because they cannot be learned. You are either born with them or you aren't.

The seven traits are:

One, the ability to buy stocks while others are panicking, and the ability to sell at a time when other investors are euphoric. 'Everyone thinks they can do this, but then when October 19, 1987, comes around and the market is crashing all around you, almost no one has the stomach to buy,' Mr Sellers said.

'When the year 1999 comes around and the market is going up almost every day, you can't bring yourself to sell, because if you do, you may fall behind your peers.

'The vast majority of the people who manage money have MBAs and high IQs and have read a lot of books. By late 1999, all these people knew with great certainty that stocks were overvalued, and yet they couldn't bring themselves to take money off the table because of the 'institutional imperative', as Buffett calls it.'

Two, the great investor has to be obsessive about playing the game and wanting to win. 'These people don't just enjoy investing; they live it. They wake up in the morning and the first thing they think about, while they're still half asleep, is a stock they have been researching, or one of the stocks they are thinking about selling, or what the greatest risk to their portfolio is and how they're going to neutralise that risk.

'They often have a hard time with personal relationships because, though they may truly enjoy other people, they don't always give them much time. Their head is always in the clouds, dreaming about stocks. Unfortunately, you can't learn to be obsessive about something. You either are, or you aren't. And if you aren't, you can't be the next Bruce Berkowitz.'

(Berkowitz was a managing director of Smith Barney and set up his fund Fairholme Capital Management in 1999. Since inception, Fairholme Fund has returned 18.7 per cent annually on average.)

The third trait of a great investor is the willingness to learn from past mistakes. 'The thing that is so hard for people and what sets some investors apart is an intense desire to learn from their own mistakes so they can avoid repeating them. Most people would much rather just move on and ignore the dumb things they've done in the past.

'I believe the term for this is 'repression'. But if you ignore mistakes without fully analysing them, you will undoubtedly make a similar mistake later in your career. And in fact, even if you do analyse them it's tough to avoid repeating the same mistakes.'

A fourth trait is an inherent sense of risk based on common sense. 'Most people know the story of Long Term Capital Management, where a team of 60 or 70 PhDs with sophisticated risk models failed to realise what, in retrospect, seemed obvious: they were dramatically overleveraged. They never stepped back and said to themselves, 'Hey, even though the computer says this is OK, does it really make sense in real life?'

'The ability to do this is not as prevalent among human beings as you might think. I believe the greatest risk control is common sense, but people fall into the habit of sleeping well at night because the computer says they should. They ignore common sense, a mistake I see repeated over and over in the investment world.'

Five, great investors have confidence in their own convictions and stick with them, even when facing criticism. 'Buffett never get into the dotcom mania, though he was being criticised publicly for ignoring technology stocks. He stuck to his guns when everyone else was abandoning the value investing ship and Barron's was publishing a picture of him on the cover with the headline 'What's Wrong, Warren?'. Of course, it worked out brilliantly for him and made Barron's look like a perfect contrary indicator.'

Mr Sellers said that he is amazed at how little conviction most investors have in the stocks they buy. 'Instead of putting 20 per cent of their portfolio into a stock, as the Kelly Formula might say to do, they'll put 2 per cent into it. Mathematically, using the Kelly Formula, it can be shown that a 2 per cent position is the equivalent of betting on a stock which has only a 51 per cent chance of going up, and a 49 per cent chance of going down. Why would you waste your time even making that bet?'

The Kelly Formula arose from the work of John Kelly at AT&T's Bell Labs in 1956. His original formulas dealt with the signal noise of long-distance telephone transmission. It was then adapted to calculate the optimal amount to bet on something in order to maximise the growth of one's money over the long term.

Six, it is important to have both sides of your brain working, not just the left side - the side that's good at maths and organisation. 'In business school, I met a lot of people who were incredibly smart. But those who were majoring in finance couldn't write worth a darn and had a hard time coming up with inventive ways to look at a problem,' said Mr Sellers.

'I was a little shocked at this. I later learned that some really smart people have only one side of their brains working, and that is enough to do very well in the world but not enough to be an entrepreneurial investor who thinks differently from the masses.

'On the other hand, if the right side of your brain is dominant, you probably loathe math and therefore you don't often find these people in the world of finance to begin with.'

So finance people tend to be very left-brain oriented - and Mr Sellers said that that is a problem. A great investor needs to have both sides turned on, he said. 'As an investor, you need to perform calculations and have a logical investment thesis. This is your left brain working. But you also need to be able to do things such as judging a management team from subtle cues they give off.

'You need to be able to step back and take a big picture view of certain situations rather than analysing them to death. You need to have a sense of humour and humility and common sense. And most important, I believe you need to be a good writer.'

He cited Warren Buffett as one of the best writers ever in the business world. 'It's not a coincidence that he's also one of the best investors of all time. If you can't write clearly, it is my opinion that you don't think very clearly,' Mr Sellers said.

And finally the most important, and rarest, trait of all: the ability to live through volatility without changing your investment thought process.

This, said Mr Sellers, is almost impossible for most people to do; when the chips are down they have a terrible time not selling their stocks at a loss. They have a really hard time getting themselves to average down or to put any money into stocks at all when the market is going down.

'People don't like short-term pain even if it would result in better long-term results, he said. Very few investors can handle the volatility required for high portfolio returns. They equate short-term volatility with risk.

'This is irrational; risk means that if you are wrong about a bet you make, you lose money. A swing up or down over a relatively short time period is not a loss and therefore not risk, unless you are prone to panicking at the bottom and locking in the loss.

'But most people just can't see it that way; their brains won't let them. Their panic instinct steps in and shuts down the normal brain function.'

Enter the mature bull - and higher volatility

Teh Hooi Ling
Sat, Oct 27, 2007
The Business Times

STOCK investors need pretty strong nerves to stay invested in the market of late. It is not uncommon to see the Straits Times Index (STI) open up 50 points but end the day at -50. And a 100-point plunge in one day may be followed by a similar jump the next.

This is a sign that investors are jittery. On the one hand, equities around the world have done spectacularly well in the last four-and-a-half years. During that time, the STI has more than tripled. That's a lot of profits to lock up. On the other hand, there are just as many compelling reasons to hold on to, as there are to quit, equities now.

The economic force that the emergence of China and India unleashes into the world, as hundreds of millions of new consumers flood the marketplace in the next few years or decades, is unimaginable. Meanwhile, the wealth accumulated thus far in these two countries is scouring the world for viable investments. That liquidity flow will continue to support asset prices globally.

On the flipside, the economy in the United States - still the world's biggest market today - is slowing down. The impact of the sub-prime mortgage crisis on consumer spending is still a big question mark. If US consumers tighten their purse-strings as they see their home prices fall, then many of the exporters around the world will be hit by declining profits. Demand from Asia may not yet be enough to make up for the shortfall. But increasingly, the market wisdom is that problems in the US are not severe enough to cause a recession there, and hence the impact on the global economy may not be as great as initially feared.

Still, the increased volatility is symptomatic of a maturing bull market.

Four-phase cycle

In a report this month, Citigroup Global Markets' equity research said that the global equity bull market that began in March 2003 is maturing, but not finished yet. We are now into the third phase of a four-phase market cycle, according to Citi.

The first phase is when the economy is emerging from a recession. It follows the bottom of the credit bear market. Spreads fall sharply as companies repair their balance sheets, often through deeply discounted share issues. This, along with continued pressure on profits, keeps equity prices falling. Phase two begins as profitability turns and equity prices start to rally. Credit spreads fall even further as corporate cashflows rise strongly. This is an immature equity bull market. In the current cycle, this phase began in March 2003.

The third phase is when the credit bull market comes to an end. Spreads start to rise as investor appetite for leverage wanes. The equity market decouples from credit and continues to rise. "We think that the market is entering this phase now. This is the mature equity bull market," says Citi.

And after that, the market enters the bear phase, when equity and credit prices are falling together. This is usually associated with falling profits and worsening balance sheets. Insolvencies plague the credit market, and profit warnings plague the equity market. At this stage of the market, a defensive strategy is most appropriate - cash and government bonds are the best-performing asset classes.

Citi tries to identify the four phases in the last 20 years' market cycles. It found that the different phases are not equal in length. For credit market, phase one tends to be fast and furious. It lasted 18 months in 1991-92 and just five months in 2002-03. But the returns are significant - spreads collapsed by 29 basis points (bp) per month in 1991-92 and 50 bp per month in 2001-03.

Phase two tends to be longer. It lasted five years in the mid-1990s and just over four years in the early 2000s. Spreads fell by a more leisurely 3 bp a month in 1992-93 and 10bp a month in 2001-03.

The credit bear market begins in phase three. Spreads rose by around 300 bp in 1988 and 1997-00. This time round, they have already risen by 120 bp since spreads bottomed on June 12, 2007.

Spreads keep rising in phase four as defaults increase and corporate profits fall. This tends to be the most painful period for credit investors, notes Citi. It lasted 30 months back in 2000-02.

While the credit investor makes money in phases one and two, an equity investor makes money in phases two and three. In phase three in 1988-90, global equities rose by 38 percent despite a 317 bp increase in credit spreads. And in phase three in 1997-2000, equities rose by 57 per cent despite a 282 bp increase in credit spreads.

While equities perform well in phases two and three, phase two - the immature bull - lasts longer and is less volatile.

For example, the US Vix measure of implied volatility has averaged 15 in phase two and 22 in phase three. This is a key difference between a mature bull and an immature bull. "The returns may be as good, but the quality of those returns is worse," says Citi. "Sharpe ratios and risk-adjusted returns deteriorate." As for now, the Vix is 16 - having peaked at 30 in July. "But we would expect the overall trend to be rising as the mature bull market develops."

This suggests that while it is still right to be overweigh equities in phase three, the overweight should not be as great as during phase two. And a leveraged strategy is less appropriate as volatility rises.

Among the sectors, Citi's analysis showed that travel and leisure, retail, media and industrial goods and services performed well in phase three of the last two cycles. Banks underperformed during this phase as credit spreads rose.

Meanwhile, the mature bull phases are also when major bubbles develop. In 1990, Japan rose to a 60 times trailing earnings multiple and accounted for 50 per cent of total global market cap. It now accounts for only 10 per cent. In 2000, technology, media and telecoms (TMT) also rose to 60 times PE and accounted for 40 per cent of global market cap. It now makes up 20 per cent of global market cap.

"These bubbles usually build on a theme that has already been performing strongly through phase two. Into phase three, easier monetary policy and rising capital inflows from other asset classes provide the fuel to drive prices to spectacular and ultimately unsustainable levels. This then bursts and proves a major downward force on global equities in the bear phase four," says Citi.

Next equity bubble

The next equity bubble could be building in emerging market or commodity plays. "These are stocks or markets which are perceived to be most positively exposed to a robust global economy, irrespective of the US slowdown."

However, the Asia ex-Japan index, at 19 times PE, although a premium to the MSCI World's PE of 16 times, is still a long way off the 50-plus times multiple more typical of the peak in these mature bull market bubbles.

"The key point is that if the bubble for this cycle is to be created in the global growth trade, and the Asia Pacific/emerging markets indices in particular, then they could have a lot further to go.

"Investors who try to fight the current re-rating of these markets could suffer the same fate as those who tried to fight Japan in the 1980s and TMT in the 1990s. Probably the right call, but the timing could hit you," says Citi.

According to Citi, signs of the end of the mature bull run include rate hikes and extended equity valuations. Both don't apply now.

So while the recent dislocation in financial markets suggests the end of the credit bull market, it is not the end of the equity bull market. We are entering the mature bull phase, which will still provide decent returns for equity investors. However, it is becoming increasingly unstable. This is the phase where a major speculative bubble typically develops in the global equity market. Perhaps this time round, it is in emerging markets and commodity plays. However investors should remember that these bubbles can go a lot further than anybody expects - it can prove fatal to bet against them too early, cautions Citi.





The writer is a CFA charterholder. She can be reached at hooiling@sph.com.sg

Major slumps, smaller corrections

Secrets of the Millionaire Mind

by T. Harv Eker

Wealth File

1. Rich people "I create my life". Poor people "Life happens to me".


2. Rich people play the money game to win. Poor people play the money game not to lose.


3. Rich people are committed to being rich. Poor people want to be rich.


4. Rich people think big. Poor people think small.


5. Rich people focus on opportunities. Poor people focus on obstacles.


6. Rich people admire other rich and successful people. Poor people resent rich and successful people.


7. Rich people associate with positive, successful people. Poor people associate with negative or unsuccessful people.


8. Rich people are willing to promote themselves and their value. Poor people think negatively about selling and promotion.


9. Rich people are bigger than their problems. Poor people are smaller than their problems.


10. Rich people are excellent receivers. Poor people are poor receivers.


11. Rich people choose to get paid based on results. Poor people choose to get paid based on time.


12. Rich people think "both". Poor people think "either/or".


13. Rich people focus on their net worth. Poor people focus on their working income.


14. Rich people manage their money well. Poor people mismanage their money well.


15. Rich people have their money work hard for them. Poor people work hard for their money.


16. Rich people act in spite of fear. Poor people let fear stop them.


17. Rich people constantly learn and grow. Poor people think they already know.

Wealth principle

1. Your income can grow only to the extend you do!


2. If you want to change the fruits, you will first have to change the roots. If you want to change the visible, you must first change the invisible.


3. Money is a result, wealth is a result, health is a result, illness is a result, your weight is a result. We live in a world of cause and effect.


4. Thoughts lead to feelings. Feelings lead to actions. Actions lead to results.


5. When the subconscious mind must choose between deeply rooted emotions and logic, emotions will almost always win.


6. If your motivation for acquiring money or success comes from a non-supportive root such as fear, anger, or the need to "prove" yourself, your money will never bring you happiness.


7. The only way to permanently change the temperature in the room is to reset the thermostat. In the same way, the only way to change your level of financial success "permanently" is to reset your financial thermostat.


8. Consciousness is observing your thoughts and actions so that you can live from true choice in the present moment rather than being run by programming from the past.


9. You can choose to think in ways that will support you in your happiness and success instead of ways that don't.


10. Money is extremely important in the areas in which is works, and extremely unimportant in the areas in which it doesn't..


11. When you are complaining, you become a living, breathing "crap magnet".


12. There is no such thing as a really rich victim!


13. If your goal is to be comfortable, chances are you'll never get rich. But if your goal is to be rich, chances are you'll end up mighty comfortable.


14. The number one reason most people don't get what they want is that they don't know what they want.


15. The Law of Income: You'll be paid in direct proportion to the value you deliver according to the marketplace.


16. "Bless that which you want." - Huna philosophy


17. Leaders earn a heck of a lot more money than followers!


18. The secret to success is not to try to avoid or get rid of or shrink from your problems; the secret is to grow yourself so that you are bigger than any problem.


19. If you have a big problem in your life, all that means is that you are being a small person!


20. If you say you're worthy, you are. If you say you're not worthy, you're not. Either way you will live into your story.


21. "If a hundred-foot oak tree had the mind of a human, it would only grow to be ten feet tall!" - T. Harv Eker


22. For every giver there must be a receiver and for every receiver there must be a giver.


23. Money will only make you more of what you already are.


24. How you do anything is how you do everything.


25. There's nothing wrong with getting a steady paycheck, unless it interferes with your ability to earn what you're worth. There's the rub. It usually does.


26. Never have a ceiling on your income.


27. Rich people believe "You can have your cake and eat it too." Middle-class people believe "Cake is too rich, so I'll only have a little piece." Poor people don't believe they deserve cake so they order a doughnut, focus on the hole, and wonder why they have "nothing."


28. The true measure of wealth is net worth, not working income.


29. "Where attention goes, energy flows and results show."


30. Until you show you can handle what you've got, you won't get any more!


31. The habit of managing you money is more important than the amount.


32. Either you control money, or it will control you.


33. Rich people see every dollar as a "seed:" that can be planted to earn a hundred more dollars, which can then be replanted to earn a thousand more dollars.


34. Action is the "bridge" between the inner world and the outer world.


35. A true warrior can "tame the cobra of fear."


36. It is not necessary to try to get rid of fear in order to succeed.


37. If you are willing to do only what's easy, life will be hard. But if you are willing to do what's hard life will be easy.


38. The only time you are actually growing is when you are uncomfortable.


39. Training and managing you own mind is the most important skill you could ever own, in terms of both happiness and success.


40. You can be right, or you can be rich, but you can't be both.


41. "Every master was once a disaster."


42. To get paid the best, you must be the best.

Market Ups and Downs

Nasdaq Vs Shanghai A Share Index

Example of a Pyramid Scheme

Quotable Quotes

Extracted from Getting Started in Technical Analysis by Jack D Schwager

"The novice trader will ignore a failed signal, riding a position into a large loss while hoping for the best. The more experienced trader, having learned the importance of money management, will exit quickly once it is apparent that he had made a bad trade. The truly skilled trader will be able to do a 180-degree turn, reversing a position at a loss if market behavior points to such a course of action." - Jack D. Schwager

"Human nature will do things that are comfortable but the market will pay the trader for being uncomfortable." - William Eckhardt

"Market wizards do not do predictions. They just trade the market and react to the market." - Jack D. Schwager

"The trend is your friend except at the end when it bends." - Ed Seykota

"It never was my thinking that made the big money for me. It was always my sitting. Got that? My sitting tight! It is no trick at all to be right on the market." - Edwin Lefevre

"The market is like a flu virus - as soon as you think you have it pegged, it mutates into something else." - Wayne H Wager

"The successful trader has to fight these two deep-seated instincts. He has to reverse what you might call his natural impulses. Instead of hoping he must fear; instead of fearing he must hope. He must fear that his loss may develop into a much bigger loss and hope that his profit may become big profit." - Edwin Lefevre

"There is no such thing as being right or beating the market. If you make money, it is because you understood the same thing the market did. If you lose money, it is simply because you got it wrong. There is no other way of looking at it." - Musawer Mansoor Ijaz

"Every decade has its characteristic folly, but the basic cause is the same: people persist in believing that what has happened in the recent past will go on happening into the indefinite future, even while the ground is shifting under their feet." - George J Church

"If making money is a slow process, losing it is quickly done." - Ihara Saikaku

"Do not wish for quick results, nor look for small advantages. If you seek quick results, you willl not reach the ultimate goal. If you are led astray by small advantages, you will never accomplish great thing." - Confucius

"Don't invest in or buy products you don't fully understand. Don't try to out-smart the market. Investment is about adopting a disciplined aproach based on your strategy and risk appetite. It is not about listening to rumours or timing the market." - Anonymous

"We buy things we don't need, with money we don't have, just to impress people we don't know" - Anonymous

Penny stocks are where the crazy money is

18.3% compounded return a year over past 17 years - but money losers in 11 of them

By TEH HOOI LING

(SINGAPORE) Buying blue chips will yield decent returns over the long term but they are unlikely to catapult investors many more notches up the wealth ladder. The insane money lies in the penny stocks.

A BT study shows that between 1990 and now, consistently buying the 10 per cent cheapest stocks trading on the Singapore Exchange would have given investors a return of 1,641 per cent. That's an 18.3 per cent compounded return a year over the last 17 years or so.

In contrast, buying the 10 per cent most expensive stocks would have returned 60 per cent, or a mere 2.8 per cent a year over the same period.

The Straits Times Index, meanwhile, advanced 165 per cent or 5.9 per cent a year.

The above calculations do not include transaction costs. Of course, transaction costs will eat up a huge chunk of the gains especially for the penny stocks.

Assuming that a 9 per cent cost was incurred for each buy and sell transaction, the strategy of buying the cheapest stocks still provided a return of 1,070 per cent or 15.6 per cent a year.

But timing is crucial if one intended to catch a ride with the penny stocks. The sharp jumps came in spurts, and only when there was an unbridled bull market.

For example, the biggest gains among the penny stocks were chalked up in 1993, 1999, 2003 and last year.

For the first three of those years, one would have tripled one's money in 12 short months by buying into the cheapest 10 per cent of the market at the start of the year.

For 2006, the return was 100 per cent and in the first 18 trading days of 2007 alone, the cheapest 10 per cent of the market has risen an average of 30 per cent.

Other than these handful of years, penny stocks were largely a losing proposition in the other 11 years.

There are a few reasons for the phenomenal performance of penny stocks during a bull market.

First, a bull market reflects the rosy outlook in the economy. Many of the penny stocks are companies which had fallen on hard times during the previous downturn.

So a pick-up in business may benefit some of these companies. Once a company is able to generate enough revenue to cover its fixed costs, any additional increase will give the bottom-line a big boost. This is the so-called operating leverage of businesses.

And since these stocks were so down-trodden, the prospects of earnings will swing their prices up sharply. This is what we are seeing among the construction stocks in Singapore right now.

Second, a bull market will also attract many businesses to gain a quick entry into the stock market. Many a time, these are done via reverse takeovers, and the targets for the takeovers are loss-making micro cap stocks with no viable business. Since 2003, there has been a significant rise in reverse takeover deals in Singapore.

Among them are Wilmar, which took over Ezyhealth; Yoma, formerly Sea View Hotel; Indofood Agri Resources which took over CityAxis, and Time Watch which took over Wee Poh.

Deals currently in the works include Auston, which is being taken over by Internet TV operator M2B World Asia-Pacific; and China Transcom, which announced last week that Henan's Tianhai Electric (Group) Corporation will be injected into it.

And finally, there's the speculative element of investors trying to pre-empt the market by buying into stocks which they hope will turn out to be a reverse takeover target or some other kind of corporate manoeuvres.

The flight of penny stocks during bull markets has been established empirically.

For example, Malcolm Baker from Harvard Business School and Jeffrey Wurgler from NYU Stern School of Business found that when sentiment turns from low to high, returns are high on both extreme growth and distressed stocks. More stable stocks chalk up smaller returns.

However, when sentiment turns from high to low, the reverse is true.

So what makes certain stocks more vulnerable to broad shifts in the propensity to speculate?

According to Baker and Wurgler, the main factor could be the subjectivity of their valuations.

Consider a young, unprofitable, extreme-growth-potential stock.

'The lack of an earnings history combined with the presence of apparently unlimited growth opportunities allows unsophisticated investors to defend, with equal plausibility, a wide spectrum of valuations, from much too low to much too high, as suits their sentiment.

'In a bubble period, when the propensity to speculate is apparently high, this profile of characteristics also allows investment bankers, or worse, swindlers, to further argue for the high end of valuations.

'By contrast, the value of a firm with a long earnings history and stable dividends is much less subjective, and so its stock is likely to be less affected by fluctuations in the propensity to speculate.'

So ride the tide, while the going is good. But beware of the turning point. This is why analysts usually advise investors to go defensive when the market is reversing.

The Market Cycle Model

The Investment Clock

The Economic Cycle