CHAPTER 1

Rogue Waves

The phenomenon of rogue waves shows you why the environment is dangerous and howprecautions must be in place. Rogue waves are ocean waves that are about 100feet high. Such waves based on linear models should occur only once every 10,000years, but based on recent historical observations, these waves may occur moreoften. Some have even hit cruise ships. One ship disappears every week in theocean. Once thought to be caused by human error or mechanical failure, many ofthese disappearances are now blamed on rogue waves. Rogue waves can appearanywhere in the oceans without warning.

We see the same phenomenon in the investment markets. Rogue waves hit stocks allthe time. These waves are unexpected news events. Such events cause stocks toleap up or drop down in price.

The book The Black Swan by Nassim Nicholas Taleb (Random House, 2007)helps explain the impact of improbable events. Black swans were thought not toexist until they were discovered in Australia. Today the term refers to highlyimprobable events, and the book indicated that these events occur much moreoften than you would expect and that they can have a dramatic effect.

Furthermore, chaos theory indicates that small changes can have big impacts.This is also true of the markets. In other words, certain events, even smallones, can have a dramatic impact on the daily markets today. When we see theseimprobable events, most people call them black swans, but because of the havocthey can wreak, I call them rogue waves.

An Example: Subprime Mortgages

An example of a rogue wave is the severe recession of 2008–2009. One ofthe major causes was the subprime mortgage bubble. Part of that problem was thatthe rating agencies were giving all these subprime mortgages a triple A rating.One of the reasons that these agencies were giving these AAA ratings to subprimemortgage packages, which were purchased all over the world, was that theirmodels for determining the ratings had a worst-case scenario of a decline inreal estate prices by only 15 percent. Unfortunately, what we saw was a declinein real estate prices by 40 percent, something totally improbable, but again oneof these rogue waves.

Defensive Moves

In such an investment environment, it is critical that you make investments thathave a lot of upside gain and minimal downside loss. Here, options are theanswer. The option market is one of the places where you have greater safety toparticipate in the market. Also in options, diversification is necessary, andETFs will help you diversify.

An important lesson learned here is that you need to make an honest appraisal ofthe worst thing that could happen to an investment that you are consideringmaking. It is always more important to know the worst-case scenario rather thanthe best-case scenario. This is a key element in determining whether you will bea successful investor or not. This factor also tells you to be well diversifiedand to seek some protection in the options you buy so that rogue waves do notcause your major investments to tip over and sink out of sight forever.

CHAPTER 2

Avoid Wall Street Pitfalls

In the movie Wall Street, the main character, Gordon Gecko (played byMichael Douglas), made a pronouncement that you should always remember. "Moneymanagers cannot beat the S&P 500 index because they are sheep, and sheep getslaughtered."

Don't Follow the Money Managers

Not following the money managers makes a lot of sense. If we go back to the1960s, mutual funds and money managers have had a difficult time beating theaction of the S&P 500 index. In fact, numerous studies over the years havedemonstrated that 80 percent of the managed funds have been unable to beat themarket. (The difficulty of beating the market is probably why so many moneymanagers leave the profession.) Actually, money managers are not sheep, but theystill have a very difficult time beating the market.

The big question is: why are the best professionals on Wall Street not able tobeat the market? One reason is that we are faced with a very efficient market.With computers becoming almost as intelligent as people and with an ever-increasinglarge number of skilled professionals analyzing stocks, mostinformation about a stock is already in the market, and the price of a stockreflects all the information that is currently available to the public.

Don't Underestimate the Wisdom of a Crowd

There is another reason the market is so efficient—a smart crowd. Forcommanders, underestimating the enemy can be fatal. General Robert E. Leeunderestimated the morale and skill of the Union forces at Gettysburg, and hisarmy was defeated. General Ulysses S. Grant underestimated the strength of theConfederate forces at Cold Harbor, and thousands of his men were slaughtered.Don't underestimate your fellow investors or your competitors. You ignore themat your own risk. The crowd is...