CHAPTER 1

Don't Put It All on Black: Risk Management

We don't care if you ignore every other chapter in this book and get yourtrading ideas by sacrificing a goat under the light of a full moon. If you don'tmake a commitment, right here and right now, to developing and following acomprehensive and methodical risk management strategy, please put this bookdown, walk over a few aisles, pick up Roulette for Idiots, and plan yournext trip to Las Vegas. There are a multitude of casinos that would like todevelop a lifelong relationship with you.

Trading without a risk management system is gambling. Gambling relies on hope.When you gamble, in the long run, the house always wins. The balance of thisbook will lay out in minute detail a proven system for making money in themarkets, but if you don't master risk management from the beginning, weguarantee that you will lose money, regardless of the trading or investingsystem you decide on in the end.

INEFFECTIVE RISK CONTROL

Ineffective risk control is, if anything, more dangerous than a lack of riskcontrols. At least with a lack of risk controls, your emotions will let you knowwhen the pain becomes too great, and you will liquidate your position. Adherentsof ineffective risk controls spout watchwords like an oracle and will oftenfollow their creed straight to a 55-gallon drum of Kool-Aid and an implodedportfolio.

This book is not a rehash of Warren Buffett's investment philosophy. Buffett'sstrategy, while successful, does not fit with our investment style.Additionally, a multitude of authors have covered and tried to emulate Buffett.

However, Buffett does have two rules that we follow:

Rule 1: Don't lose money.

Rule 2: Never forget rule 1.

Keeping this bit of wisdom in mind, we've found that we need to convince peoplewho are new to Maverick's system to break some bad (money-losing) habits.

Dollar Cost Averaging

This is also known as DCA. Should someone suggest with a straight face that thisconcept is either an investment strategy or a method of risk control, run, donot walk, out of his office. Such people should not be entrusted with a piggybank, much less with substantial amounts of capital.

In this misguided concept, you establish a position and then continue to add tothat position if it begins to decline in value, thereby lowering the averageunit cost of the position. The basic tenet of DCA is that you get to buy more ofsomething with less money. We would rather buy more of something with moremoney.

DCA makes a very large and dangerous assumption: what goes down, mustcome up. Wrong, no, nyet, nein, non. Just take a look at LehmanBrothers (bankrupt), old General Motors (bankrupt), Citibank (down 90 percentfrom its all-time high), and any of a myriad of stocks that either have gone theway of the dodo bird or have failed to exceed their previous highs of severalyears ago.

From an objective viewpoint, every dollar that your portfolio declines in valuetoday is one less dollar that you can use to trade tomorrow. Most amateurtraders don't understand the mathematics of dollar cost averaging on losingpositions. Imagine a trader who sells his winning trades after a $500 profit butlets a losing trade go against him, doubling and tripling down as the stockmoves lower. When he finally has to sell the position, he will take a loss ofseveral thousand dollars, erasing 5 to 10 of his positive trades. The negativemathematics of doubling down on losing positions ensures that the trader willhave an abysmal reward/risk ratio in the end. At Maverick, we teach pyramidingin winning trades to get the mathematics working in our favor, adding to atrader's reward/risk ratio.

The arguments made by financial advisors who advocate DCA as a method of riskcontrol have several implications that we disagree with philosophically. (1)These advisors tell you that you can't time the market, so don't worry aboutshort-term swings. (2) These same advisors illustrate the supposed benefits ofthis strategy by showing examples where the stock or mutual fund is higher thanyour entry price when you exit the position, with the implication that youcan time the market when you get out. If this isn't an example oftalking out of both sides of your mouth, we don't know what is.

Darren: In a previous firm, I consulted with alternative asset fundsseeking to raise capital from institutional investors. In 2008, I was speakingwith a long-only fund manager to determine if it would be worthwhile for hisfirm and mine to enter into a relationship. As any fund manager would be, he wasextremely excited at the prospect of gaining access to institutional capital. Hegave an elaborate presentation focusing on the fact that he was a stock pickerpar excellence and went over his entire methodology regarding how his bottom-upapproach was certain to pick winners "over the long run." For his cornerstoneexample, he highlighted an office supply company that was already in anestablished downtrend.

After listening to his presentation, I said, "Well, this looks interesting, butwhat do you do if you're wrong?"

His reply: "What do you mean?" A little red LED in my brain started blinking atthe rapid rate.

"When would you exit the position? What would you do if this stock dropped 50percent?"

"I'd buy more." Not with my money, I thought. I ended the call shortly afterwardand politely declined interest in working with his fund in the future. Thatstock did, in fact, go on to fall 50 percent from where it was when the managerrecommended it and has yet to recover.

Even professional managers who control millions and even billions in pensionfunds, endowments, and trusts can fall victim to the dangers of dollar costaveraging.

Efficient Market Theory

Proponents of the efficient market theory (EMT) hold that you can't time themarket, that the price action reflects all that is known about the stock at thetime, and that trying to time the market is ultimately detrimental to aportfolio. These people believe that the best investment philosophy is tosystematically invest in a broad-market index fund.

Ah, the world of academia. Viewed strictly at a single point in time, from astrictly economic point of view, this idea has a certain appeal, especiallyimmediately after significant events (such as earnings surprises,...