How to make big money from big market movements.
This article is the second of a three-part series. You can read the first article here and the third article here.
By 1929, Jesse Livermore, who Time once described as "the most fabulous living US stock trader", had turned a few dollars into $100 million, over 38 years, by what he described as "investing and speculating" on the stock market. That sum has the spending power of about $1.3 billion today.
In my first article, I described Jesse Livermore as being misunderstood as a gambler; today, some would describe him as a trader. The truth is that he was a focused, business-minded stock-market operator who based his decisions on fundamentals, investor psychology and market movements.
He put great store on thoroughly learning his lessons as he progressed through his stock-market career. Because of that, he eventually formulated an investing system consisting of three parts: timing, money management and emotional control.
Any investor expecting to gain from share-price movements hopes for a price trend in their favour. Thus Livermore was interested in capturing the big share-price trends, either by jumping on when the price paused at a 'continuation pivotal point', or by getting in after identifying a 'reversal pivotal point'. (Please read my first article for a refresher on pivotal points.)
To make his investments, Livermore always tried to trade when the trends of the stock market, sector and individual shares were all moving higher together.
This wasn't 'blind' trading. Instead, he was backing a fundamental view with confirmation from the wider market before entering (and exiting) positions at pivotal points.
He favoured the leading companies of the day, so in today's stock market he would probably be dealing with well-known FTSE 100 companies such as Vodafone (LSE: VOD), Marks & Spencer (LSE: MKS) and Unilever (LSE: ULVR), or following the big upward trends from fast growing companies such as Imagination Technologies (LSE: IMG) and ARM (LSE: ARM).
Once into an investment, Jesse Livermore would attempt to ride the trend through minor ups and downs, letting his winners run, before exiting when a trend reversal showed him the time had come to sell.
Staying on the big trends
Jesse Livermore believed human emotions, like greed and fear, moved share prices. But he also understood that company earnings, or earnings potential, would lead to an investment decision for the sector or an individual share.
So with strong evidence of earnings progression at a share such as Imagination Technologies, it would be possible to view market setbacks, like the one that occurred during August 2011 and the one that occurred last month, as normal in a long upward trend.
Indeed, investors could see those setbacks as generating 'pivotal points' for an entry rather than a complete reversal of trend that would throw an investor out of the investment.
Jesse cautioned investors against being "so engrossed with the minor ups and downs that they miss the big movements" Apart from missing the big gains, reacting to minor wobbles could lead to over trading, which over time can seriously increase costs (as explained in this free Fool report).
To my mind, Jesse Livermore's timing system is most useful to the modern investor when viewed over a long timescale.
Jesse Insight – Invest with big trends using minor market movements for advantage.
It's being right that counts
The second part of Jesse Livermore's strategy concerned his ideas on money management. Today, we might call it risk management.
One of his main rules was to cut losses when he was wrong from the start. He said: "Investors should insure themselves from considerable losses by taking the first small loss"
It almost goes without saying that he was against averaging down on a losing investment. He believed further funds were best applied to new opportunities rather than risking more on a losing trade. Jesse said: "Markets are never wrong; opinions often are."
It's true that cheaper share prices can mean greater bargains, but I think Jesse's method of letting the share-price action provide the confirmation of the 'correctness' of a view has mileage, if we are already in an investment that's showing a loss.
Even if we don't cut the loss, if we are right, the original position will prove us correct eventually and there should be no need to put further capital at risk.
Jesse was blunt on the issue of losses: "Investors often take tremendous losses for no other reason than that their stocks are bought and paid for."
To him, the way forward was clear, "Profits always take care of themselves, but losses never do."
Jesse Insight – Cut your losses, and don't risk compounding them by averaging down.
As well as cutting losses, Jesse would sell shares that languished for a long period and/or had failed to perform as expected.
In my third and final article, I'll explore the methods Jesse used to both avoid and minimise losses, and how he achieved emotional control.
For now though, let me remind you that I've become sold on how Jesse Livermore invested his way to a million dollars (and well beyond!), and I'm using his lessons – plus this free report -- to battle with the market and take my own portfolio to the magic seven-digit milestone. Wish me luck!
At last -- a special free report that introduces novices to shares! "What Every New Investor Needs To Know" and The Motley Fool are helping Britain invest. Better.
Kevin does not own any shares mentioned in this article. The Motley Fool owns shares in Imagination Technologies and has recommended shares in Unilever.