How to minimise losses and keep profits.
This article is the third of a three-part series. You can read the first article here and the second article here.
Jesse Livermore, who over 38 years turned a few dollars into $100 million by 1929, once revealed that he targeted -- and made his big money -- on the large movements and swings in share prices.
That is just what today's investors are aiming for when they invest in fast-growing or undervalued companies -- they're trying to catch a substantial long-term upward move in the share price.
Jesse Livermore formed investment opinions based on his research of macro-economic, sector- and company-specific news flow, and considered valuation indicators such as profit growth and dividend payments. But he would never invest on his opinion alone. He always looked for market movements to confirm his analysis before committing to a position.
Despite his efforts to achieve a 'view' based on fundamental analysis -- and timing his entry points with as many factors in his favour as possible -- Jesse Livermore recognised that it was still possible for an investor to be wrong.
He believed in cutting his losses when a share price went against him, but he also tried to limit any losses by committing his funds to every investment in stages.
He therefore only built up to a full position if his early, small positions showed him a profit, thus proving his reasoning had been correct.
He called his small, early positions 'probes', and when he cut his losses, it was only these small probes that he terminated. Such probes thus reduced the financial cost of any unfavourable decisions.
Jesse Insight -- Build up large investments in stages, as the market proves you right.
Harvesting big profits
Jesse targeted big moves in the stock market just as today's investors might look for stunning ten-year returns. I'm referring to moves such as Rangold Resources (LSE: RRS), up 2,399%, Tullow Oil (LSE: TLW), up 1,383%, and REA Holdings (LSE: REA), up 1,504%, all of which were highlighted in this free report.
When Jesse latched onto a winning trend, he tried to stay with it until its conclusion.
Jesse Insight – Stick with winners.
Good opportunities for investing are not present every day in the stock market and Jesse cautioned that it was unwise to trade when they are absent. He believed that good opportunities occurred maybe four or five times a year, perhaps after a sizeable market fall.
He believed it was a good idea to build up a cash reserve to employ at times of opportunity. To do that, he recommended banking 50% of profits gained from every successfully concluded investment (or speculation). Such a strategy had a psychological benefit as well as a strategic benefit, he argued.
Jesse Insight – Bank profits to build up a cash reserve for times of high opportunity.
Balancing risk and reward
Like the Free Capital millionaires and other successful investors, Jesse believed in reducing his risk by limiting the amount of positions to which he had simultaneous exposure, saying:
"It is much easier to watch a few than many."
He also believed in making sure the risk was worth the potential reward before entering any stock-market commitment. For that reason, he shunned very cheap shares, which he considered to carry excessive risk, saying:
"Choose the most powerful stock in the group, not the best bargain, or a beaten-down stock poised to recover."
I think that's good advice as recovery plays rarely recover, and top-performing companies such as Imagination Technologies (LSE: IMG) and SDL (LSE: SDL) don't often get thrown in the bargain bin. If you search the bottom of the heap for bargains, be prepared to find many broken companies.
Jesse Insight - Manage risk and reward by investing in just a few strong companies.
Rational thought and profits
Jesse Livermore realised that human emotions, such as fear, greed and hope, moved share prices, and he tried to use that to his advantage with his timing rules. He also understood that "in the final analysis, it is company earnings, real and imagined, that eventually drive the price of stocks".
Jesse Insight - Profits are the spine of every share.
Livermore tried to protect himself from his own emotion-driven actions with his rules for money management, and he worked hard to think and act rationally. To help with that, he tried to keep fit, stick to a good diet and sleep well.
Livermore was spectacularly successful and only failed, as he freely admitted, when he broke his own rules. He said:
"There is no magic about achieving success in the stock market. The only way I know for anyone to succeed in his investments is for him to investigate before he invests; to look before he leaps; to stick to the fundamentals of his rules, and to disregard everything else."
I hope you've enjoyed Jesse's insights from this article and the previous two (here and here). Though Livermore died in 1940, I believe his insights are as relevant today as they ever were.
After all, to use his words: "Nothing new ever occurs in the business of speculating or investing in securities or commodities" -- now that certainly is one insight that it's very difficult to disagree with!
Finally, after studying how Jesse Livermore invested his way to million dollars (and well beyond!), 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.