I previously wrote a post about Market Wizards: Interviews With Top Traders. This post is the sixth in a series of curated interview questions and responses from the notes that I took while reading the book.
Who is Michael Steinhardt?
Michael Steinhardt began his career on Wall Street as a research assistant and later found positions as a financial journalist and research analyst. After a successful career as an analyst, he founded one of the earliest hedge funds, Steinhardt, Fine and Berkowitz at the age of 26. He is considered a legend in the hedge fund industry not only because he was one of the earliest hedge fund managers, but also because of his remarkable investment performance. At the time Market Wizards was written, Steinhardt’s firm had achieved a compounded annual growth rate of over 30 percent in the 21-years since its inception. This far outperformed the S&P 500 which only achieved an 8.9 percent return over the same time period.
I thought that Steinhardt’s responses in highlight the importance of having a contrarian mindset (which he refers to as “variant perception”) and remaining flexible. This chapter is also one of the more interesting chapters in Market Wizards and another interview that I highly recommend.
How would you define your philosophy of trading?
My particular style is a bit different from that of most people. Concept number one is variant perception. I try to develop perceptions that I believe are at variance with the general market view. I will play those variant perceptions until I feel they are no longer so.
Could you give me an example of variant perception in the current marketplace?
We have been short Genentech for a year and a half. There was a period of months and months when we lost a lot of money in that position. But I stayed short because I continued to have a variant perception about the future of their drug, TPA. [TPA can be injected intravenously to dissolve blood clots.] It is our perception that, in a year or two, TPA will be a minor drug that will be supplanted by more effective drugs that also cost substantially less. The thrust of the entire company has been based on this one drug. If our perception is correct, this company will be earning 20 or 30 cents per share and selling for under $10. The stock is currently at $27 [June 1988], down from a high of $65. [By late November, Genentech had fallen below $15 and Steinhardt was still short.] But I think the general perception is still that Genentech is a first class biotechnology company that will produce many products that are going to revolutionize the industry. As long as my view is a variant perception, I will stay short.
My attitude has always been that to make money in the markets, you have to be willing to get in the way of danger. I have always tended to short stocks that were favorites and backed by a great deal of institutional enthusiasm. Generally speaking, I have tended to short too early and, therefore, have usually started off with losses in my short positions. If I short a stock and it goes up a lot, it may skew my exposure a bit, but as long as my variant perception is unchanged, I’ll stay short. If I’m wrong, I’m wrong.
Are you saying that as long as you think the fundamentals, as you perceive them, are unchanged, you will hang tough no matter how much the position goes against you?
Right. Of course, if it is triple horrible, I might trade around the position to take the pressure down a little bit. I would say, “OK, this looks awful; I see nothing but buyers. Why don’t I join the buyers and see if I can make some money.” In a matter of speaking, I dichotomize myself. I have a fundamental view, which I believe in my heart, but I try to separate that from the short-term fervor and intensity I may see in the market. So even though I am short in that type of situation, I might periodically be a buyer.
If you are very negative and short in a particular stock, but are not necessarily bearish on the industry, might you sometimes hedge yourself by buying another stock in that group against your short position?
I have tried that at times, but have generally found it to be unsuccessful. What it tends to do is give me two problems instead of one. Usually, your knowledge about the second stock on the other side will tend to be relatively skimpy because you are just grasping at it to use as a hedge. If your problem is so great that you need to hedge it, why not address the problem directly rather than taking on a totally separate position? Let’s say you are short a paper stock and the paper stocks are roaring, so you buy another paper stock against it. Maybe your short stock will go up more; maybe the other stock will go up more. Who knows? If you have made a mistake, deal with the mistake; don’t compound it.
Besides your variant perception concept, what are some of the other elements of your trading philosophy?
Nothing that is so distinctive. I don’t use stop-loss orders or such. I don’t use any rules about buying on weakness or strength. I don’t look at breakouts or breakdowns. I don’t use charts.
If a stock is not acting like it should based on its fundamentals, would that be the type of market action that would change your thinking?
I try to assume that the guy on the other side of a trade knows at least as much as I do. Let’s say I buy Texaco at $52 and it suddenly goes down to $50. Whoever sold Texaco at $52 had a perception that was dramatically different from mine. It is incumbent on me to find out what his perception was.
Relatively speaking, how important is the bias of the right market direction versus stock selection as a contributing factor to your overall superior performance?
As I look back on the past twenty-one years, there is no set pattern of successful activity. In some years, we did particularly well on the strength of a few well-chosen stocks. In other years, we did exceptionally well because we were on the right side of the market. For example, in 1973-174, when the market went down enormously, we were up substantially, largely because we were net short. There were other periods when the bulk of our money was made in bonds. I think there is a message in the fact that there is no real pattern: Anyone who thinks he can formulate success in this racket is deluding himself, because it changes too quickly. As soon as a formulas is right for any length of time, its own success carries the weight of its inevitable failure.
Where were you, positionwise, coming in on October 19 (Black Tuesday)?
I came in very much long exposed – 80 to 90 percent – and I increased my exposure during the day.
Why? Were you still bullish?
My increasing exposure was strictly a contrarian trade in the sense that when the markets have an enormous move, most of the time, it is right to take the view that there is a lot of emotionalism and extremism in that move. If you can maintain a bit of distance from the emotionalism, you tend to do well. So my buying that day is what I would have done on any 300-, 400-, or 500-point down day.
As you look back on the October 1987 experience, are there mistakes that you believe you learned from?
There is a very good investor I speak to frequently who said, “All I bring to the party is twenty-eight years of mistakes.” I really believe he is right. When you make a mistake, there is some subconscious phenomenon that makes it less likely for you to make that same mistake again. One of the advantages of trading the way I do – being a long-term investor, short-term trader, individual stock selector, market timer, sector analyst – is that I have made so many decisions and mistakes that it has made my wise beyond my years as an investor.
The typical mutual fund adheres to a buy-and-hold approach. Do you think that concept is basically a flawed strategy?
Yes, although flawed isn’t quite the word I would use. I would say it is too limiting a strategy. The objective of participating in the long-term growth of American equities, willing to suffer through those periods when equities decline, is fine, but it leaves so much on the table in terms of potential professional management. It is an incomplete strategy.
What would be the most important advice you could give to the layman?
One of the allures of this business is that sometimes the greatest ignoramus can do very well. That is unfortunate because it creates the impression that you don’t necessarily need any professionalism to do well, and that is a great trap. So the major advice I would give anybody is: Recognize that this is a very competitive business, and that when you decide to buy or sell a stock, you are competing with people who have devoted a good portion of their lives to this same endeavor. In many instances, those professionals are on the opposite side of your trades and, on balance, they are going to beat you.
Is the implicit message that, most of the time, the novice trader would be better off having his money professionally managed?
The term professionally managed implies a credit I am not sure I would give the average professional in this business. My point is that you should have a good reason to assume that you are going to achieve significantly superior return for investing in stocks. If you can get 9 percent or 10 percent by investing in T-bonds and 7 percent or 8 percent by investing in T-bills, what should get you get in stocks to offset the incremental risk? Probably something much higher. You have to decide what that number should be, and whether you have a realistic change of achieving it.
Don’t underestimate the difficulty of the game.
Right, and forget the shibboleth that stocks are going to give you a higher rate of return because they are more risky. That is not true. They are more risky; therefore, you have to be convinced that you are going to get a higher rate of return in order to play the game. Don’t assume that by investing in some mutual fund, you are going to get a higher rate of return.
What are the elements of good trading?
Good trading is a peculiar balance between the conviction to follow your ideas and the flexibility to recognize when you have made a mistake. You need to believe in something, but at the same time, you are going to be wrong a considerable number of times. The balance between confidence and humility is best learned through extensive experience and mistakes. There should be a respect for the person on the other side of the trade. Always ask yourself: Why does he want to sell? What does he know that I don’t? Finally, you have to be intellectually honest with yourself and others. In my judgment, all great traders are seekers of truth.