The Lifetime Trade

April 1, 2002

Dear Investor:

Three years ago we had to look dumb when we refused to invest in companies like while they soared in make-believe value. In those heady days, people would throw millions at an idea scribbled on a napkin. In the post-Enron present, people are reluctant to sink so much as a nickel into a company like GE. It seems the psychological pendulum may have swung too far again—this time to the other side.

This particular swing probably heralds the last throes of the bear market. Not that there won’t be more “gales of creative destruction,” as the economist Schumpeter called them: many over-leveraged companies with unsustainable business models still haunt the Nasdaq landscape. But as psychology now swings to punish the blue chips and people withdraw money from equities to feed a bubble in housing on the back of artificially low interest rates, it appears that the stock market may have come through the worst.

The biggest danger for investors is to give up on a disciplined policy of diversified asset allocation. Some investors will throw in the towel on stocks, thereby buying high and selling low. Others will seek refuge in gold, following a fad that always ends in disaster since non-industrial commodities are never a good long-term investment. A few will keep the money under the mattress, and will be ravaged by inflation when interest rates perk up. And the most unlucky will succumb to the lure of trading, as volatility stemming from the increased problems in the Middle East and other events makes such a strategy seem attractive.

It’s important once again to address the flaws in a trading mentality, since hucksters and hedge funds alike will hawk infallible trading “systems” as the market dawdles in the netherworld between bear and bull. Trading is a zero-sum game: for every winner there must be a loser. In other words, when a buyer purchases a share in Enron, she is buying it from a seller. And only one of them—the seller or the buyer—can be right in that transaction: the stock will either go up or down. The odds are actually worse than 50/50 since the “house” (in the form of brokerage bid-ask spreads and commissions—Wall Street’s version of double-zero on the roulette wheel) makes no trader’s random chances better than 49%.

In contrast, two investors can both buy Citigroup and hold it for the long-term, confident that they both will make money if the corporate profits rise over time. This is known in not-so-formal economic terms as an ever-expanding pie, and it is the secret to Warren Buffett’s success and to that of every other established investor.

The disadvantage of investment is that it requires patience and so is totally unsuited to gamblers. It is also useless to those who wish to get rich at another’s expense, since it is only as a trader that you trade “against” someone and thereby dine on caviar while they scour the trash bin. It’s a bad approach for those who are confident they will always have the upper hand in any of a million separate transactions, since trading would be the best strategy for anyone who is always right. Unfortunately or fortunately, we do not have confidence in our ability to always be right; therefore, we stick to investing where patience, not infallibility, is the key to a good result.

The talented speculator Jesse Livermore, who amassed an enormous sum by shorting the market in 1929, and who built and lost his fortune many times, at the end knew his flaws all too well. After years of exchanging estates in Great Neck for fleabag hotels on Broadway; after numerous bankruptcy filings followed by extraordinary comebacks; after buying the best diamonds at Harry Winston and then pawning them after the inevitable “missed” trade, he realized that a gambler lives to lose as much as to win. And he put a bullet in his head upon the realization.

The disciplined, diversified investor will never feel especially omnipotent; nor is he likely to go broke. All of which is probably good for those who would rather make that all-important lifetime trade: exchanging gambling for common sense.