JESSE LIVERMORE VS WARREN BUFFETT

Investors pore over financial statements to ensure that the company they are researching has enough money in the bank to pay the bills and enough new business on the horizon to continue delivering a healthy dividend. They aren't totally buried in the past — judgements need to be made regarding the company's future business prospects — but they often rely on historical data to assist in divining the future. Traders who rely on technical analysis to guide their decision making reckon that's all a waste of time. They look for patterns in historical share price charts and study trade volume data. In other words, rather like investors, they use historical data to divine the future.

Which group is right? In an attempt to solve this conundrum let's pit a great trader against a great investor: Jesse Livermore against Warren Buffett.^a I'll admit Livermore didn't rely on charts, but a trader he definitely was. Both were/are extremely intelligent men. Both devoted themselves to understanding the market — how it works, what moves it, how to beat it. Livermore was media shy but expressed his views in a book he wrote not long before he died. Buffett hasn't written a book but is far from media shy. Buffett has also outlined his investment philosophy through his yearly chairman's letter to Berkshire Hathaway shareholders. So the views of both are on the public record. They operated in different eras — Buffett was 10 years old when Livermore died — and hence they never had the chance to discuss their views face to face. So let's create a hypothetical debate between them.

WHAT IS THE MARKET PRICE TELLING US?

Let's start with how each has interpreted market price. Both have stated that market price ultimately tracks value. Both have stated that sometimes market price reflects reality, sometimes not, but that over time a clear relationship between value and market price exists. No argument here between our combatants.

Would both suggest that factors other than value influence the market price? Yes, you'd get agreement here as well. Both would say the market price regularly deviates from value. The factors causing this are best described as influences on investors' perceptions of value. It's a distinction that both Livermore and Buffett have been able to make and capitalise on.

So far, so good. But from here Buffett and Livermore start to disagree. The main point of contention is how they apply their respective beliefs when interacting with the market. And it's a very interesting distinction. So here it is straight from the mouths of our combatants.

First Livermore: ‘Markets are never wrong — opinions often are.'⁴⁸ Livermore is telling us that market prices are sacrosanct. The trader is trying to outsmart the market, but market prices are what they are and it's pointless disputing them. As he said: ‘Just recognise that the movement is there and take advantage of it by steering your speculative ship along with the tide.'⁴⁹

This runs afoul of a principle Buffett has held dear throughout his investment career, one he learned from his mentor, Ben Graham. Graham preached it through his ‘Mr Market' allegory, which effectively says that the market doesn't provide you with information, but rather opportunity. See the price movement, acknowledge it, but don't respect it or join in with it.

The following quote from Graham's bestseller, The Intelligent Investor, explains this reasoning:

If you have formed a conclusion from the facts and if you know your judgment is sound, act on it — even though others may hesitate or differ. You are neither right nor wrong because the crowd disagrees with you. (You are right because your data and reasoning are right.)⁵⁰

Buffett has often repeated in public this quote of Graham's. It is the creed of the value investor that the market price can be wrong, sometimes very wrong, which means the intelligent, Socratic investor is at times presented with the opportunity to profit from crazy prices. So just sit and wait until they're delivered to you.

So which is it? Should the market be considered as periodically wrong, as Buffett believes, or should it never be doubted, as Livermore believed? The environment is the same; it's just a different approach to interacting with it.

Livermore told us how he defined being right or wrong. For him it was black and white: ‘The market will tell the speculator when he is wrong because he is losing money.'⁵¹

Buffett would disagree with this, not always but much of the time. He largely trusts his analysis and typically continues to call the market wrong even when prices are moving against him. There are times when he has stood defiant in the face of paper losses amounting to tens of billions of dollars. Buffett had this to say on the matter: ‘Unless you can watch your stockholding decline by 50 per cent without becoming panic stricken, you should not be in the stock market.'

It would seem Livermore's and Buffett's views are irreconcilable. Given a falling stock price, Livermore would be quick on his feet — sell out, admit he's wrong. Buffett would usually stand firm, arguing that the market price has become ‘more wrong'. He doesn't perceive them as real losses, just paper losses that will eventually correct themselves.

But, as disparate as their views seem to be, they can be reconciled. It's a sentence in chapter 12 of John Maynard Keynes' book The General Theory of Employment, Interest and Money that does so:

If I may be allowed to appropriate the term speculation for the activity of forecasting the psychology of the market, and the term enterprise for the activity of forecasting the prospective yield of assets over their whole life …

Clearly Livermore is acting as a speculator, betting on shifts in market sentiment and how it impacts market prices. Buffett is relying on the returns delivered by enterprise. The former can deliver trading profits or losses quickly; the latter typically delivers returns over a much longer period.

THE STOP LOSS ORDER

Another point of difference between Livermore and Buffett — and a source of confusion for those approaching the share market for the first time — is the stop loss order.

A stop loss order is a ‘no exceptions' sell order established at a predetermined price in the event a purchased stock falls in price. It limits losses should the market move against you. It's preset and automatic so you can't fall prey to the paralysing emotion of hope in wishing a fallen share price back up.

The initial stop loss is typically set when you buy, commonly at 10 to 15 per cent below the purchase price. Many traders then employ a ‘trailing stop loss', whereby the predetermined sale price is reset upwards as a stock increases in price. That way gains are locked in. Livermore believed strongly in the stop loss and set his limit at 10 per cent of his purchase price.^b

Traders use stop loss orders because it fits in with their trading philosophy, which is based on short-term price movements. Since they are less likely to have a view on value, their aim is to limit losses. However, the stop loss makes less sense to investors. If they're confident in their research, they see a falling share price as manna from heaven — to them buying more stock at a lower price means an even better deal than the previous one.

But there's a third type of behaviour, and this one is dangerous. Many don't hold any conviction regarding a stock's value but still choose to buy more stock after it's fallen in price. They support their actions with comments like, ‘Hey, if I buy more now it will lower my average buy-in price, then it will take less of a share price recovery for me to get out even.' Problem is, the stock market can't hear their hope. Livermore had very strong views about this process of ‘averaging down': ‘It is foolhardy to make a second trade, if your first trade shows you a loss. Never average losses. Let that thought be written indelibly on your mind.'⁵²

So what should the budding market participant do? Sell or buy when a stock price falls? To answer this question you need first to be clear in your own mind whether you're a trader or an investor, because the stop loss is a trader's tool, not an investor's. Don't fall prey to the following logic: ‘Sure I'm a value investor. I select stocks by studying the financials in my search for value, but if the price drops I'm out.'

If you're a trader then use a stop loss. But if you call yourself an investor and you use them, please save everyone the pain. You're not behaving as an investor would. An investor might choose to sell after a stock has fallen, but the decision would be based on a review of the facts, not because a stop loss has been triggered.

Buffett took many of his cues from Ben Graham, who was more a contemporary of Livermore than Buffett was. So how did Graham feel about Livermore's activity and how did Livermore feel about Graham's? This from Graham:

We think that, regardless of preparation and method, success in trading is either accidental or impermanent or else due to a highly uncommon talent. Hence the vast majority of stock traders are inevitably doomed to failure.⁵³

So Graham thought most traders were one step removed from gamblers. This from Livermore:

From my viewpoint, the investors are the big gamblers. They make a bet, stay with it, and if it goes wrong, they lose it all. The speculator might buy at the same time. But if he is an intelligent speculator, he will recognise — if he keeps records — the danger signal warning him all is not well. He will, by acting promptly, hold his losses to a minimum and await a more favorable opportunity to re-enter the market.⁵⁴

He said, she said. Who do you believe?

Well, as they say in the classics, ‘the proof of the pudding is in the eating'. Buffett's principles have allowed him to become the wealthiest man in the world. Livermore lost the lot (so much for ‘holding his losses to a minimum'). A broken Livermore ended his life by placing a gun to his head at the age of 63; he'd made and lost a fortune several times over. And while it can never be known how much of Livermore's success was due to skill and how much to luck,^c Graham was spot on in one respect: his description of success in trading as ‘impermanent'. While Livermore wasn't completely broke when he died in 1940, he had long since lost most of the $100 million trading profit he'd made in the wake of the 1929 Crash.

‘What to do?' asks the budding market participant. Am I to be a trader or an investor? Am I to be guided by Livermore or Buffett? Both with brilliant minds, both with a wealth of experience. The question remains, is there any way to reconcile these opposing views?

Fortunately there is. The first thing is to recognise that the two disciplines are built on similar premises. Both acknowledge that the market is driven by perceptions of value, and that these perceptions can become distorted at various times due to varying degrees of irrational behaviour. Investors and traders agree on this point; they differ principally in execution.

An investor will try to exclude behavioural issues from their analysis. They are the only sane person, watching the lunatics in the asylum, observing them but seeing no need to understand them. A trader also watches the lunatics in the asylum but wants to get amongst them, to understand them. What's running through the lunatics' minds holds the key to the short-term direction of the market. As long as the trader keeps their wits about them and stays quick on their feet, they can outsmart the lunatics. They're not interested that the slow-moving pendulum of value will eventually correct market prices. They want to get on board the pendulum now and ride it profitably for a while.

It's as if the trader can understand the lunatics — appreciate them, empathise with them — but also shut them out, maintain a sane state and profit from the whole experience. The investor remains detached, remote and unsympathetic — allowing the lunatics to head off in any direction while confident in the knowledge they'll eventually come around to the value position, so correcting market prices and vindicating his position.

THROWING CHARLES DOW INTO THE MIX

I mentioned in chapter 7 that Charles Dow saw the stock market as having three forms of movement: long-term ‘primary' movement (bull or bear), typically remaining in place for years; medium-term ‘secondary' movement, typically running between 10 and 60 days; and short-term ‘daily' movement, represented by random, erratic moves of no significance or informational value — market noise. It's interesting to consider how traders and investors operate within Dow's framework.

Dow would see some traders as performing an act of futility — trying to profit from the random and erratic daily movements of the market. There will be winners and losers but none of it due either to skill or a lack of it. Both Livermore and Buffett would agree that ‘day trading', as it's called, is a waste of time. Livermore was a trader, but not a day trader. He was always looking for the bigger moves because he knew the little ones were unreadable.

Now to a consideration of the medium-term ‘secondary' moves described by Dow, those occurring within a longer-term bull or bear market move. This is the space where Livermore was most active. While he wasn't a day trader, neither did he lock himself down to a long-term view on the market's direction. That is, he didn't like being tagged as a bull or a bear; these were expressions used by the press. He preferred to remain flexible, to move on either the buy or the sell side depending on the signals the market was delivering at any particular time.

Buffett would care very little for any of this discussion. Market direction and sentiment might be of interest to others but his interest lies in whether value is on offer. Trying to read shifts in sentiment doesn't tell him that. He simply sees the market price and his price; his senses remain immune to any other inputs.

So whether you choose to become an investor or a trader, the following applies:

• Success doesn't come easily, whichever approach is used.
• Both require discipline, training and experience.
• Both require control of one's own emotions.
• Neither approach will produce success all the time. It's like the house in a casino. The odds are set in a casino so that patrons can and do win, though the casino wins more often. Similarly, successful investors and traders don't aim to be right all the time but do aim to tip the odds of winning in their favour.
• Neither approach is applicable all the time. Experienced traders and investors alike describe extended periods when activity is futile.
• Both disciplines work best when the market is primed with emotion. Livermore had his biggest wins in the wake of the 1907 and 1929 crashes, while Buffett bought bargains in the wake of the 1973–74, 1987 and 2008 financial crises.
• Success using either approach typically involves a mix of skill and luck. It's not possible to know for sure how much each contributes to any outcome.

It's important to appreciate and understand the differences between the two skill sets associated with trading and investing. I've heard it said on several occasions that it makes sense to draw from both disciplines, and that increasingly investors/traders are working with a bag of tools derived from both. If you choose to do this then be careful, because bringing the wrong tools together can create a potentially dangerous mix (as we saw with the discussion of stop loss orders). Personally, I can't see any need to mix the two.