Given the historic meltdown going on in the financial stocks, I wanted to post a passage from How To Trade in Stocks, written by the legendary (infamous?) Jesse Livermore, one of the best traders in the early 1900s. In Chapter 4, titled “Money in the Hand,” he writes:
“Blunders by incompetent speculators cover a wide scale. I have warned against averaging losses. This is the most common practice. Great numbers of people will buy a stock, let us say at 50, and two or three days later if they can buy it at 47 they are seized with the urge to average down by buying another hundred shares. If one is to apply such an unsound principle, he should keep averaging by buying two hundred shares at 44, then four hundred at 41, eight hundred at 38, sixteen hundred at 35, thirty-two hundred at 32, sixty-four hundred at 29 and so on.
How many speculators could stand such pressure? Yet if the policy [of averaging down] is sound it should not be abandoned.
Of course, abnormal moves such as the one indicated do not happen often. But it is just such abnormal moves against which the speculator must guard to avoid disaster.” (Emphasis mine.)
The market, you see, has a way of baiting investors into doing things that, in most cases, seem logical and, in fact, do produce profits. In most cases, for instance, a stock that falls a few points will bounce back to some extent. A big company that has a bad few months will often recover at least somewhat in the months that follow. Thus, the logical investor believes, it’s best to buy on weakness and sell on strength.
Unfortunately, the occasional time when a stock does not conform to this pattern, it can not only wipe out all your profits from your prior ventures, but also drag your portfolio into the mud for years.
That, I believe, is what’s happening to many bottom-fishing investors right now. They believe American International Group (AIG) was a bargain at 40 … and 35 … and 30 … and 25 … and 20 … and now the stock is 13 and selling off in a hurry. Same goes with Lehman (LEH), Merrill (MER) and even stalwarts like General Electric (GE), which is no higher today than it was in early 1998!
So please take care to protect your capital, and to practice sound investment practices. That includes cutting all losses (in growth stocks) and raising cash during downtrending markets. Following those two simple steps will make sure you’re never faced with the “pressure” that a devastating portfolio decline can do.