Chicken Little Investing Rules - the short version

On August 11, 2016, Chicken Little changed his relationship status. After a nearly decade-long love affair with US Treasury bonds, Chicken Little packed his bags and moved to a small apartment near the beach with a bean bag chair and one cracked plastic cup.

Unfamiliar with the new financial dating scene, Chicken Little has been nervous. "It is too soon." "Do I swipe right or left on Tinder?" Before going on a few financial dates, Chicken Little knew that he had to set some rules. 

Chicken Little Looks for Investment Love

Chicken Little Rules for Financial Dating

Fortunately, Chicken Little has written down his dating rules. First in the 2005 book, Mean Markets and Lizard Brains, and then again in the PBS column "Where does Chicken Little Invest"

Chicken Little follows The Rules

The four most important rules are: 

1. Invest with conviction.
2. Markets have momentum.
3. Losers average losers.
4. Be aware of the sentiment cycle.

1. Invest with conviction

Chicken Little believes in a deflationary depression. The rules require investments to be consistent with this view. Investors are tempted to catch a short-term trend to make a few bucks. 

Reminiscences of a Stock Operator describes a series of losses incurred by traders attempting to buy a fur coat. The traders take short-term risky positions in effort to generate cash immediately. All of these risky "fur coat" trades lose money. 

Investing without conviction is costly
"What does a man do when he sets out to make the stock market pay for a sudden need? Why he merely hopes. He gambles. He therefore runs much greater risks than he would if he were speculating intelligently."  

Rule #1: It is necessary but not sufficient to believe in the positions that you take. Weak hands do not make money. Chicken Little believes in a deflationary depression. 

2. Markets have momentum. 

Markets go in the same direction for years. Gold went up every year from 2004 to 2011, US real estate went up every year from 1946 to 2007, Stocks went up ten fold between 1982 and 1999. US Treasury bonds bull market went on for at least 35 years (1981-> ??). 

Portrait of man in black with shoulder-length, wavy brown hair, a large sharp nose, and a distracted gaze
Newton's Laws apply to apples and markets

Investing with momentum is the simplest, most effective way to make money. However, investing with momentum is psychologically difficult. A momentum buyer has to, for example, buy Facebook at $50 when it was selling for $19 soon after the IPO. Conversely, a momentum seller might sell Blackberry at $70 when they could have sold it at over $200. 

Reminiscences of a Stock Operator advocates investing with momentum, "Remember that stocks are never too high for you to begin buying or too low to begin selling."

Rule #2: "It is tough to beat a 5th grader with a ruler." This is a famous technical analysis line. It means, make a graph of price, draw a line through the prices. Buy only assets that have positive momentum -- where the line goes from lower left to upper right. Sell or sell short only assets that have negative momentum -- where the line goes from upper left to lower right. 

3. Losers average Losers

Chicken Little increases winning positions and decreases or ends losing positions. When buying an asset, each subsequent buy comes at a higher price. When building a short position, each sale comes at a lower price.

Paul Tudor Jones II - self-made billionaire

Rule #3: Increase the size of winning positions, decrease the size of losing positions. 

4. Be aware of sentiment.

In the spring of 2014, 100% of economists predicted that interest rates would rise. If these noted sages were correct, then one of the worst choices would have been to buy Treasury bonds in 2014. 

When economists agree, run the other way

What happened? 

You would have made a fortune by doing exactly the opposite of the advice of these economists. Specifically, if you had purchased the riskiest, 30-year US Treasury in the spring of 2014, you would have earned 30% over the next two years. 

Interest rates around the world hit historic lows in 2016. Two years after being absolutely wrong in predicting rising interest rates, economists might be wrong in the opposite direction. On July 13, 2016, the Wall Street Journal ran an article with the headline:

Why Ultralow Interest Rates Are Here to Stay

When all the economists agree, taking the other side is as close to free money as is possible in the investment world. Economists are reliably wrong, but all of them being wrong in the same way at the same time, is an incredible alignment of the financial stars.

Chicken Little pointed out the dismal science lemming consensus in 2014, and was, accordingly, invested on the opposite of the economists, "98.75 percent of my family’s money is invested in cash or Treasury obligations."

Why is rule #4 "Be aware of sentiment" and not "be contrarian". The answer is that sentiment goes in cycles, and being contrarian is well-trod path to ruin.  

Being contrarian too early is an extinction event
Every year, Gallup asks Americans, "What is the best long-term investment". In April 2016, the Gallup answer was,

#1 Best investment: Real estate 
#2 Best investment: Gold 

A naive contrarian approach would be to immediately sell real estate and gold. 

Naive Contrarian
Chicken Little's view is popular investments are (almost) never exceptionally good investments. This suggests that real estate and gold are unlikely to have rocket ship returns after April of 2016. However, the upward cycle in a popular investment can continue for years. 

Having an opinion of sentiment is important, but there is no easy money in naive contrarian investing. 

Rule #4: Pay attention to sentiment. Look for opportunities where sentiment is extreme such as consensus among economists. 

Summary of Chicken Little Investing Rules

Chicken Little takes positions that are consistent with a deflationary depression and momentum. Positions that win, survive and grow. Positions that lose, shrink and die. Popular positions may prosper, but are unlikely to do extremely well. 

Chicken Little has his lipstick on, is going to the gym to shed a few pounds, and getting ready to go on some first dates. 

Chicken Little gets ready to enter the financial dating market

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