Stock-Picking Rules to Live By | Stock, Stock market, Stock Investing, Online Stock Trading

You now know all the strategies I know about finding the biggest gains in stocks. Now, what tactics do you use to keep those gains and to sell before your gains turn to losses.

When I started writing for TheStreet.com eight years ago, I entitled my column "Wrong" because I .believed fervently that if you lost money, even if only for a day, it would be "wrong." As a hedge fund manager I thought there was no excuse to lose money on trading. None. Although of course it happened all the time. That didn't make it forgivable, though.

As a hedge fund manager, managing impatient wealthy money (and, by the way, all wealthy money is impatient), I had little tolerance for losses. I could say only so many times, "Look, I really believe if we wait long enough we can have a home run here." At times the speed of the gains was more important than the size of the gains. The preoccupation with near-term performance was amazing to me and gripped me as soon as I started my fund in 1987. What rich people cared about was being with the "hot hand," with who was making money now, hand over fist, who was beating everyone else now. It was so NFL-like, you were either the champion or "they," the investors, went home with someone else.

When I started running other people's money I thought I could report yearly. But no one would give me money unless I agreed to report quarterly. Heck, it was their money, so naturally I agreed. A couple of years into the process and the next thing I know, they want reports monthly. A few years later and they want weekly. In my last few years many of the partners wanted daily performance. They didn't want to wake up one day and find they had lost money, so they grilled me endlessly about how we were doing. As someone who could go long or short, I knew that meant that when the market was up they expected me to make money and when the market was down they expected me to make money. If I could short and the market dropped 2 percent, they expected me to make 2 or 3 percent. If the market rallied 2 or 3 percent they expected to hear that they made 4 percent.

I used to complain to my wife that I had become a dancing bear and a dancing bull, a circus animal. I had to deliver results constantly. With that kind of partner-fueled obsession you are driven to trade. You can't let positions run against you, even for a minute, or you risk remonstration at the close of the market (I wouldn't let the partners speak to me when the market was open). You have to stop out all losses before they become consequential, even if it is for positions that you believe in. You can't sit in a good position, an AT&T Wireless, for example, while it goes down and you build it up, because the partner critics won't tolerate the short-term unrealized loss. They think that any loss on the way to riches is "wrong." You have to book every gain as quickly as it can be taken, lest it be taken away. I had to expand my trading day to between 4:00 a.m. and 11:OO p.m., trading in any market that was open— Finland , Japan , Hong Kong —just to be able to rack up enough short-term gains to please the partners,

There is no doubt that the model I adopted, quick trading gains whenever possible, is a good one that led to immense riches. But it isn't at all replicable for you, unless you want to give up every aspect of your life—including your family, as I did—to succeed. The price is just too high for a model of extreme short-term performance, even if it delivers above-average returns. When I quit my hedge fund at the end of 2000,I vowed that I would never again put myself in that position. I knew that such a short-term trading style was not sustainable and would not even necessarily beat a longer-term, more tax-advantaged style of investing. I had an opportunity, not long after I retired from the hedge fund, to manage money in a slower fashion, at a mutual fund. There I wouldn't be taking 20 percent of the gains, both realized and unrealized, as I was at my hedge fund. I would be taking only 1 percent of the entire asset base as a fee. That intrigued me, until I recognized two terrible aspects of the mutual fund business: One, I would have to be selling my fund constantly, and two, I would have to be accepting money all of the time, regardless of whether I needed it or could use it.

As difficult as it was as a hedge fund manager with daily demands on performance, I could see where these two demands, the selling demand and the imperative to take in more money all of the time, could be disastrous to performance. I rarely, if ever, opened my hedge fund to new money. I insisted that you be nominated by a partner in the fund already, as a way to be able to keep the asset base from growing too quickly. Nothing's worse than taking in too much money when you can't handle it. Almost all my temporary bouts with underperfor- mance came when I took in new chunks of money and couldn't adjust to the new position size. My goal as a hedge fund manager was to make 24 percent after all fees, year after year. That was what I had done initially and I thought it was a great goal to maintain. But making 24 percent when you are running $10 million or $100 million is quite different from when you are running $250 million or $500 million, let alone the billions that all of the successful mutual funds have under management. At my hedge fund initially I could make $20,000 a day and hit my benchmark. By the time I quit I needed to make $423,000 every day to make my "quota." I did it, but it was incredibly hard.

Given the incentive of the mutual fund model, though, which pays you for asset growth through sales more than for performance, you are setting yourself up to underperform the averages. If I kept growing I would have had to be making a million dollars a day just to stay even with my record. The biggest enemy of great returns is the law of large numbers; it's simply too hard for most mortals to beat the market when they are running gigantic sums, particularly when those sums are coming in over the transom every day. Especially when you are out there glad-handing to raise more money when you should be inside analyzing companies.

So, I decided to heck with it. I'm not running other people's money in a hedge fund manner; too stressful. And I am not going to run other people's money in a mutual fund manner; too prone to underperfor- mance. What's the point of playing the game if you aren't going to make big money, bigger than the next guy?

Instead, what I decided to do was free myself of the constraints of both business models. I would run money myself, my money, and I would do all of the things that I couldn't do that constrained my performance at the hedge fund. I would build big positions in companies I loved and own them over time regardless of the short-term vicissitudes. I would stop worrying about the day-to-day performance and concentrate on long-term performance. I would no longer blast as "wrong" short-term glitches on the road to long-term wins. I would have a trading discipline and an investing discipline commensurate with this new, commonsensical view, and I would make money both short- and long-term when I thought it was right, not when they, the investors, thought it was right.

1n short, I became, in a word, you. And you know what I discovered? Being a private investor like you beats both models. You can easily outperform the short-term-obsessed hedge fund manager who is always looking over his shoulder trying to please the partners. And you can totally trump the mutual fund model with its endless obsession with growing assets under management and salesmanship.

Strangely, many of you have no idea how good you have it. I take calls from people on my radio show who complain that such and such a stock is going against them or that it is dropping when it should be rallying. I will say, "Don't you believe, don't you have conviction?" If they say no, I say, "Well, by all means sell it.'' But if you are on your own, and you like the company underneath, and the stock is being marked down because of the occasional craziness of the market, that's an opportunity, a blessing, a gift! Most people just can't run their own money well, though. They just don't have the qualities or the rules they need—the discipline to see it through and to beat all of the others out there, including the high-priced managers that they are willing to throw their money at for no reason at all.

The following sections of this book are about the discipline you need to trade and invest like a pro without the inherent bias against performance that pros in the hedge fund and mutual fund camps have. This chapter will help you to get all the advantages the pros have in handling money with none of the disadvantages. You already have all the basics: the skills to analyze price-to-earnings multiples, the ability to understand the cycles that drive stocks, the knowledge of the best places to look for big gains. Now you need the tools—the real tools, not the silly stuff that passes for tools advertised by brokers desperate for your business—to trade and invest your portfolio to riches.

1. Never turn a trade into an investment. If there is one concept you must take away from this book, it's that you must never, ever turn a trade into an investment. First, let's talk about the process of buying a stock. When I decide I am going to buy Kmart, the reconstituted real estate and retail play, I have to declare right up front whether I am buying it for a trade or an investment. A trade means that I am buying it because of a specific catalyst, a reason that will drive it higher. That catalyst is a data point, a recommendation, a belief that things are better than expected when the earnings come out, some news about a restructuring, or something material that could occur. There is a moment to buy and a moment to sell. But you must declare first before you buy. Here's why. The vast majority of you will buy a stock for a reason and then either the reason occurs and nothing happens, so you then decide, darn, I'll just call it an investment and I will buy more as it goes down, or else the reason doesn't occur—the reason may never occur—and you decide to hold on to it because, well, what's the worst thing that can happen? The answer of course is plenty, and almost all of it bad. The answer is that you would never have bought it in the first place if you didn't think the reason was going to occur, so there is no reason for you to own it now. I have seen myriad investors turn trades into investments, developing a rationale or an alibi to fool themselves that they are doing the right thing. That's because they don't make the distinction between a trade and an investment. When I want to "invest" in a company I buy a small amount of it to start and then hope the market will knock the stock down so I can buy more. When I want to trade, I put the maximum on at the beginning because I believe the data point is about to occur. I never buy anything for a trade without that catalyst. I never buy anything for a trade just hoping it will go higher; there can be no hope in the equation. I buy down when I am investing. I cut my losses immediately when I am trading if the reason I am trading the stock doesn't pan out.

2. Your first Loss is your best Loss. People know when trades have gone awry. They know the stock doesn't act well. On my radio show I talk about how stocks talk to me; they tell me things. Actually, of course, they tell everybody everything, but most people don't know how to listen. If you buy a stock for a trade and it starts going against you in a meaningful way, perhaps a decline of 50C or more, you may have a real problem on your hands. I am not kidding. When it comes to trading I am an extremely disciplined person. I like to cut my losses quickly and get over them quickly. That's why I say that my first loss is my best loss. All other losses tend to be from lower levels and at bigger cost to me. Again, people instinctively can feel the trade going awry but because of ego or pigheadedness, they don't want to heed the thunder and they stay in only to have to panic out at lower levels.

• It's okay to take a loss when you already have one. One of the silli
est things individual investors do is to pretend that they aren't losing
money simply because they haven't realized the loss. I talk to investors
all the time who rationalize that they are in the money until they take
it off the table—regardless of whether they are profitable or not. Non
sense. A loss is a loss, realized or unrealized, and most of the time it is
better just to take it than to act as though you don't have one. My goal
is to get you to realize the loss before it does so much damage that
it cuts into your gains. No one can come back from the chronic loss
position; no one is good enough or has enough ammo to stay in the
game. Cut your losses now; let your winners do the running.

• Never turn a trading gain into an investment loss. You've just made
a terrific trade, you bought Philip Morris (now Altria) before a great
quarter and watched it go up 4 points on the good earnings news. Do
you take the trade? Or do you begin to wonder, "Hmm, this MO is bet
ter than I think; I should hold on to this." I did that once, that exact
trade. I bragged to the Trading Goddess as I was driving her to the air
port for a flight to Paris. I told her I had a big gain on a couple of hun
dred thousand shares. She reminded me immediately never to use the
word "gain" unless it was taken, because as far as she was concerned,
there was nothing booked so nothing had been done. A week later I
picked her up at the airport, back from France and gay as I have ever
seen her. She could see through my sullen look immediately. "What
did you screw up on?" she asked, knowing full well that the only thing
that could have made me unhappy at that juncture was a big loss in the
market. I then had to describe to her that a day after she left a court
had ordered Morris to pay billions in tobacco medical damages to
everyone who had ever smoked a cigarette, or something like that. The
stock had dropped 15 points. She reminded me of the cardinal rule,
that a trade is just a trade, and when you turn it into an investment you have overstayed your welcome. I had turned my solid six-figure gain into a multi-million-dollar loss. Let my loss be the lesson to you, so you don't have to learn it yourself.

• Tips are for waiters. At one point in both our lives, my wife and I
were waiters. To be more accurate, I was a busboy, because you had to
be twenty-one to serve alcohol in the state of Pennsylvania. She was a
waitress. Later, when we worked together, my wife would handle all
the incoming calls from brokers. That meant that at least four times a
week I had to hear her lecture someone about the tip they were giving
us, telling the poor shmoe on the other end of the line that we were
both waiters once and that they should save the tips for those in that
profession and not hit us with them. Why was she so adamant? Be
cause the logic of a tip, or really, the illogic, is so palpable. If you really
"know something," then you are per se an insider and aren't supposed
to tell anyone without running afoul of the securities laws. And if you
don't know something, you should shut the hell up because you don't
know what you are talking about. So, any tip is, per se, a bum steer—
unless it is left at a restaurant. This no-tip rule is a very hard lesson, be
cause invariably the people offering tips are experts at making them
sound like genuine insight. But believe me, the only reason someone
really gives a tip is so he can get out of what would otherwise be a ter
rible position that he's stuck in and will definitely lose money on if he
doesn't get you to take him out of it.

• You don't have a profit until you sell. This commandment is a vari
ation of the rule of not turning a trade into an investment. People con
stantly confuse booked gains, real gains that you can take to the bank,
with phony paper gains that are meaningless because they can be
taken away. Most people are also reluctant ever to take a profit because
they don't want to pay taxes. I always tell people that if we could just
rewind the videotape to January 2000, when people were sitting on
trillions of dollars of unrealized gains, we would be able to drill this
point home well enough that people would respect it. Gains not taken
can be losses. Gains taken can never be losses. It's that simple. I stress this point because we have all been brainwashed not to sell; we think it is sinful. It is commonsensical. It is logical. And it is the only way to be sure you get rich in this business.

• Control Losses: winners take care of themselves. One of the amaz
ing things about this business is how often I hear people say, "If it
weren't for that Nortel position, I would have been up big," or, "I
would be making a huge amount of money in the market if only I
hadn't let Lucent run against me." It takes only one or two losers to
wreck a portfolio. I try to devote far more of my time toward my
losing stocks than my winners, and not because of some sort of
masochistic streak. Rather, I recognize that stocks often telegraph de
clines. I recently bumped into a policeman in town who owned a cou
ple hundred shares of Enron. He was thanking me profusely because I
told him at $20 he had to bail. Of course he was reluctant to do so; the
stock had been at $80 not long before. I told him that loss control is
the paramount concern for all of those in the market, because the
winners, the good stocks, tend to take care of themselves. He sold
the Enron. He told me that if he hadn't he would have wiped out all of
the gains he had had in all the other stocks in his portfolio. I tell the
story because it is typical; one bad apple in this business truly does de
stroy the whole barrel. Take the loss before it gets hideous. Don't buy
into the notion that you can't sell until it comes back and then you
promise not to do it again. That's how losers think. You need to think
like a winner.

• Don't fear missing anything. I can't tell you how many times I
have had my heart in my throat, pounding, pounding, because I didn't
have enough in the market. I can't tell you how often I felt that I had to
"play," I had to be in because the market was going higher and higher
and higher without me. Do you know that almost every time I had
that feeling, almost every time I had that "I can't miss this action"
drama playing around in my head, I lost money? Discipline is the
most important rule in winning investing, and sometimes that disci
pline means admitting that you missed the opportunity and it is too

late. I almost always feel like I have missed something right near the top of the move. When I was in the Bigs, I used to turn that sentiment into a profit in my final years by actually betting against the market when I thought I was missing something, because that heart-stuck-in- throat feeling correlates with the tops of moves, not the bottoms. Always remember that the best time to buy is when it feels most awful, not when it would relieve the incessant pain of fearing the next big rally, especially given that that rally invariably has already occurred.

9. Don't trade headlines. The press is almost always wrong in its
quick takeaways of what business news is about. Some of it is the rush;
Reuters wants to beat Dow; Dow wants to beat Bloomberg. Some of it
is the lack of grounding of most journalists in business news. And
some of it is complexity: The headline can't capture the reality be
cause the reality is a jumble. Headlines that present stories about such
and such a number being "better than expected" are the types of
headlines that punish traders constantly. They can't understand how
they could be wrong because the "tape" just said that the quarter was
better. Typically, the reality is that there is something else, some other
metric that might be important, or that the quarter is finagled with
one-time gains. I think that you have to wait to read the whole story
and you can never be sure of what that story is going to be from the
headline. This point is very important because with electronic trading
you can move too fast, and often many of you do. Learn the whole
story. If this really is a great opportunity, you will not miss it by taking
time to iniform yourself.

10. Don't trade flow. You are watching CNBC, you see multiple
"takes" or trades to the upside in IPIX or MACE or some other four-
lettered hot stock. Do you want to go buy it? That's called trading flow.
People always want to trade flow. I used to get calls from dozens of
brokers saying that they had big buyers of Microsoft or big sellers of
EMC, and my instincts were to go along with the trades, to buy be
cause they were buying. Wrong! When you have no idea why people
are buying, when you are just operating on the buys and sells of 0thers, you are trading on ignorance. Ignorant traders never ever win. I promise you that by trading flow you will lose far more often than you will make money, even though it seems so easy. Why would they buy if they weren't right? The answer, of course, is that many investments made by others are ill-considered and attempting to piggyback off them is nonsensical even if it feels great. No matter how many times I stress this point, people still see large buyers on the bottom of the TV screen and they go nuts imitating them. That's just plain stupid. Do you think they will tell you when to sell, too?

1. Buk and bears make money; pigs get slaughtered. My favorite expression of all when it comes to the market is that bulls make money, bears make money, and pigs get slaughtered. In fact I have a tape of pigs snorting that I play on Jim Cramer's RealMoney when I think that someone's been too greedy. I am all about common sense, which, unfortunately, seems rarely to be interjected into the investing dialogue. It makes sense that a bull can make money when the market moves up, and it makes sense that a bear can make money when the market moves down; both going long and shorting are noble endeavors. It's when you act piggish, when you refuse to take anything off the table after a huge run, that you get hurt. My style of investing is to buy down, simply because I believe, when I am investing, that I am buying shares in an enterprise, and unless that enterprise has faltered in the interim between my decision to buy and my buying, I stick with it. I use the market's irrationality and randomness in my favor to accumulate more stock, to the point where I am perfectly willing to have up to 25 percent of my portfolio in one name if I think it is absurdly valued. Just as a market can take a stock down irrationally, it can also take a stock up irrationally, although far too few individual investors think this way. The difference is that when a stock goes down irrationally it is getting cheaper and cheaper, but when a stock goes up irrationally it is getting more and more expensive. In any walk of life other than investing in stocks there comes a price that we are not willing to pay and a price where we would be a seller of goods. Only in stocks do we feel we should hang on regardless. That's just plain against common sense. When you are a pig, therefore, I expect you will be slaughtered. Many people have asked me how in March 2000, within ten days of the top of the market, I knew to take money off the table and begin to short (arguably my best call since the cash for the crash call in 1987 that my wife steered me to). The answer, in a rather unrigorous and nonelo- quent moment, is that I was not willing to be a pig. I had made a ton of money virtually in a straight line and had watched many of my stocks go to absurd valuations. Of course, at the time, people had plenty of justifications, intelligent, rational-sounding justifications for staying in the market. But my "bulls make money, bears make money, pigs get slaughtered" philosophy got me out right on time.

2. It's okay to pay the taxes. At the time when I said to take money off the table in March 2000,I received close to a thousand e-mails from people saying that if they took the profits that I was advising them to do, they would have to pay a tremendous amount of tax, much of it short-term, which, of course, carries with it much higher rates than long-term gains. I wrote back to each person individually saying that if you don't take profits, you won't have profits, that the least of your worries is the tax man. Not one agreed with me. The abhorrence of taxes transcended good judgment. Years later, I am still getting e-mails of apology from people bemoaning the fact that they cared more about paying taxes than taking profits and that their portfolios subsequently shifted from being well into the black to dripping with red. Never consider taxes as a reason to hold a stock if the stock has gone up too far too fast and can head back down hard. Never hold on to something not worth holding on to or something that has gotten dangerously overvalued simply so you can wait until the gain goes long-term. This is the single biggest investment mistake people have made in our generation, and despite the trillions lost in the bear market of the turn of this century, I still see people making this error. Shameful, just shameful. Taxes do not trump fundamentals; dangerous stocks are dangerous whether they are owned long- or short-term. You can't base investment decisions on the tax man.

3. Don't buy all at once ; arrogance is a sin. I consider myself one of the greatest market timers of my era. I was able to accumulate wealth as quickly as I did because I timed lots of big moves, getting in right and exiting right. Yet, when it comes to buying stocks, to the way of buying stocks, I never buy all at once. I buy increments on the way down, spaced out gingerly to avoid emotion. Similarly, I never commit a lot of capital at one level, and I space out my capital commitments. Let me give you some examples. For my retirement account, my 401(k), I like to put aside a twelfth of my commitment every month. But if I catch a market break, a substantial market break of 10 percent, I speed up the next month's contribution. If I catch a break in excess of 15 percent I put in the next quarter's contribution. And twice in the last ten years, when there was a 20 percent decline, I invested all that I had left to contribute. That way I was able to take advantage of the declines and average in at great prices. I did it this way because I know I am fallible. I also know behavior and common sense. I know that if I commit all my money at one level and then the market takes a huge tumble, I will be so angry and sullen that I'll believe that the market itself is rigged or that it can't be tamed or that it is just too hard. I hear those sentiments from callers every day on my radio show, and I know that they can only be combatted by humility and a recognition that the market can be an unpredictable morass at times, but over the long term it makes plenty of sense.

Similarly, when I wanted to build a position, a sizable position in a stock, I never bought it all at once. I recognized that there was inherent fallibility in my moment of buying. Perhaps the market was about to take a huge tumble. Perhaps some negative event would occur that would make the buy seem ludicrous a few minutes later. So space them out. That's always been the way with me, even though it often drove my brokers up the wall. They hated the fact that instead of going in and buying 50,000 shares of Caterpillar in one fell swoop, I bought 5,000 every hour, or 5,000 at one level and then waited for a 254 drop to buy the next 5,000. They wanted to get my order done; I wanted to get my order done right. You are the client; you are in command of your money. Don't let anyone rush you or make you put it all to work at one level. How do you know that tomorrow the market won't crash? How do you know that tomorrow there might not be an unbelievable opportunity to buy one of your favorite stocks at a much better level, but you have just committed all the money you had? Accept the fallibility of man's judgment and use it to your advantage. The worst that happens with my method? Simple: You don't get enough stock on before a very big move. You don't have as big a profit as you would like. Now that's what I call a high-quality problem!

4. Look for broken stocks. not broken companies. Most people so closely affiliate the stock with the company in their minds that they can't tell the difference between the two. That's nonsense. There are lots of very bad companies with very bad stocks. But there are also lots of good companies with very bad stocks. Your job is to know the difference, because the former is no bargain and the latter defines a bargain. After every sell-off of any magnitude, and we will surely get a dozen of them every year, there will be stocks that have been crushed unfairly. Most people gravitate toward the broken stocks of broken companies, the Suns, the Gateways, the CMGIs. Instead, they should focus on the companies that have been unfairly beaten up. On my radio show, I say, Don't buy damaged goods, buy damaged stocks of companies that are on the mend or improving. How can you spot the disparity? Simple homework. I can't tell you how many conference calls I go on with companies where they say, in plain English, even though our stock is down, our business is particularly strong. A year ago, Yellow Roadway, the best truclung company on earth, reported a shortfall because of some execution problems involving the merger. The CEO, Bill Zollars, came on my CNBC show and said the model wasn't broken; the business suffered a hiccup, but the stock was refusing to recognize what the business knows: the hiccup's over. Sure enough, the stock subsequently moved up 50 percent when the company reported its next quarter. It was the classic example of the broken stock masking the healthy company.

During sell-offs I always tell people to build a shopping list of what they want to buy while it is happening and stay current about those companies so they can buy them at markdown prices. Remember, in the end, the stock market is just a big store where inventory at times has to be moved. Sometimes the marked-down merchandise at a department store or a supermarket is broken. Don't waste your time speculating on broken companies—those are the spoiled fruit on sale at the supermarket. There are enough healthy companies out there whose stocks have been knocked down for unfair reasons that you don't need to buy spoiled rotted companies that are crummy at any price. Chances are that most companies deserve those low prices and won't go up unless you get real lucky. You don't want luck, or hope, to be part of the equation.

5. Diversification is the only free lunch. Nonetheless, nobody wants to be diversified in real life. They want 100 percent of the next Microsoft; they want to put it all in a couple of stocks that could rally off the next big tech thing. But life's not like that. You have to be diversified to spread the risk. I always explain this in the commonsense way that takes you back to the supermarket: Would you put all of your eggs in one basket? Would you be willing to let all your chips ride on one number at roulette? Of course not. Then how can you have all of your money on tech or health care? How can you make such a big bet on one sector? It's just plain foolhardy.

Why don't people realize it? Because most people process the downside ineffectively. They don't understand that you can lose everything if you are concentrated. You know, though, that the same people who would buy nothing but tech would quickly realize that a dinner made up of four beef dishes is just plain unhealthy. These same people who would put all of their money in Enron would recognize that betting the farm on a lottery ticket is the height of folly. These are pieces of paper, for heaven's sake. Some of the pieces of paper are going to turn out to be worthless, even ones you think are worth a lot. Some are going to zero. The only way to ensure that you are not destroying your nest eggs is to diversify the cartons you place them in.

The toughest thing about diversification is that it is a real party spoiler. When I started my radio show the NASDAQ was much higher than it would be a year later. I wanted people to sell some tech and buy some dividend-producing stocks. I got so despondent about how unwilling they were to do so that I started the game "Am I Diversified?" I believe I have personally helped tens of thousands of people fight off the unmitigated assault on their wealth that was the bear market of 2000. But there's plenty more work to be done. Not one year after the bottom, I started getting those "I own EMC, Oracle, Microsoft, Hewlett-Packard, and Intel" calls all over again. I had to painstakingly remind them how all of these stocks trade together, and if you catch a squall in the market, you are liable to drown in tech stocks. If the goal is to stay in the game, there is no worse way to try to accomplish that goal than to stay in one sector. You will hate me when the market is straight up, but you will love me when the market goes down and the sector you would have otherwise owqed is swamped by sellers.

6. Buy and homework. not buy and hold. When I started Jim Cramer's RealMoney I had a ton of people who didn't want to part with their failing tech or biotech stocks. I always told them, fine, they could continue to own them if they could just answer a few simple questions in English: What does the company do, what price-to-earnings multiple does it sell for, and whom does it compete against? No one could tell me. They just said that they were taught to buy and hold and that anything else was just speculation. I thought long and hard about this misapprehension and decided that the key issue was that they were buying and holding when they should be buying and doing homework about what they bought. Homework is analyzing the Web page, conference call, articles, research, and the like that I discussed earlier. If an investor didn't do those things after he bought, one hour per week per position, I thought he was being reckless, and I said it out loud. I told people that they had no business being their own portfolio managers. They either had to give it up to an index fund, if they had no time, or they should just put it with a couple of funds or managers and review them regularly. But the idea of buy and hold after the tragedy we went through in 2000-2003, one that is on bad days still very much with us, is just preposterous.

If there were truly an arbiter, if there were really an organization or an entity that regulated who had a right to come public, with some standards about how much money they are making and how good their balance sheets are, then you could buy and hold. But the one thing we have learned in the last five years is that anybody can bring anything public and we can't let the low barriers to entry into the stock market hurt us. So the mantra is buy and homework, not buy and hold. Always remember that no asset class over the long term— defined as twenty years—has ever beaten high-quality stocks that pay dividends. But unless you keep up and do the homework, how do you know if your stocks are high quality enough to pay a dividend one day? Without the homework you shouldn't own individual stocks. It is too likely that you will stumble and too likely that the long-term payoff of stocks will elude you. I can't tell you how many times I have bought the stocks of good companies that subsequently went bad. That's what the homework should tell you. It is a check on when to bail because a company's not coming back. It is not designed to find a hot stock so much as it ensures that you don't have your portfolio wrecked by an ice-cold one.

7. No one ever made a dime by panicking. No matter how many times I tell people that panic is not an investment strategy, I see people cut and run at the very worst time. When you sell into the maw, when you join the rout, you never get a good price. You feel good momentarily, you feel relieved that the pain is "gone," but it's always wrong.

When I ran my hedge fund I made millions of trades. I dutifully saved all the trading records in giant boxes and then at year end went over every single trade to look for the biggest panicked losses—you know which ones you panicked on—and then I would look at a chart of the stocks the day before I sold them, the day after I sold them, and a week after I sold them. Do you know in almost every single case—and I am talking millions of trades—the stocks were up the next day and up appreciably a week later. That doesn't mean they weren't substantially lower a month, a quarter, or even a year later. It does mean that it was the wrong time to execute the sell strategy. A patient, less panicked style always generates a higher return. Always. That's a certainty in a world where there is very little certainty.

In the mid-1990s I let a film crew into my office as part of a Frontline documentary on the markets. It happened to be a day where I panicked and sold half of my portfolio to Goldman Sachs at a price about 5 percent lower than the previous day because I thought the market was going to be down 10 to 15 percent. I kept a copy of the tape and I watched it every time I felt a panic attack coming on, because on that day, the very day where I felt that things were coming unglued, the market actually rallied. I wish I could say that it was just irony, but it was rationality. Typically the panic comes at the end of the sell-off, not the beginning or even the middle. The panic marks the capitulation of all of those who tried to stay the course. That's why the panic tends to be the bottom. In October 1998I forgot about Frontline and panicked into a gawdawful tape, the second time in three years that I went against my discipline. Then, too, the market looked like it was going to crash. Instead it rallied steadily after I made my sales.

If you are one of those people who simply refuse to believe me and my empirical work on this, do me a favor. Next time you feel a panic attack coming on that tricks you into wanting to sell, adopt the approach of the Trading Goddess and "throw a maiden into a volcano." That's where you take one stock and sacrifice it in order to forestall taking a more drastic action. Remember my goal: to keep you in the game. Nothing drives people out of the game faster than waiting and holding and then selling at the panic bottom. Don't let it happen to you.

• Own the best of breed; it is worth it. Here's a principle that is fol
lowed strictly among professionals, yet is studiously ignored among
the hobbyists and amateurs. So many people are suckers for cheap. So
many people look at the E x M = P and say, "Wait a second, that's too
high a multiple to pay; Intel's not that much better than AMD." Or,
"There's no way that I will pay that much of a premium for Procter
over Colgate." Shame on you. The biggest bargains tend to be the best
of breed. The amateur loves a "cheaper" alternative, whether it is
cheaper in stock price or cheaper in multiple. The professional says
the reason why Walgreens has a more expensive multiple than Rite
Aid is that it is much better, and when things get difficult, manage
ment is more likely to figure out their problems than to get buried by
them. When the choice is among two or three companies in an indus
try, always go for the one that's the best of breed regardless of the
price. Far too ofien the market simply misprices the weaker of the two,
giving it too much credit. The underdog hardly ever wins in this game.

• He who defends everything defends nothing, or why discipline
trumps conviction. One question I am asked repeatedly in my business
is, "Don't you worry about your stocks?" The answer is that I am al
ways worried about my stocks, always, but I am particularly worried
when they go down! I am doubly worried when they go down when
the market as a whole is going up. That's a sign to me that something's
wrong, that someone knows something I don't know and that I'd bet
ter find out or I won't be able to take advantage of the weakness to buy
more—I will have to sell instead. That's why I demand that if you are
going to have your own portfolio you have the time and inclination to
make the calls, or read the homework or listen to the conference calls
or check the Web sites and articles that will determine whether it is a
buying opportunity or a selling opportunity. Of course, there are
plenty of times when stocks go down and the homework shows you
nothing. There are plenty of times when there is chicanery in the

numbers, or there is puffing by the management, and we don't really know the truth. Or, worse, someone does know the truth, and it was found out at the seventeenth hole at Baltusrol and is known only to a select—and illegal—bunch of insiders. There are also tons of times where you simply have too much stock in the market versus what the market's going to do; you are too "long," as we say in the vernacular. So, what do you do? How do you manage a portfolio under conditions where things go wrong with the stocks you own and things go wrong in the market? There are no magic bullets, but I believe that when in doubt, discipline trumps conviction. You have to have a discipline, a discipline that ranks all of your stocks so that you know which ones you are willing to buy right now and which ones you are willing to sell if you need the capital to sell. You need to rank stocks because not all stocks are created equal and when things go awry you have to be willing to "circle the wagons" around a few good stocks and buy them down so you get a better basis.

I can't tell you how many times, either because of overconfidence or because of an excessively benign period of market rallying, I was lulled into being too long. That's why I developed a four-step system of ranking every stock I own: 1 is a stock I want to buy more of right now, 2 is a stock I want to buy more of if it goes lower, 3 is a stock I want to sell if it goes higher, and 4 isa stock I want to sell now. I actually used to get off the trading desk at my hedge fund every two hours and rank the stocks I owned, forcing my portfolio managers to have only one or two 1s and making them choose what they really liked. The rankings force discipline and make discipline trump conviction. A wise soldier once said, "He who defends everything defends nothing." In war that means don't defend every beachhead and valley. In investing, that means trying to buy all of the stocks that you "like," because no one, not even Bill Gates, has that kind of money. That's how I run my money. I know that I can't protect every stock, so I choose the ones I believe in the most and I buy them down, I "defend them and let the others go. In a serious sell-off, the Is become the only stocks I will own, and I will sell off all the others. This method keeps you from being a kid in a candy store at the worst possible time—when you are about to get your fingers cut off. It requires you to examine every decline as a potential point of action. It also is proactive. You are determining what you are selling, not the market. Most people sell because they can't take the pain; this method builds in the pain and turns a decline into an asset. Almost all my great investments since I started ranking stocks ten years ago came from buying my Is at the time when everyone else was selling them.

10. The fundamentals must be good in takeovers. You want to speculate in takeovers; who can blame you? You want to catch the next Mandalay Bay or the next Nextel Communications. You think that you can wait it out because the payoff will be big. Let me tell you what I think of that: You are a fool if you speculate on takeovers. What you must do is buy undervalued good companies that are doing well. If you go and buy stocks with poor fundamentals betting that someone will take you out with a high bid, you are going to be wrong far more often than you will be right. In my last year at my hedge fund I decided that after Best Foods got a takeover bid it was inconceivable that Campbell would stay independent. Just inconceivable. Too good a brand, too easily acquired. I knew that the family behind the brand was getting restless, and in the meantime the stock had a 4 percent yield. My associate Matt Jacobs, who later became my research director, asked me how the fundamentals were. I told him that the takeover story was "too good to check out," and that if I really drilled down on the fundamentals I would probably not buy it. A year later, after a slash in the dividend and several shortfalls of a gigantic magnitude, I had lost more than 10 points on Campbell. Funny thing about the fundamentals: If the market doesn't like them, the potential acquirers won't, either. When you buy crummy companies and they go down, you can try to console yourself by saying that "maybe I will get a bid." It is far more likely, though, that you will have a Campbell on your hands. Remember the premise of this book: Let me be your lab; I have made every mistake in the book. You can't speculate on bad companies betting that they will get bids. They don't. Nobody wants them, least of all other companies.

• Don't own too many stocks. You can overdo the virtues of diver
sification and become your own mutual fund. Given my constraints
about time and inclination—you need one hour per week per stock to
stay on top of the fundamentals—it is impossible to own more than
twenty stocks unless you are a full-time stock junkie. The right-sized
diversified portfolio where you can do it yourself is a five-stock port
folio. Too few and you lack diversification; too many, and you can't
stay on top of them. Try to come up with a "just right" formula that al
lows you the comfort of staying on top of every position.

• Cash and sitting on the sidelines are fine alternatives. Lots of peo
ple believe in being fully invested at all times. Lots of managers think
they are supposed to be fully invested at all times. This is total non
sense. Lots of times the market just stinks and you want to have cash.
Lots of times there is nothing to do except sit in cash. One of the rea
sons why I outperformed every manager in the business in my four
teen years at my hedge fund is that there were substantial blocks of
time when I was largely in cash, including the 1987 crash. Cash is a
great investment at times. It is a perfect hedge, as opposed to shorting
the market, because if the market keeps going higher as it did, say in
1999, far longer than anyone thought, you could face devastating
losses. I think that cash is the most underrated of investments because
nothing feels as good as cash when that market comes down. It is one
of the reasons why if you follow my method of how to trade around a
stock, you will know that as the market spikes I take stock off, raise
cash, and reposition myself for the next decline. Some people confuse
this with buying on dips. I don't buy on dips; I sell strength and buy
weakness in the stocks of the companies I love. When the time is right
I almost always have the cash to put to work because I believe so
strongly in cash as an option.

• No woulda shoulda coulda. One of the most despicable traits of
amateurs, and even some professionals, is second-guessing. You make

a call, you go to buy Newel1 Rubbermaid, and then it has a shortfall. You sit there and stew about what should have happened. Or you sell Cyberonics the day before it doubles and you ruminate all the next day about what might have been. That's all nonsense. The market requires you to have the right head on at all times. You have to be ready to see the ball right for the next pitch. There is no time to remonstrate. You clear your head and go right back out there. If you want to be introspective and constructive, bracket some time at the end of each month, or maybe the end of each quarter, to assess your strategy. But to second-guess decisions is to put yourself in a loser mind-set. Mind you, I want the pain felt. When I thought one of the younger people in my office made a mistake that was costly, I made them wear the symbol of the stock that they screwed up on as a Post-it on their forehead for the day. But I insist that any time spent saying, "If only I..." is time that keeps you from getting the next big stock. My wife, by the way, believes that women are such good traders because they lack the second-guessing instinct that men have. Whatever, but she taught me to steel myself and to come in the next day without the mental baggage of a screw-up so I could be ready to swing at the next fat pitch.

14. Expect corrections: don't be afraid of them. When a correction happens, investors sometimes decide that they want nothing to do with the market, that the correction signifies that something is wrong and the market can't be touched. That's another very big mistake. Corrections happen all the time after big runs and they are to be expected, but you can't write off the market when they happen. I always tell the story of Joe DiMaggio after his fifty-six-game hitting streak— still the most amazing baseball feat of all time. When he failed to hit in game fifty-seven, should you have traded DiMaggio? Was he finished? Is that smart thinking? Same with the market. Corrections are to be expected; when they happen they are not a reason to panic. They can be great opportunities even as people insist that they've wrecked the charts, taken out the two-hundred-day moving average, or made the market unpalatable, claptrap that I hear every time the market snaps a winning streak with a couple of big losses.

• Don't forget bonds. We always look at the stock market as a her
metically sealed operation. We don't think of it in the broader context
of all markets. Big, big mistake. You have to be aware at all times that
there is an intense competition going on among assets. The most im
portant rivalry is stocks versus bonds. When interest rates are high,
particularly for risk-free investments like U.S. treasuries, that's formi
dable competition for stocks, where there is a ton of risk. The tug of
war between the two goes on at all times. When interest rates go higher
there will alwaysbe someone who says "I like these more than stocks"
and stocks get sold off. That always happens. But many of the people
who got in the market in the last decade don't even think of bonds.
That's financial suicide. It was no coincidence that the Fed had the
overnight cash rates as high as 6.5 percent at about the time that the
bear market of 2000-2003 began. The ratcheting of rates that the Fed
did in 1999-2000 and back in 1994 crushed the market, just crushed
it. And that will always be the case. Pay attention to interest rates and
bonds; ignore them at your own peril.

• Never subsidize Losers with winners. So many bad portfolio
managers and so many terrible individual investors always sell their
best stocks so they can hold on to their worst stocks. You can always
tell when you see this pattern. You will be reviewing someone's portfo
lio and it will be the biggest pile of junk, and you will say, "What hap
pened to your blue chips?" They will say, "I had to sell them to buy
more of these stocks because these stocks kept going down." Everyone
has this problem. I have counseled enough hedge funds that were in
trouble to know that the first thing that gets sold are the best ones be
cause "they can be sold.'' There's always a bid for the good stocks. But
when you have a handful of good and awful stocks, you don't sell the
awful ones because "they are down too much," or because you "will
knock them down" if they are small stocks and you have a lot of them.
I understand that problem for institutional readers, but individuals,

• Hope is not a part of the equation. Emotions have to be checked at
the door in this business. I often hear people say "I hope" that a stock
goes up. This is not a sporting event; this is money. We have no room
for rooting or hoping. We are buying stocks that we believe should go
higher because of the fundamentals and avoiding stocks where the
underlying business is bad and getting worse. Where should hope fit
in? Nowhere. People treat this business at times like a religion. They
believe that if they pray that things will work out, maybe they will. Or
they fall in love with these miserable pieces of paper with the idea that
the love will be requited. Be realistic. Hope, pray, love, rooting—these
are all the enemies of good stock picking. Hard work, research, being
realistic about the prospects is the stuff of good stock picking. I can
still recall the ringing in my ears when I would get off the trading
desk with my wife and she would say, "What's the deal with this Mem-
orex," and I would say, "I am hoping it gets a big contract." She would
scream, "Hope? Hope? We need hope to make this work? Sell it and get
me something where we have more in our favor than just hope." Many
times she didn't even ask, she just sold it after I used the word "hope"
to see if I would buy it back. Invariably I didn't buy back the stocks I
was hoping something good would happen to.

• Be flexible. Readers of TheStreet.com hated me in the spring
of 2000 when I turned bearish. They despised the fact that I could
turn on a dime, hate the very stocks that I had liked, suddenly short
ing what I was going long just a month before. They thought I
was lacking in rigor, a joker even. I even got plenty of death threats
and was worried about my personal safety because the change I made
was so stark. But you know who agreed with me? The insiders. All
of my views that changed had to do with hearing the companies at
conferences—all available on the Web—saying "something's not as

good as it was before." This was granular stuff, like being at the Nortel meeting when former CEO John Roth said, "Business has gotten softer in the last few weeks," or being with Cisco when the company said, "The quarter is not yet in the bag," when the quarter was always in the bag by this time in previous years. You see the situations change, the business conditions change. Something that might be good one month can turn bad.

Maybe you don't care and you are only in it for the long term, but if you are playing fireflies, Game Breaker stocks, and their business hits a wall, their stocks will soon hit a wall, too. I never took action on a stock, going from buy to short sell, unless I heard from the company first that things had gotten less predictable or that business had softened. That's why the homework and the conference calls and the writings are so important, because if a business is saying that things have gotten soft, it must do so in a public forum, and you have to be listening to that public forum as or soon after it is happening. If you are devoting only fifteen minutes a week to each position you have, you aren't doing enough homework to be there at the inflection point of good to bad and you will be caught, as so many were caught in the great bear market of 2000.

19. When high-level people quit a company, something is wrong. I don't believe in shooting first and asking questions later. I think that there is almost always time to do homework to see what's up with a stock—except when a major executive leaves unexpectedly. One of my cardinal rules—and these are all cardinal rules here—is that I will not own a stock when a CEO or a CFO leaves suddenly. I just sell it. I might buy it back later, even if it is higher, but I don't like to own stocks where either of these two heads suddenly departs. Sometimes I am going to lose money because I will have acted rashly. But then again, for every one of those situations there are ten like that of Enron, where CEO Jeffrey Skilling quit abruptly for the usual "family reasons" in the summer of 2002 when the stock was at $47. The stock went to zero soon after. People don't quit for family reasons when they are needed at companies. They just don't. You can't be sure what the real reason is, but when someone leaves like that, someone is making a statement. You have to make a statement, too. You have to sell.

• Patience is a virtue—giving up on value is a sin. Sometimes
stocks you like do nothing. They can do nothing for ages. If you are a
professional investor at a hedge fund, this waiting can be unnerving.
You have people calling you daily and asking you how you are doing
with their money. If you have lots of stocks that are doing nothing,
they will take the money away and you will have to sell those stocks
anyway. But individuals have no such pain. Individuals can sit on
stocks as long as they want. Unfortunately, when I counsel patience
individuals get antsy. "If it were any good it would be going up now,
no?" Do you know how patient I was in owning Intel? For eighteen
months I watched Intel do nothing in the late 1980s. But I believed. I
held on to it because at that time I had only a few partners, and none
of them needed to know every minute how much they were worth.
Later in my career I could never have held on to an Intel that long. Lots
of stories take a long time to develop. Lots of turnarounds take eigh
teen months to two years. When you buy a stock and you recognize
that it could take a long time to turn, mark it as such in your mind so
you don't get tired of it and just sell it. Stocks that are stuck in the mud
a long time tend to romp like thoroughbreds when they are freed from
the gate. Do you have the patience? If you don't, let someone else run
your money.

• Just because someone says it on TV doesn't make it so. This is
one of my favorite tenets. So many jokers come on TV. So many
clowns, people who know nothing. Sometimes people get on because
they are telegenic. Sometimes they get on because they look good.
Sometimes they get on because they have great PR people. Sometimes
they get on because they are friends or because we owe them a favor.
Oh yes, and sometimes they get on because they are good. The last is
the exception. I can't tell you how unimportant performance is to the
media. They are embarrassed to ask about it. They don't want to be in

the business of grading content or making decisions about whether someone is any good or not. That could leave them with no one to come on the show! That's right, they need to book these shows; that's the primary motivation, not bringing you people who know the most about stocks. Not all programs are like this, of course, but far more than you would like to believe. Yet I constantly see people who say, "I bought Covad because I heard this really smart guy say he liked it on TV." Well, let me ask you something. Was he selling it to you when he did? Do you know? Here's an odd fact: I am the only person who comes on TV who has to disclose his positions publicly. I volunteered to do this to protect everyone—my listeners and myself—from charges of pumping and dumping. Nobody else has that restriction, even though it is illegal to pump and dump. But if we asked managers to swear that they don't use the networks to sell their stocks, would they come on our programs? Don't they have an obligation to do the right things for their shareholders? If someone recommends a Covad and it goes up 15 percent when they do, do you really think they keep it? If so, think again. Don't trust anything you hear; go do the homework. If you like it, then buy it. But remember you are never going to get the sell call from the TV. Ever.

22. Always wait thirty days after an earnings preannouncement before you buy. Nothing seems more tempting than to buy a stock after it's been completely poleaxed by an earnings shortfall preannouncement. Nothing, however, could be more foolhardy. Here's why: A company preannounces a soft quarter not because it is having a soft quarter— that goes without saying—but because there is no way out and things are getting worse, not better. That means you are buying into a situation where things are deteriorating as you are buying. My advice: Wait at least thirty days from the preannouncement if you insist on buying. By that time the bad news, the ongoing bad news, should be factored into the stock price and you can begin to anticipate positives going down the line. Never buy a stock just because it's down on a preannouncement. That never works. You will lose money. I promise you.

• Never underestimate the Wall Street promotion machine. When
Wall Street gets behind a stock, that stock can go much farther than if
the fundamentals were doing the driving. There was a time when Wall
Street firms would compete with one another to sponsor companies
so that when the stocks of the companies got high enough, the man
agers would hire the brokers to do deals. That stuff still goes on, but it
is no longer linked so closely because the analysts who do the shilling
can't be paid by the investment bankers, courtesy of the investigatory
work of New York attorney general Eliot Spitzer. Still, when a com
pany's stock gets picked up with a buy from a major firm, that stock
is going to go higher than it should. That kind of sponsorship is
what I like to sell into. Remember, I believe that that stocks are inher
ently poor, short term, at tracking the fundamentals of the compa
nies. Longer term they are great; shorter term, though, when they
ratchet up because of sponsorship, that's the time to bail, not buy.
That's one of the reasons why I advocate buying weakness and sell
ing strength at all times. When you get the artificial strength of a buy
recommendation—there are very few sell recommendations, so I
don't care about those—use it to do the unnatural, counterintuitive
thing, and sell.

• Be able to explain your stock picks to someone else. One of the
worst things that ever happened to stock picking was the Internet, be
cause it took away one of the most important brakes on the process:
talking to someone about a buy. Buying stocks is a solitary event, too
solitary. As I love to say, we are all prone to make mistakes, sometimes
big ones. One way to cut down on those mistakes is to force yourself to
articulate why you would like to buy something. When I was at my
hedge fund I always made every portfolio manager sell me the stock,
literally sell it to me like a salesperson, before I would buy it. If you are
in a position where you are picking stocks by yourself, get someone to
listen to you, let you articulate the reasoning, the philosophy behind
the buy, why you like it. The simple selling of the idea, the notion of
fleshing it out in a coherent way, often reveals one or more flaws.

The last question was particularly crucial because my wife never liked to add a stock without subtracting one, in part because she believed it was impossible to have dozens of good ideas at once that you could have an edge on. That's valuable advice. Without a sounding board, you simply aren't being rigorous enough. If you are in a jam, heck, call me on my radio show on Friday and articulate it, and I will give you the straight up or down in the "Lightning Round," the ultimate test of your conviction. Buying a stock should be like buying a car; there's a lot that goes into it. Don't short-circuit the process. Or as my wife would say, "Look for reasons not to do it," because they will certainly surface soon after you buy the stock.

25. There is always a bull market somewhere. At the end of every radio show I sign off with, "This is Jim Cramer reminding you that there is always a bull market somewhere." I say that because I can't stand the bellyaching I hear from professionals and amateurs that there are no good stocks out there. There are always markets and sectors and exchanges that are in bull mode. Even at the height of the just-completed bear market in 2000-2003, you had tremendous out performance first in the food and beer stocks and then in the silver and gold stocks. These weren't proverbial flash in the pan moves, either. These were real, sustained, and totally catchable. There's a terrible desire among professionals and amateurs not to try something new, not to look at new markets or new stocks. The aversion comes from the amount of work that is required to learn new groups and from the belief that you can't stretch your knowledge. That's nonsense, as I showed you in the metrics section. In every situation, E X M = P, and it can be solved for. More important, the obvious nature of the bull sectors should be self-evident to you by looking at the tables of exchange-traded funds that are readily available online in dozens of places. If you want to read about where the best bull markets are in what sectors, there's a terrific free publication put out twice a year by Fidelity for its investors, The Fidelity Sector Fund Report, which is the single best text about which sectors are doing what and why. I devour it as soon as it comes out, as I have for ten years. It's a brilliant document, and it will be obvious to you, as it is obvious to me, that there is always a bull market occurring at any given time somewhere on the planet, and is totally worth nailing, instead of bellyaching about how Cisco and Intel and Microsoft don't move anymore.