“The most important rule of trading is to play great defense, not great offense.” -Paul Tudor Jones pic.twitter.com/2VvcZ5Akpp
— Jesse Felder (@jessefelder) February 5, 2014
A few years ago I was coaching my son’s flag football team. I’m no football buff; this was a group of first and second grade kids who were just starting to learn the game. The parks & rec department was short on coaches so I volunteered.
Anyhow, it was late in a midseason game and we were ahead by a touchdown, with a decent chance of getting our first “W” of the year (I told you I’m not a football buff). The other team had the ball at midfield and the clock was running down. I called the kids into a huddle and before I could say a word, one of my first grade boys, clearly pumped up by the situation, interjected, “c’mon guys! Defense wins championships!”
I don’t know where little 6-year Beau learned it but he didn’t know how right he was. I tweeted one of my favorite investing quotes today: “The most important rule of trading is to play great defense, not great offense.” I pulled it from an interview with Paul Tudor Jones in Jack Schwager’s fantastic book “Market Wizards.”
But what does ‘playing defense’ mean in terms of investing? I think it means something different to everyone and should depend entirely on your personal investment philosophy and plan.
For Paul Tudor Jones it means getting out of losing trades as soon as possible. In the words of Jesse Livermore, another famous trader, “The only thing to do when a person is wrong is to be right, by ceasing to be wrong. Cut your losses quickly, without hesitation. Don’t waste time. When a stock moves below a mental-stop, sell it immediately.” This is how traders “play defense” in the markets.
For investors it works a bit differently. For Warren Buffett, “playing defense” means ensuring he has a “margin of safety” every time he commits capital and raising cash when stocks generally get too expensive. These fit with his two rules of investing: Rule #1 – Never lose money. Rule #2 – Never forget rule number one.
For individual investors it can mean a variety of things and I can only make one recommendation in this regard: whatever “defense” means to you, whether you are more of a trader or more of an investor, be sure it is within your abilities to implement. Don’t try short selling just because you’re nervous about stocks going lower. Don’t start trying to time the market if you’re not PTJ or Warren Buffett.
For most, I think the best way to “play defense” is to simply adhere to a plan of regular rebalancing. When stocks go up and bonds go down you sell a little of the former and buy a little of the latter to keep your desired allocations in tact. This way you are guaranteed to “buy low and sell high” while most investors are doing just the opposite.
For more information about rebalancing and building an investment game plan read my e-book, “FIRE Wall Street.”