Don't focus on making money, but protecting what you have

In the arena of investing, there are numerous ways to make billions. But Paul Tudor Jones II’s methods would never make an appearance in any classic investing manual. In fact, neither would they be part of the curriculum in most business schools. A point he noted decades ago.

When in his twenties he was all packed to head off to Harvard Business School. All of a sudden, he was struck by an epiphany that they would not instruct him in anything he needed to know to be a successful trader. This skill set is not something that they teach in business school. He decided against the prestigious degree. Instead, he started his own fund - Tudor Investment Corporation, which eventually earned him the iconic status as the world’s greatest trader.

Rather than focus on individual companies or sectors, Jones is a macro trader making bets on moves in interest rates and currencies. His most notable successes was going short and making money on Black Monday in 1987. That year, his fund returned 129% and he is estimated to have made $100 million. Not surprisingly, it put him on the hedge fund map.

During that period, Jones realised that there was a tremendous embedded derivatives accident waiting to happen due to portfolio insurance. That essentially meant that when stocks started to go down selling would actually cascade (not dry up) because the people who had written these derivatives would be forced to sell on every down-tick. He grasped the dynamics of how large derivatives had grown in such a relatively short period of time and its impact on a relatively unknowing (and overvalued) market.

In an interview, Jones explained this well.

There's whole variety of benchmarks that you look at when trading a particular instrument, whether it's a stock or a commodity or a bond. There's a fundamental information set that you acquire with regards to each particular asset class and then you overlay a whole host of technical indicators and that's how you make a decision. You need to understand what factors you need to have at your disposal to develop a core competency to make a legitimate investment decision in that particular asset class

And then at the end of the day, the most important thing is how good you are at risk control – 99% of any great trade is going to be the risk control.

In the late 1980s he saw that a bubble was forming in Japan. In 1987, Nippon Telegraph and Telephone was floated on the Tokyo stock exchange at a P/E of 250. The overvalued market continued to surge. Over the next two years, the Nikkei continued its upward climb. Jones bided his time and did not bet against the bulls. At the start of 1990 came the moment he was waiting for- the Tokyo market fell 4% in just a matter of a few days.

Japanese investors expected their fund managers to show annual returns of 8%. If the market suffered its reaction at the fag end of the year, fund managers who were above the 8% hurdle due to gains in the previous months might not have minded. But a fall in January was different. Fund managers, to secure their 8%, might flee to bonds causing the stock market to tumble. Jones’ assessment was right and the market tumbled that year. By studying patterns of the earlier market collapses, Jones anticipated a weak rally post the initial fall.

A key element in his favour was that he could respond like lightning. He was not wedded to any of his positions. His hallmark was flexibility. His profits came from agile short-term moves.

He switched from a heavy short position to a mild long one. The Nikkei rose, he benefited. But he never wavered from his forecast that the market would experience rallies on its way down. By late summer he went short again. His timing was excellent. In 1990, when the market plunged in Japan, he made a fortune.

He repeated this feat when the tech bubble burst early this century.

The very best money is made at the market turns. Everyone says you get killed trying to pick tops and bottoms and you make all your money by playing the trend in the middle. But I have made a lot of money at tops and bottoms.

In the book Inside the House of Money: Top Hedge Fund Traders on Profiting in the Global Markets, the author speaks to Dr Sushil Wadhwani on his experience with working with Jones. In 1999, Wadhwani was selected by UK Chancellor Gordon Brown to replace Alan Budd as one of the four “outside” members of the 9-member policy-making group at the Bank of England. Prior to this he worked with Jones as a proprietary trader. The three traits about Jones that impressed him the most were knowledge, intellectual flexibility and playing a good defense.

Lessons from Paul Tudor Jones
•Knowledge

According to Wadhwani, Jones’ encyclopedic knowledge of market history and ability to spot the appropriate parallels was second to none. Jones himself stated that the secret secret to being successful from a trading perspective is to have an indefatigable and an undying and unquenchable thirst for information and knowledge.
•Intellectual flexibility

However strongly you believe in something and coherent the case is, you need to be willing to accept that you might be wrong and able to take the position off even though you may not be wrong in a medium-term sense.

If I have positions going against me, I get right out. If I have positions going for me, I keep them. If you have a losing position that is making you uncomfortable, the solution is very simple: Get out, because you can always get back in.
•Good defense

The most important rule of trading is to play great defense, not offense.

Jones once stated that most people lose money as individual investors or traders because they’re NOT focusing on losing money. He believed that one should not focus on making money but on protecting what you have.

People need to focus on the money that they have at risk and how much capital is at risk in any single investment they have. If everyone spent 90% of their time on that, not 90% of the time on pie-in-the-sky ideas of how much money they’re going to make, then they would be incredibly successful investors.
•Be dead to ego

Don’t be a hero. Don’t have an ego. Always question yourself and your ability. Don’t ever feel that you are very good. The second you do, you are dead.

If you make a good trade, don’t flatter yourself by crediting it to some uncanny foresight. Maintain your sense of confidence, but don’t let it get the better of you.

That, in a nutshell, encapsulates the investment philosophy of billionaire Paul Tudor Jones II.

His main hedge fund produced an average annual gain of about 26% from 1987 through 2007, which dropped to about 5.3% from 2008 through last year. The fund lost 4.8% in 2008 and is down 2.3% as of mid-August 2016. (Bloomberg.) While some are of the opinion that Jones' best days are behind him, the billionaire and legendary macro trader has been making huge changes in the running of the fund and is determined to convince investors that he has not lost his mojo.

Only time will tell.