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February 2, 2004

George Parker's Rules of the Game

John P. Hussman, Ph.D.
All rights reserved and actively enforced.

On a rainy day in the summer of 1883, 16-year old George Parker modified an old card game for the entertainment of his friends and called it “Banking.” He would eventually found Parker Brothers, maker of games like Monopoly and Trivial Pursuit.

As Philip Orbanes writes in The Game Makers, Parker saw business itself like a game - its outcome had a certain amount of unpredictability, but was more or less influenced by the quality of the moves you make. That line of thinking led him to a dozen business principles.

•  Know your goal and reach for it

•  Find winning moves

•  Play by the rules but capitalize on them

•  Learn from failure, build upon success

•  When faced with a choice, make the move with the most potential benefit versus risk

•  When luck runs against you, hold emotion in check and set up for your next advance

•  Never hesitate long enough to give your opponents an advantage (paraphrased)

•  Seek help if the game threatens to overwhelm you

•  Bet heavily when the odds are long in your favor

•  If opportunity narrows, focus on your strengths

•  Be a gracious winner or loser. Don't be petty. Share what you learn.

•  Ignore principles 1 to 11 at your peril!

(Philip E. Orbanes, The Game Makers – The Story of Parker Brothers)

One of the interesting features of this list is that at first glance, the items seem to be almost obvious, even trivial. But if you take the time to carefully think through each item in the context of your own successes or failures, they suddenly become enormously insightful, and you start to question how many people actually put ideas like these into practice.

For example, it's striking how many investors seem to need assurance as to which direction the market is headed. They believe that knowing the future direction of the market is the key to their success. But that direction really is not knowable with any amount of statistical significance (which is why we don't rely on forecasts). Instead, the key to good investing rests on exactly the kinds of elements that Parker suggests. Here are a few that seem particularly relevant:

Know your goal and reach for it

If your goal is to catch every market advance and avoid every market decline, and you actually know how to attain that objective, great. We have no idea how to do that here at Hussman Funds. So, we focus on a goal that we believe is attainable – investing for long-term returns while managing risk; achieving strong returns over the full market cycle with less downside risk than a passive approach. Knowing your goal (and believing that it can be attained through actions that you can control) can't be underestimated.

Find winning moves

As I've written frequently over the years, the key to success in just about everything is daily action. You find a set of actions that you believe will produce good results if you follow them consistently, and then you follow them consistently. Too many investors put their capital at risk based on beliefs – even hunches – that they have never verified with any sort of historical data or analysis, or that would be impossible to verify at all. For us, it's critical to know both the average result, and the potential range of results, that we can expect from a given action.

For example, one of our most consistent day-to-day actions is the attempt to purchase stocks with some combination of favorable valuation and market action during periods of short-term weakness, and to replace less attractive holdings on short-term strength. By doing that, we're constantly trying to improve the value and market action inherent in our portfolios at points of opportunity. Very simply, you can't buy low and sell high, on average, if your daily actions aren't designed to force you to buy low and sell high on average.

When faced with a choice, make the move with the most potential benefit versus risk

Again, this seems almost pedantically obvious. But all too frequently, investors make decisions based only on potential benefit, or without any careful reflection about potential benefits and risks at all. Probably the two most frequent questions in my day-to-day “self talk” while managing the Hussman Funds are ones I learned from Chess: 1) What is the opportunity? and 2) What is threatened? If you don't constantly ask those questions, you can miss outstanding chances to add value or avoid losses.

Bet heavily when the odds are long in your favor

This is an extremely important principle, but one that has to be modified somewhat for the financial markets. The crucial modification is that you should never, ever take an investment position that would be successful if you're right but would lead to unacceptable losses if you're wrong. With that modification, Parker's rule on this is probably one of the most important principles for successful investing that you'll find.

Very simply, good investing requires taking greater amounts of risk when the return per unit of risk is likely to be high, on average, and taking smaller amounts of risk when the return per unit of risk is likely to be low, on average. Too many investors believe that every risk is worth taking (witness buy-and-hold investors), or hold a position that they're very uncomfortable with because they're scared to miss out on any further gains (why not sell a portion of it?!?) The key is simple: vary the size of the risk exposure based on the average return/risk you can expect.

If you read the Prospectus of either the Hussman Strategic Growth Fund or the Hussman Strategic Total Return Fund (and we highly encourage that), you'll see exactly this principle in action. We wrote those Prospectuses to allow the flexibility to take risks in proportion to the return per unit of risk that can be expected in each Market Climate we identify. In the most favorable Climate (favorable valuations and favorable market action), you'll find that we allow the Funds to take greater amounts of market risk, but in a way that allows for the possibility of being entirely wrong. The investment part of the job requires research – finding find good opportunities. The risk management part of the job requires humility – knowing you'll sometimes be dead wrong, and factoring that in so that the potential losses are acceptable.

For instance, the Strategic Growth Fund can take a certain amount of leverage. But it can do this only by holding a few percent of assets in call options. That way, we can participate to a greater extent in the market advances that frequently occur in that Climate, but if the market plunges, our additional losses as a result of that leverage are limited to the few percent invested in calls. In the Strategic Total Return Fund, we've written in the ability to purchase Treasury STRIPS (essentially zero-coupon bonds) in the most favorable Market Climate, but we also limit the expected duration of the portfolio (to about 15 years) even in that most aggressive Climate.

In contrast, both Funds have the ability to reduce their exposure to stock and bond market fluctuations during less favorable Market Climates (some combination of unfavorable valuations and unfavorable market action).

In short, we vary our exposure to risk based on the average return/risk profile of each Climate we identify. Parker's rules make sense to us – the way to earn high returns per unit of risk over the long-term is to take greater amounts of risk in conditions where the return per unit of risk tends to be high, and to take smaller amounts of risk otherwise. This also goes back to finding winning moves. A strategy that does not systematically force you to take more risk when the return/risk is high and less otherwise is probably not a strategy that's likely to earn a high overall return/risk profile over time.

Share what you learn

Though I try not to discuss proprietary aspects of our approach, one of the joys of writing these weekly comments is finding ideas that I think will be useful to others. I hope that I'm occasionally successful at that.

Market Climate

The Market Climate for stocks remains characterized by unusually unfavorable valuations but still modestly favorable market action. Last week's plunge in the Dow Transportation index was troubling, because it was so far out of line with other market action that it suggested an important shortfall in final demand. Particularly with energy prices still fairly benign, the weakness in the Transports suggests that whatever increase in output we're seeing is taking the form of inventory rebuilding rather than sales. Still, that divergence is not at all sufficient to move our measures of market action to a negative condition.

To the contrary, the fact that those measures remain modestly positive (combined with a generally falling interest rate environment, a relatively low CBOE volatility index, and a decent market pullback) creates an interesting, if very short term, positive condition for the market. Regardless of valuations, this set of conditions has generally been associated with an above-average return per unit of risk over the following couple of weeks. Essentially, the market tends to produce a snap-back rally, which may or may not be sustained beyond that couple of weeks. While we don't rely on that as a forecast, and neither should you, the historical tendency is strong enough that we purchased a moderate number of index call options last week (a fraction of 1% of assets).

The overall position in the Strategic Growth Fund, then, is as follows. The Fund remains fully invested in stocks that we believe have some combination of favorable valuation and favorable market action. About half of that exposure is hedged against the impact of market fluctuations with an offsetting short sale in the S&P 100 Index and the Russell 2000. In addition, the Fund now has a “straddle” – long both put options and call options. In the event of a substantial market decline, the puts in that straddle would increase the overall hedge to about 70% of portfolio value, meaning that we would expect to be exposed to only about 30% of the market's further losses. In the event of a substantial market advance, the calls in that straddle would reduce our overall hedge to about 30% of portfolio value, meaning that we would expect to be exposed to about 70% of the market's gains. The cost of that straddle is currently less than 1% of portfolio value. To the extent that the volatility of the market falls short of the already fairly low volatility implied in the options, we would expect to experience time decay in that 1% that we could not make up through management of the position. Though you probably don't want to try this all at home, this is fairly standard stuff for us.

In short, we continue to see some initial breakdowns that could very well lead to a negative shift in the Market Climate if they persist. At the same time, the particular set of conditions we observe have created a very short-term positive for the market that we've responded to in a limited way. We certainly don't rely on a market advance here, but as always, we try to align our investment position with the profile of opportunities and risks we observe.

In bonds, the Market Climate remains characterized by modestly unfavorable valuations and modestly unfavorable market action. The Strategic Total Return Fund continues to hold a duration of about 2 years, meaning that a 100 basis point shift in interest rates would affect the Fund's value by about 2% on account of bond price fluctuations. The Climate for precious metals shares has improved modestly given the recent weakness in gold stock prices and a fairly benign interest rate picture, so the Fund has a few percent of its assets in that area, and we would be inclined to add to those positions modestly on further weakness in gold shares.


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