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I was introduced to Karate as a martial art during my teenage years. Recently I happened to re-read the major 20 Karate philosophy precepts summarized by Master Funakoshi Gichin before he established the Japan Karate Association around 1950s. As the behavioral finance gains popularity nowadays as a way to explain the edge that some traders and investors have over the market, it appeared to me that many of those Karate foundation points were clearly applicable to trading and portfolio management. Whether you trade the PowerShares Nasdaq 100 ETF (NASDAQ:QQQ), the SPDR S&P500 fund (NYSEARCA:SPY), the gold through the SPDR Gold Trust (NYSEARCA:GLD), or engage in currency trading or hedging by some ETF like the CurrencyShares Euro Currency Trust (NYSEARCA:FXE), the principles presented below will be beneficial to you. Most of them, in one form or another, can be found as leading tenets of many famous traders and investors - from Jesse Livermore, an American stock and commodity trader from the Great Depression years, also known as the "Great Bear of Wall Street" to Paul Tudor Jones II, the founder and manager of Tudor Investment Corp., whose assets under management currently amount to about $18B. A collection of Warren Buffett's thoughts on investments also includes some concepts similar to the Karate precepts.

We all know the Bruce Lee movies or the more recent Jackie Chan ones. Their movie characters fight with whatever obstacles come in their way and to win they must exercise an utmost concentration. They have to fight as there is no second chance. And thus they win. Their training often requires a lifetime and their learning never stops. As Paul Tudor Jones II is known to have said:

If life ever ceased to be an educational experience. I probably wouldn't get out of bed in the morning.

We should recall that one of the famous price charting styles of today, the candlesticks, also come from Japan. So it should not come as a big surprise that many of the 20 precepts of Karate carry a treasure of investing wisdom. Let us examine the first part of them.

1. Never forget: karate begins with rei and ends with rei (Rei means courtesy or respect, and is represented in karate by bowing).

When entering a trade the investors place their opinions and expectations against those of the other market participants. Their opponent in this trading battle consists of the sum of all other anonymous market participants which collectively represent the market.

Respecting the market frees the investors from the "pride that comes before the fall". Respect towards the expectations of others keeps the mind open for flexible decisions given the market turns against you. As a famous quote of Jesse Livermore states:

To be angry at the market because it unexpectedly or even illogically goes against you is like getting mad at your lungs because you have pneumonia.

Respect towards the market has also another dimension. It concerns the work of traders and investors. Successful investors know that trading requires preparations. They have to take the time to do the proper due diligence and research. We know however, that one pays a little attention to something he or she does not respect. Respecting one's own investment actions would make that person behave in a more responsible way and hopefully, he or she would learn how to minimize their mistakes. As a result this would increase the returns on capital and the capital itself.

It is no surprise that diligence, respect, competence and integrity are included in the CFA Institute Code of Ethics which every CFA Institute member must abide by. For those not familiar with it, the CFA Institute is a global organization of more than 100,000 investment professionals whose mission is to engage its members in promoting the highest standards of ethics, education, and professional excellence for the ultimate benefit of society.

2. There is no first attack in karate.

As Mark Twain has said "Don't go around saying the world owes you a living. The world owes you nothing. It was here first." Most certainly the market was here first, as well.

Traders and investors are entering into an already working mechanism and they must get familiar with its rules and behavior. As long as they have taken positions and committed investments, they are open to all the winds that blow in the market. Moreover, due to inflation and other price changing factors, investors are susceptible to the market's effects even if they hold only cash. So in general it does not matter who has made the first punch - whether you took a position in anticipation of some movement or the market moved first against your trades. In either cases you have to guard your investments and act accordingly to protect your portfolio.

3. Karate supports righteousness.

Karate supports that one should do what is right. So is the market. There is a saying of Livermore:

They say there are two sides to everything. But there is only one side to the stock market; and it is not the bull side or the bear side, but the right side.

Foreign exchange traders know this best because the currencies fluctuate relative to each other all the time. One month the right thing might be to go long the U.S. dollar. The next month shorting it could be the right path to success.

Markets often fluctuate on a greater scale. Thus the turning points that precede movements which may last for many months are able to provide significant increases in the investment return with the risk of a relatively smaller loss. With proper stop loss orders the size of the value at risk could be further controlled.

As many would agree exiting of U.S. equity indexes, shorting them or engaging in some other hedging strategy around the end of 2007 would in the worst case protect the investment before entering the market again. In the best case such actions could have brought a significant profit (about 50% is the decline of S&P 500 for the period of November 2007 to February 2009).

Paul Tudor Jones II has a famous saying about this type of trading:

I believe 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. Well for twelve years I have been missing the meat in the middle but I have made a lot of money at tops and bottoms.

Being right could mean a different thing for every trader. Most of the people could be more confident when trading inside the trend. Others will prefer the swings. This separation of investors' preferences leads us to the next precept.

4. First understand yourself, then understand others.

The investors have to be comfortable with their actions. This is also among the main features and tasks of the portfolio allocation - to construct a portfolio that suits your needs and your constraints, in your time horizon. The same also applies to strategies - one should choose trading and investment strategies that suit one's temper and mentality. There is a Wall Street saying that "if an investment keeps you awake all night, you should sell it to the sleeping point". Know yourself and your abilities before starting to analyze others, including the market.

5. The art of developing the mind is more important than the art of applying technique.

The proper attitude could save the investors a lot of trouble, and money. As our actions are controlled and led by our beliefs, our view towards life often determines the strategies we use. Some people do not engage in short selling because they do not feel it to be right. They prefer to be only long. Other traders have not trained their minds to apply enough critical thinking so they would simply copy the investment decisions of the leaders around them. There are also those who prefer to feel the action and thus they trade all the time.

Those hardly seem like sound principles of investing, capable of providing a long term growth of capital. And all those come from a mind that is not developed in the proper direction.

As Warren Buffett once put it:

Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy when others are fearful.

Jesse Livermore adds an important practical element to the development of the mind:

A trader gets to play the game as the professional billiard player does-That is, he looks far ahead instead of considering the particular shot before him. It gets to be an instinct to play for position.

6. The mind needs to be freed.

We have heard that we should not fall in love with a stock. Or an index, for that matter, or an asset, or even a strategy. "Falling in love" and hoping that our investment would do fine just because it is already ours, does not suddenly change it into a good investment if it never was. "Falling in love" often clouds judgment and permits the trader or investor to continue to support hype movements until their very end without paying attention to any warning sings.

The environment and individual constraints also often affect the suitability of the investment itself. It might be a good long term deal but your investment horizon may be shorter. Or the time of entering into the investment might not be able to provide enough further growth for the given investment horizon. All those consideration should be taken into account when entering or exiting a deal. The mind should be flexible and be ready to act accordingly. As Paul Tudor Jones II has said:

You adapt, evolve, compete or die.

For instance, Apple (NASDAQ:AAPL) could serve as a recent example of a stock with a significant base of fans' support. By definition such a support is more emotional ("following the crowd" and "not wanting to miss the next big thing" attitudes included) than rational and could lead to extremely large movements once the prevailing price direction gets broken. Especially if this coincides with a major market downturn. Rational investors should be aware of these capabilities and take precautions. A put option would be a possible way to protect a long investment in Apple given those investors believe the stock has a further upside potential inside their investment horizon.

7. Trouble is born of negligence.

This is almost a self explaining principle. As the financial markets in general are the most liquid ones in the world there is always someone who is ready to step in and take advantage of your mistakes. The speed does not promote negligence as often traders know that if they miss the moment to close a successful deal it might sometimes turn into a loss very quickly.

Long term investors also admit the need of diligence in their work. The information has to be processed, the researches have to be done, the risks have to be analyzed, the conclusions have to be drawn. If anything of the process is missing, the investor is risking not making the optimal decision.

Negligence is often connected with the lack of discipline. Not putting the stops when you have to or falling short of cutting your loses when the market goes against you are just simple examples.

In his book "Market Wizards" Jack D. Schwager writes:

The key to trading success is emotional discipline. If intelligence were the key, there would be a lot more people making money trading… I know this will sound like a cliché, but the single most important reason that people lose money in the financial markets is that they don't cut their losses short.

Buffett goes even further in affirming the notion that the trader's character is what matters most:

Success in investing doesn't correlate with I.Q. once you're above the level of 125. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.

Those are almost half of the Karate precepts. Even though we are still in the first half of the list, the particles of investment wisdom found in them are worth considering. The other half will be examined in the second part of this series.

In the meantime, any comments on the presented principles would be appreciated as sharing of different viewpoints trains the mind to search and explore further risks and possibilities.

Source: Karate Principles In Trading And Portfolio Management