Sun Tzu's The Art of War Applied to Investing

The art of war is an ancient Chinese military treatise attributed to the military strategist Sun Tzu, believed to have been written during the 5th century BC. It is composed of 13 chapters, each dedicated to a different aspect of warfare. 

Despite its military origins, its principles have been widely applied in various fields, including business, sports, and politics, due to its emphasis on strategy, leadership, and psychology. This article will show how to apply some of its principles in the world of investing.

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"All warfare is based on deception."

This quote highlights the importance of strategy and cunning in warfare. Trading and investing are not always buy low, sell high; they can embody other forms to make money. For example, some quantitative high-frequency trading firms resort to shady techniques such as:

* Quote stuffing

This technique involves rapidly placing and then canceling large numbers of orders to flood the market with quotes. This can slow down competitors' trading systems and create confusion in the market, giving the HFT firm a momentary advantage.

* Layering and spoofing

Layering involves placing a series of non-bona fide orders to create a false impression of market demand or supply. Spoofing is similar but involves placing orders with the intention of canceling them before execution. Both practices aim to manipulate market prices and deceive other traders.

* Front running

Front running involves an HFT firm detecting large orders from other traders and then quickly placing orders ahead of these trades to profit from the expected price movement. This can be done by exploiting the information from these large orders before they are fully executed in the market.

* Ping orders

Ping orders are small orders sent to detect the presence of large hidden orders in the market. By placing and quickly canceling small trades, HFT firms can identify significant buying or selling interest and exploit this information.

* Quote matching

HFT firms may engage in quote matching to identify other traders' algorithms. By placing orders that match the patterns of other traders, they can predict their future actions and trade ahead of them.

In negotiations, such as mergers and acquisitions, psychological tactics are often used to gain the upper hand. This can involve bluffing, misinformation, or strategic concessions to achieve a more favorable outcome.

One might argue, is investing comparable to warfare? Well, in warfare, there is a winner and a loser. In trading, for one to make money, another one has to lose money. They can be close cousins in the very least.

Navinder Sarao, a British trader, used quote stuffing among other techniques to contribute to the 2010 Flash Crash, where the Dow Jones Industrial Average plummeted nearly 1,000 points in minutes. Sarao rapidly placed and canceled large orders to create market confusion and exploit the resulting volatility for profit .Another example is JP Morgan Chase's trader Bruno Iksil, known as the London whale, engaged in trades that were so large they moved the market. His activities led to significant market manipulation, contributing to a $6 billion loss for JP Morgan. While not HFT, this case underscores the potential for market manipulation through large trades.

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"If you know the enemy and know yourself, you need not fear the result of a hundred battles."

This quote is about emphasizing the significance of self-awareness and understanding your adversary.

When you understand your risk profile and match it to the market's statistical properties, you are likely to be considered as someone who has done their homework. Alternatively, this is known as due diligence, an important concept in financial analysis. Thoroughly researching potential investments, understanding the financial health, business model, market position, and future prospects of a company is essential. This is akin to knowing the enemy.

Diversifying your investment portfolio reduces risk and increases the likelihood of achieving stable returns. This strategy reflects the principle of preparing for various outcomes and reducing the impact of unforeseen events.

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"In the midst of chaos, there is also opportunity."

A wise man once said "buy during fear and sell during euphoria". Followers cannot control their fate. Now, it's important to not misunderstand this as a bash against trend following strategies. Rather, it's always wiser to choose your path independently with no bias, be there chaos or serenity.

Known as the father of value investing, Benjamin Graham emphasized the importance of looking for intrinsic value in companies, especially during market panics when prices are irrationally low.

During chaos, people who took advantage of the fear and bought when others were selling, are likely to be the smartest people in the room.

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"The supreme art of war is to subdue the enemy without fighting."

The highest form of strategy is to win without physical confrontation. This can be equated to safe investments that reflect the true nature of your risk appetite.

In certain times, equity returns and fixed-income returns can be so close that equity investing is not justified. This quote by Sun Tzu advises us to win without putting too much effort if possible.

Reinvesting earnings, such as dividends and interest, allows the power of compounding to work in your favor. This strategy helps grow your investments over time without the need for active trading. 

Additionally, investing in dividend-paying stocks can provide a steady income stream without the need for aggressive trading strategies. This method focuses on the reliable income generated by dividends.

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"The greatest victory is that which requires no battle."

Well, we knew this one was coming. Passive investing has enjoyed a lot of notoriety these past years and for a good reason. Take a look at the following table:

These returns could have been achieved by simply placing an amount of money in a tracker that replicates the returns of the S&P 500. How many fund manager could say that they outperformed these numbers?

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"To know your Enemy, you must become your Enemy."

This quote emphasizes the importance of understanding your adversary so thoroughly that you can anticipate their moves and strategies. In the context of investing, this principle can be interpreted as deeply understanding the market, competitors, and other market participants to make informed and strategic decisions.

By deeply understanding the strategies, behaviors, and motivations of other market participants, investors can better anticipate market movements and make more informed decisions. This approach aligns with Sun Tzu's principle of thoroughly knowing the enemy to achieve strategic advantage.

Another way of thinking about this is to put yourself in the place of your broker, dealer, or any counterparty. You have to think about what they are trying to do and what will they do. This can also be a proxy for market sentiment.

For more in-depth market sentiment analysis, you can follow my weekly newsletter on Substack which presents weekly market sentiment indicators and what they say about the different global macro assets:

The Weekly Market Sentiment Report | Sofien Kaabar, CFA | Substack

A Weekly Report Covering Global Market Positioning Using Complex Models. Click to read The Weekly Market Sentiment…coalescence.substack.com

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"The wise warrior avoids the battle."

Sometimes, it is worth staying on the sidelines. Not every trade must be taken. No risk is better than excessive risk. 

During volatile and chaotic market environments, it is sometimes wiser to wait for a better opportunity which has a higher success probability.

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"Opportunities multiply as they are seized."

This quote highlights the concept that taking advantage of opportunities leads to the creation of even more opportunities. In the context of investing, this principle can be applied in various ways to achieve financial growth and success.

Reinvesting profits from successful investments can compound returns over time, creating new opportunities for growth. Using the profits from one successful investment to fund additional investments can lead to a diversified portfolio and greater overall returns.

Also, continually improving investing knowledge and skills can help investors identify and seize new opportunities more effectively.