In Part one we talked about how outlier events in the markets play such an important role in our final performance, yet how few are really aware of this fact. These events come out of nowhere, yet the experts concoct explanations for them after the fact, making them explainable and predictable and therefore unlikely to happen again, and besides, everything smoothes out in the long run. Well, these explanations might make us feel better at the time but are hardly useful.

So, what can we do to minimize some of this complex uncertainty?

One thing for sure, we should really take a strong look at “market timing” in the traditional sense. If missing a few good days can wreck your long term performance, timing the market has a whole other dynamic to threaten us. What would happen to our performance if we missed the 10 good days but were in for the worst 10 days? Or, what if we avoided the 10 worst days? I know this much, if a few periods can be so meaningful; it puts quite a strain on the timer.

We should also take a good look at the traditional long term buy and hold strategy like mutual funds, ETF’s and indexing. You may think your mutual fund manager has downside “outlier” protection, but is that true? He can’t afford to be out of the market while his competition is in. He might lose his job. Obviously ETF’s or Indexes have the same problem. So, if you stay exposed to reap the upside rewards you might get clipped, yet if you time the market, you may miss the upside and still be exposed to the downside. See what I mean about hard?

As trite as it sounds, the first thing we need to do is understand completely what we have invested in. Do we really know how it works, what environments it should do well or not? Next, we need to know what amounts to risk and still sleep at night if everything went wrong. I know this sounds rudimentary, but most people don’t give these things enough thought. I think they have a passing knowledge of what they invest into, and assume the advisor knows what to do. Well, I wouldn’t risk it.

I think we need to take on these responsibilities and stop assuming our advisors have. Since it is so difficult for them to predict the good periods, we should concentrate on what we can control, the downside outliers. We most likely won’t be smart enough to see those great periods coming, but we can protect ourselves against a catastrophic loss that we won’t recover from.

It is critical we understand the investment. It is critical to understand the relationship it has to the current financial climate, or otherwise how do we know how it will behave? It is critical to stay in liquid investments and have an “uncle point” where you call it a day. We are all aware of using a stop on a trade, but how many of us use a stop on a mutual fund or a money manager? We assume our advisor is doing that. Well, good luck with that.

Finally, it is critical to consider the impact on our overall net worth if it goes wrong, otherwise how will we behave? Look at the BP situation. You would think BP, of all the oil experts in the world, would have guarded against something as catastrophic as this spill. Now they are simply reacting, trying anything to stop the oil.

Once we follow the advice above, a reasonable application might be to get aggressive with a small % of the overall trading capital. This is a technique that I use all the time. For example, one could invest 15% of his capital into a fund, ETF or futures trading program and risk 100%. If the idea works out, the interest on the 85% cash position plus the aggressive 15% market position should give you a reasonable overall return yet with a definitive 15% downside. Also, since your worst case is identified, you should not be shaken out by volatility or outlier days.

Obviously the numbers can be manipulated to suit individual appetites for risk. Risk a 5% position in three ideas for an overall 15% exposure or a 5% position in six positions if you want to risk 30%.

This is not to be confused with a trade risk. In a managed futures program or mutual fund the individual risk on each trade should be much less.

I’m saying to risk the 15% on the success of the idea. If you control the unexpected downside surprises of your ideas you will eventually hit some upside outliers. If not, and all your ideas are just plain wrong, I suggest visiting with an Algiers voodoo doctor to remove the hex, or simply finding another line of work.
 
 
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Malcolm Gladwell in his book Outliers says an “outlier is a scientific term to describe things or phenomena that lie outside the normal experience”. In Florida for example, you can expect most days during the summer to be somewhere between hot and Africa hot. What if however, in the middle of August, the temperature dropped to forty degrees? That would be an outlier, but more importantly, we would be hard pressed explaining why it happened. We seem to have a good understanding of what is normal, but know a great deal less about the ”outlier”, in spite of the hind-sight explanations.

What role do outliers play in the markets? Are the returns in a buy and hold strategy in stocks reasonably distributed?  Do we really achieve steady returns over the long term like the experts say? I don’t think so.

As they say, the devil is in the details, and a closer look into long term returns paints quite a different picture than what we’ve been sold. It turns out that long term returns are anything but smooth and steady, or reasonably distributed. In fact, most of the upside (and downside) performance we see over the long term comes from a few outliers. 

In their book Dance With Chance, authors Makridakis, Robin and Hogarth, researched the standard deviation of returns for the DJIA from 1900-2007 with some surprising results. The time period reflects a rather large sample of just shy of 30,000 days with more “outlier” days than one would suspect. An outlier day is defined as three or more standard deviations from the mean (average) return for a day. This is a mathematical formula that determines when returns are outside the experience of “normal” returns.

Academically speaking, if returns were “normally distributed” there should have been about ninety days where the daily returns were more than three standard deviations from the mean. In the real world however, there were 429 days. That is almost five times as many as modeled. Even more surprising, there were 91 days where the returns (or lack of them) exceeded five standard deviations from the mean. According to the “The Normal Distribution” there should be essentially none at that extreme. If this were happening in my Florida weather example, we would have some very upset tourists shivering on the beach.

This characteristic of extreme measurements drives the academics crazy when modeling. As the Authors say “Typically, the attitude of financial forecasters and statisticians alike consider the 429 days outside the three standard deviation limits as “outliers” (somehow  external to the system) and the 91 days as outside five standard deviations as non-existent. Ignoring them allows analysts to use the nice, comforting properties of the normal distribution for making calculations”

Well, this may be O.K. if you measuring something more stable like heights and weights or smokers, but ignoring “outliers” in our field can lead to financial suicide. The October 1987 massacre for example was twenty three standard deviations below the mean (a drop of 22% in one day). If you’re not aware that something like this can happen, you’re likely to have a heart attack some day. The research proves that outliers have an enormous impact on long term performance and a few days here and there can mean everything.

 Javier Estrada in his paper Black Swans, Market timing and the Dow elaborates more on this concept when he pointed out that during this same period “missing the 10 best days in the stock market resulted in portfolios 65% less valuable than a passive investment, whereas missing the worst 10 days resulted in portfolios 206% more valuable than a passive investment”. In other words, if a person was lucky enough to avoid those 10 days he ended up with three times the money in his account at the end of the rainbow. 

So, what can we do with this information? Obviously, this is the tricky part. You have to be in the market to get the upside outlier periods but at the risk of the downside periods. You know, I’m beginning to think this investing thing is hard. There’s always something to worry about.

Check back soon for Part II where we explore some concepts that help us cope better with these uncertainties.
 
 
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Unfortunately the “do it yourself” approach is no guaranteed success either.  The problem lies in the ability for the investor to maximize on his do-it-yourself approach. You can have the fastest execution at the lowest cost available and still consistently lose money. You can back test until your blue in the face only to find the “real world” upsetting your back tested strategy. 

I hear traders all the time use the term “statistically significant”, when in fact it is nothing more than an illusion of certainty. There is uncertainty in all statistical suggestions, but some are more like intellectual fraud. These TV advertised platforms are particularly dangerous in their limitations. 

There are countless obstacles to overcome when building dependable quantified trading strategies, but one limitation in quantified trading will never be resolved, and must be addressed through proper risk management strategies. 

Let’s focus on that one. 

In his book The Black Swan, author Nassim NicholasTaleb coins the phrases Mediocristan and Extremistan to distinguish between two types of randomness. All randomness is not created equal if you will.

 In Mediocristan, everything has boundaries and limits that can be easily measured. Things like IQ scores, height, and weight, and how much people smoke would be examples of Mediocristan. If we were to randomly select 1000 people and calculate the mean weight, we can be reasonably assured that no one sample will dominate the distribution. In other words, you may find the average weight of 1000 men to be 200 lbs, but you won’t find a man weighing in at 200,000 lbs. Even the heaviest man in the sample will not materially affect the mean value of a distribution.

In Extremistan, the variation within distributions is quite different. In Extremistan, one sample can affect the entire distribution. Let’s say that instead of weighing the 1000 men we find out their incomes.  Now, even though the mean income might be $75,000 for 999 men, what if the final entry made 75 million a year? Well, that would mean we can legitimately see a single event that’s 1000x the mean (there are people who make 75 mill), and also double the mean value.

This one sample (event) can change the entire distribution and in fact in some ways make it meaningless to depend on. After all, if I am trying to get some idea of what to expect from sampling, and one event can ruin the whole thing, what good is it?

In this case, it misleads me into thinking that the mean income of the 1000 men is $150,000 per year, twice as much as the 999 men actually make. So, if I had a product that was dependent on the fact that the 1000 men made $150,000 with little variation, I would be quite surprised when my product only sold to the rich guy.

Now, let’s say the income examples above are trades. That extreme entry could be the event that sends us to the financial graveyard. We are at risk of pulling a sample that excludes the extreme event when back testing, fooling us into thinking that the distribution we have is dependable enough to trade. Then we are likely to build an approach based on this sample and these assumptions. When we finally are confident enough to trade the strategy, we are unaware of the extreme, and therefore unprepared and eventually surprised.

In the trading world we have a duel edged sword. On one hand we are unfortunately held hostage to the same extremistan surprises that could blow us up. On the other hand these are the events that can make us wealthy. In trading, it is the same extreme moves that make the effort worthwhile. It is one of those businesses that one or two big events (trades) can make your whole year. Just like authors or rock stars where a handful of stars generate most of the revenues, a handful of trades do the same thing. The trick is staying alive long enough to be there when the come.

Quantified trading systems and strategies, like randomness, are not created equal, and therefore should be scrutinized to see how they will handle the adverse extremes. Constant risk monitoring is the key.
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Here are a few viewpoints from Larry Hite and Salem Abraham on managing risk and expecting the unexpected. You can not only be wrong, you can be totally surprised on occasion.

Larry Hite, one of the original “Market Wizards” was quoted On Michael Covel’s site as saying, “Most of the Ivy League guys I know are so used to being ‘right’ they get very uncomfortable dealing with uncertainty – when there is no right answer.

Their ego often makes them so afraid of being ‘wrong’, that they’re unable to make good bets. They are not comfortable with the idea of risk, because they don’t know how to assess it or measure it. [They have been] taught to absorb knowledge, not what to do with it.

There are just four kinds of bets. There are good bets, bad bets, bets that you win, and bets that you lose. Winning a bad bet can be the most dangerous outcome of all, because a success of that kind can encourage you to take more bad bets in the future. You can also lose a good bet, but if you keep placing good bets, over time, the law of averages will be working for you.”

Below, Salem Abraham, who was also an original “Market Wizard,” talks very briefly on risk and expecting the unexpected.

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Now, I would assume that Ben Bernanke has a research staff, and access to information, that would dwarf our capabilities, not to mention he can call anyone he wants on the phone and pick their brain.

So, in light of that, how in the world could he have been so wrong with such a high degree of confidence?

This is just another example of the “expert” arrogance. The old “I’m right so why should I have a plan B” way of thinking. On a brighter note, it is more evidence of a few things I know to be true.

First, it is extremely difficult to predict and forecast large systems such as the financial markets or the economy, no matter how many facts you think you have.

Second, if with all his resources he can be this wrong, that doesn’t bode well for the rest of us who might be going about the markets in a similar fashion.

Third, it’s OK to have an opinion (forecast) if you firmly believe, but it’s not OK to bet the farm and have no real plan to manage the situation if you’re wrong.
 

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Those that have knowledge don’t predict. Those that predict don’t have knowledge – LAO TZU 

What criteria did you use to choose your latest investment? A better question would be, are you sure that you even understand the criteria? 

For example, let’s say that you chose a mutual fund based on your advisors presentation of how well managed the fund is, and the fact that it has done so well over the last x amount of years. He then assures you it will do well into the future based on the past facts. On the surface this seems reasonable until one considers a few undeniable facts. One, the advisor really has no idea of the future, and two, the performance could be random.  

In fact, history proves that the average mutual fund over the last 25 years has grossly underperformed the market averages. Keep in mind that the advisor is in the business of showing you products that compete with the averages, and is not paid to guide you into something as simple as “buy the S&P.” Also, the fund managers themselves continually compete with the averages, selling their “expert” forecasting as better mousetrap. 

In their book Dance With Chance, Authors Spyros Makridakis, Robin Hograth & Anil Gaba point out a rather astounding piece of research. I think most people have heard that the fund managers don’t out perform the averages in the long run, but I’m not sure that they know to what degree. 

According to the authors, if a person had invested $50,000 into the market average (S&P), 25 years ago they would have 1,061,527 today. The average Index fund (those that track the S&P) would have sent you back 1,015,541. Pretty close. However the same $50,000 in the average mutual fund would have sent you back $541,735. Not so close. 

The significance of this is that the S&P is not a person and therefore can’t claim any expertise. It is essentially the growth of 500 companies. On the other hand the fund managers do claim the expertise, but can’t really seem to deliver it.  It’s amazing how people continue to fall for this, but I suppose the lure of large returns is just too strong to resist. 

When one considers the survivorship bias for those that actually did outperform the averages, the picture becomes even dimmer. In other words, many of the funds that have outperformed the averages still cannot be attributed to skill. Some for sure, but not all.  

To make my point simple, consider a scenario where 1000 manages have a 50% chance of beating the S&P in a particular year. After one year there would be 500 that did. By the fifth year there would be 31 that have beaten the S&P five years in a row. Pretty impressive, but still cannot be attributed to skill.  

After 10 years there will be one manager, from sheer luck, that will have beat the S&P for ten years in a row. The last man standing, the survivor so to speak. Very impressive, but still luck. Past and future performance simply are not related, therefore chasing past success should not be the primary reason to invest.   

What is even more astounding is the “I’ll do it myself crowd.” The average investor investing on his own, according to the research, ended up with $271,371. In other words if the average investor just stayed with the S&P he would have had 4x the amount of money. This could be the difference between financial freedom and “I owe, I owe, it’s off to work I go.” 

I guess this is one walk of life where many of us wish we were just average. 

John Kenneth Galbraith once said “when it comes to the stock market there are two kinds of investors. Those who don’t know where the market is going, and those that don’t know that they don’t know where the market is going.” 

I guess people will draw different conclusions from the above statistics, but I agree with the author’s conclusion. DON’T TRY TO BEAT THE AVERAGES. If you are a stock market investor buy the S&P (or another index or ETF), the numbers speak for themselves.  

If you like gold mining companies buy a mining index (ETF) and don’t try to find the company that will outperform the index (many mining companies). It appears that our odds of choosing the fund, or stock, that will consistently beat the indexed averages is practically impossible. 

Also BE PATIENT the authors say. People just don’t seem to exercise the patience that is required to do well as a investor. Don’t give into the temptation to try and sell the highs and buy back later, or quit your trend following system because it had a sluggish year. The average investor will fail at this. Play the probabilities of long term growth and trends. 

Finally be RISK AWARE, the area that I think is the most important. This does not mean risk-adverse. It means realize that what you don’t know is always greater than what you do know….. and manage your risk accordingly.   

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THE Lloyd’s Prayer

Our Chairman,
Who Art at Goldman,
Blankfein Be Thy Name.
The Rally’s come. God’s Work Be Done
On Earth as there’s No Fear of Correction.
Give Us This Day Our Daily Gains,
And Bankrupt Our Competitors
As You Taught Lehman and Bear Their Lessons.
And Bring Us Not Under Indictment.
For Thine Is the Treasury,
The House and the Senate
Forever and Ever.
Goldman.

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Here is an interesting video of Trader Salem Abraham and Howard Lederer, legendary poker player. They discuss the similarities in managing a good poker hand and a good trade, and how folding bad hands in both cases is the key to success. 

Howard Lederer is known as “the Poker Professor” because of his demeanor, analytical style and long history of wins. He is known for his focused, calm demeanor at the poker table; he has stated that he has applied Zen wisdom to his poker playing. He has won two World Series of Poker bracelets and two World Poker Tour titles. In 2008, he won AUD1.25 million by winning the $100,000 No Limit Holdem Challenge, billed as the world’s most expensive tournament buy-in, at the Aussie Millions. As of 2009, his total live tournament winnings exceed $5,200,000. 

Here’s another post and video with Howard Lederer.

Salem Abraham is the founder of Abraham Trading Company (ATC). Abraham’s trading methodology is a 100% systematic, long-term, trend-following approach, implementing filtering techniques that avoid trends with adverse risk/reward characteristics.

Abraham says “While the goal is to capture long-term trends, the system only enters the market during periods when the risk/reward of a trade is heavily in the trade’s favor. If unacceptable risk characteristics exist, the system will even avoid trends that have a positive profit expectation. The end result is a trading method that has historically provided exceptional returns that are uncorrelated to traditional stock and bond investments.” 

“Over the last few years the markets have become choppier, and many traders’ returns are suffering. In ATC’s continuing research efforts, a technique was discovered that helps to identify these choppy markets and keep the system out during these periods. ATC modified its system with a filter, added markets to the portfolio, and made other changes that will continue to help performance in non-trending markets, while simultaneously not penalizing returns during trending periods. All the models tested are robust with very few degrees of freedom/parameters.” 

“A myriad of proprietary statistical techniques are looked at that include analyzing multiple time period subsets, market-by-market as well as sector analysis and correlation, risk/reward analyses, parameter degradation studies, slippage analysis, and drawdown analysis.” 

“Experience helps in developing a successful trading system. The most common and most dangerous error made in system development is curve fitting. One thing we have learned over the last 15 years is that curve fitting cannot be understood by theory alone. There are many statistical traps that can only be learned by trading systems real-time.” Read related post

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Those of you that follow this blog know that I am a big fan of a definitive trading plan. Having a plan however, does not equate to success, there are still limitations. One limitation is the small account. Unfortunately, the small account has many more obstacles to overcome to be successful than the large account. Let’s take a look at why that is the case.

Most commodity futures have underlying collateral value in the tens or hundreds of thousands of dollars. A gold contract for example is worth $113,000 today and crude oil is $82,000. When you add low margin requirements and increased volatility into the equation, you have a recipe for small speculation disaster.

So, what makes the larger account fair better in the long run?

Well, to name a few reasons, large accounts can afford to trade virtually any opportunity, at any time. There are 75 to 100 or so liquid commodity markets worldwide, and should buy or sell opportunities emerge, a large account can easily afford the margin and risk to trade them all. In addition, they can scale into and out of positions. This is in stark contrast to the small account where prudence dictates only having exposure in a limited number of markets with one contract.

Also, large accounts are not restricted from trading contracts whose volatility is relatively high. For example, a gold trade today with a 5% cash stop would translate into over $5600.00. That happens to be a little over one half of 1% of a million dollar account, yet over 11% of a 50K account.

Now, the devils advocate would say that “I wouldn’t use such a wide stop”, but it’s necessary to use expanded stops in expanded volatility to avoid being stopped out by “noise”. Also, as the contract becomes more valuable, the risk to trade it increases. Gold is not $400.00 anymore it’s $1130.00 per ounce. A 10% move now is close to three times the dollar risk of $400.00 gold.

To stay with the gold example, we run an in-house volatility filter that is currently suggesting that gold has $1238.00 of daily noise (around 12 dollars). So, if you are trading gold and would like to be “outside the noise”, 3 standard deviations would suggest a stop at $3714.00 (around 37 dollars). Even this wider stop does not insure anything, as we all know markets frequently make 3+ standard deviation moves on a routine basis.

So, in a nut shell the 50k account trading gold would have to risk close to 7.5% of his account (per trade) to hopefully stay in the game of trading gold. Good luck with that.

So, how can we trade a smaller account that has the probability of success equal to the large account?

One approach we have explored, and now successfully trade, is the concept of building a model that employs multiple systems, and multiple markets, along with an effective filtering process and risk management controls.

Let’s elaborate.

The process of running multiple systems over many markets will generate a fair amount of trades (like the large account). The filtering process, and the risk controls however, allowed us to filter down the many trades to a few “higher probability” trades. Since the small account cannot take on all the trades, it is the next best approach. This strategy attempts to identify a limited percentile of all the markets it tracks as being the best candidates, using a systematic process to select the few that the small account can handle in terms of volatility and risk.

The portfolio selection process is dynamic as opposed to static (like the small account). This means that from day to day the basket of markets we would trade can change due to strength, weakness and/or volatility changes. We feel this keeps our trades limited to only those markets with the best risk adjusted potential. This allows us to evaluate a very large portfolio (like the large account) while still keeping the number of trades and margin requirements very low to address the small account.

Monitoring a very large portfolio is critically important because if you initially limit yourself to a predetermined small portfolio, how do you know that those markets will be the best markets in the future? (Hindsight bias portfolio selection is a form of curve fitting and is a major downfall of many traders). If an exceptional opportunity develops in a market outside of your predetermined portfolio wouldn’t you want to take advantage of it? By trading with this type of strategy you don’t arbitrarily rule out any market that may perform well in the future and you have eliminated the tendency to pick a portfolio based merely on past performance (curve fit) considerations. See related post

If anyone would like to see more detailed research, feel free to contact me.

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Vince Lombardi once said, “It is a reality of life that men are competitive and the most competitive games draw the most competitive men. That’s why they are there – to compete. The object is to win fairly, squarely, by the rules – but to win.”

Well, we have seen another year come and go and I hope most of you will continue to compete in the most interesting and challenging game in the world. As far as I am concerned, there is nothing like the trading game.

To wrap up 2009 here are a few words of wisdom from Viewpoints Of A Commodity Trader for 2009.

“Analysis can be equated with poker. Security analysts carefully follow the table talk of the game and examine the up-cards. Although analysts effectively follow and communicate these two aspects of the game, they either ignore or ineffectively guess at the other major element-the down-cards.” Read Full Post

“The most important rule of trading is to play good defense, not great offense. Every day I assume every position I have is wrong. I know where my stop risk points are going to be. I do that so I can define my maximum possible draw down.” Read Full Post

“Gamblers think they are betting on red or seven but in reality they are betting on the clock. The loser wants a short run to look like a long run so the odds will prevail. The winner wants a long run to look like a short run so the odds will be suspended.” Read Full Post

“Many major problems people have in trading are caused by their expectations – of where the market is headed, how much money will they make from this trade, etc. One thing I learned that has helped me: it is wrong for a person to enter any market with any preconceived expectations.” Read Full Post

“The great danger is in confusing courage with bravery. The market is no place for heroics. That is for another battlefield. In the market place it often takes more courage to live than it does to die. The greatest courage is the one that lets you graciously admit that you are wrong when you no longer have a good reason to trade. The courage associated with the hero often destroys the courage that is needed to be successful. I have witnessed cases where temporarily successful traders have lost their touch because they lost their courage.” Read Full Post

“As people find out more about a situation, the accuracy of their judgments is not likely to increase, but their confidence does increase, as they fallaciously equate the quantity of information with its quality.” Read Full Post  This can cause us to put the blinders on when we see negative information. It can also cause us to have a larger position than we should, or be over weighted to one position. Most important, it seems the more we overestimate what we think we know, we simultaneously underestimate what we don’t know ……the downside risk.  

“Great decision makers aren’t those who process the most information, or spend the most time deliberating, but those that have perfected the art of “thin slicing”- filtering the very few factors that matter from an overwhelming number of variables.” Read Full Post

“We have seen how good we are at narrating backwards, at inventing stories that convince us we understand the past. In spite of the empirical record we continue to project into the future as if we were good at it, using tools and methods that exclude the rare events.” Read Full Post  Funny isn’t it, since the big, rare, unpredictable events are precisely what shape the world. Events like the automobile and the World Wars, the internet and the Beatles.

“Systems trading is ultimately discretionary.  The manager still has to decide how much risk to accept, which markets to play, and how aggressively to increase the trading base as a function of equity change.  These decisions are quite important, often more important than trade timing.” Read Full Post

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