Why do we always feel so bad when we are in a trading slump, or in a draw down if we are trading a system? Do we not realize that this is part of the process of being profitable in the long run?

While some kinds of suffering are inevitable and can’t be avoided others are self inflicted. The answer is that even though we know there are periods of draw down, we don’t really accept them when they arrive. We sometimes feel victimized, or fall into a high anxiety worry role. It always seems no matter how many draw down periods we have been through, that this one is different. The current one always looks like the one that’s going to break us.

We need to realize that trading and building an equity curve for the purpose of building net worth is in fact a game. Part of that game are set backs. No different than any other games we watch on any given Sunday. We don’t necessarily think our favorite football team has lost the game if the opponent is in scoring position.  We realize that’s part of the game, defending ourselves in the process of our own scoring. Even if they score, we then have the opportunity to score back on them. In fact, with out this threat, the game would cease to be a game and we would lose interest in playing.

We also add to our pain by being overly sensitive and taking ourselves way too seriously. We have a tendency to take a routine part of the game and blow it out of proportion. In other words I think that to a large extent how much pain you go through is directly correlated with how you respond to the situation. How we will respond will depend on whether we have really accepted set backs as part of the game, which are routine pauses in an ongoing process.

It really is a simple concept, but like most important things it’s anything but easy. It takes constant reminding. If we carefully examine the situation in an unbiased and honest way, we will realize that WE ARE RESPONSIBLE for how things will turn out. We are responsible for realizing a set back and playing through, or throwing in the towel in the grip of anxiety.

Human emotions are very powerful, and if not kept in check will cause us to make some pretty poor decisions. So if you find your emotions getting the best of you, go through this quick checklist. Remember what Helen Keller once said,
“Character cannot be developed in ease and quiet. Only through experience of trial and suffering can the soul be strengthened, ambition inspired, and success achieved.”

1- RELAX. Tell yourself it’s ok to be anxious. Welcome to the human race. You’re not supposed to feel good about draw downs, but if you want to win the game, going through draw downs is the price you pay to win. It is the difference between the winners and the losers.

DO WHAT’S RIGHT NOT WHAT’S COMFORTABLE.

2- Remind yourself of where your overall uncle point is, and if you are not there, then tell yourself that this is another routine set back, part of the process of winning.

CHANGE YOUR PERSPECTIVE ABOUT WHAT IS REALLY GOING ON.

3- DONT TAKE THE SITUATION OR YOURSELF TOO SERIOUSLY.
Have you ever noticed that once you’re through a draw down and your account is at new equity peaks you can’t even remember the pain in the same way? It seems like it was just another routine part of playing the game to win.

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I don’t know about you but I think it’s pretty confusing out there right now. How are the government interventions to the financial crisis going to play out? Is the result going to be rampant inflation? Are we going to be crushed under the debt? Should I buy gold and silver or are they in a bubble? How am I supposed to figure all this out? How do I make money?

The truth is no one knows what’s going to happen. On the other hand, do we really need to know what is going to happen to make money? I don’t think so. What we need to do is focus on the things that matter and the things we can control.

Even though we are poorly calibrated in estimating probabilities, we just love to do it. We think we are smarter and have better information than we actually do. Unfortunately most of the information has been discounted in the market or just plain doesn’t matter.

Carl Richards from behaviorgap.com says, “Overconfidence is a huge problem when it comes to making investment decisions. In fact, it’s a huge problem when we’re dealing with any issue that has an unknown outcome. It’s clear that we’re very bad at dealing with unknown outcomes, but the biggest problem is that we actually think we’re good at it. We think that we can control much more than we can, and we can actually forecast the future. Often we point to what we view as clear evidence and wonder how anyone that doesn’t see it the same way can be so stupid. Focusing on the things that matter and the things we can control will go a long way to avoiding investor overconfidence.”

Good trading requires flexibility and since predictions have an inflexible outcome, they can change our focus. If we get attached to our predictions our focus will shift from being profitable to being right. Being profitable “matters”, being right does not matter. Also we have no control over what the future may bring, but we can control our risk. We need to stay focused on what matters and what we can control.

It’s practically impossible not to have opinions on the markets, but the trick is to bankroll the opportunity that may be there and not the need to be right. Usually the academic predictor won’t predefine his risk because it doesn’t cross his mind that it’s necessary. As Mark Douglas said in Trading in the zone “the only way he could believe it is not necessary (to define risk) is if he believes he knows what’s going to happen next. The reason he believes he knows what’s going to happen next is because he won’t get into a trade until he is convinced he is right. At the point where he’s convinced the trade will be a winner, it’s no longer necessary to define the risk (because if he’s right there is no risk).”

Try not to be a bull or a bear but an opportunist. The opportunity seeker is influenced by the same endless opinions that dominate the news, yet he doesn’t allow himself into an inflexible point of view. He explores various scenarios and designs low risk trades to exploit the possible outcomes. He focuses on things he can control.

In the end, making money is a different game than being right or wrong. I know a lot of smart guys who were right about a market’s outcome but still went broke because they were inflexible. In short, they got too invested in being right and lost focus of the real goal, which is to make money.

Vincent Ryan Ruggiero, in his book Critical Thinker, says that one way to avoid falling into a committed trap is to train ourselves to think in terms of exception. Once the “case” has been made, begin to run through your mind the exceptions that could upset the case.

One exercise that I use all the time is to think in reverse. Whenever I feel very strong about a scenario, and find myself assuming I’m right, I take the exact opposite posture to see if there is a case there. The more exceptions that I can find, the less impact the original case has, and therefore the more cautious I am about my position. I try and stay focused on making money and not being right about my scenario. I concentrate on what I actually do have control over.

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Most traders and investors that I know are quicker to accept data processed from a computer than they are their own intuitions. I think the logic is that our intuitions are a bit mysterious; they seem to pop up out of nowhere and have little quantitative support to make an important decision. In reality however, our instincts and intuitions qualify much better to make investment decisions than a computer, providing you have enough investment or trading experience.

As I said in my post I like my information sliced thin, “These feelings are natural and should not be second guessed or ignored. After all, they are based on the culmination of all our experiences, just like data stored in a computer. Yet somehow we tend to think they are not as valuable as quantitative analysis. The gut feel and snap decision are just not taken seriously in the decision making world. In fact, we unconsciously make things up to substantiate our behavior in a more scientific fashion.”

The “adaptive unconscious” is a set of mental processes, thought to be involved in “high-level” cognition, influencing judgment and decision making. These processes are quite different from conscious decision making. We act faster, without effort, and are focused in the present. It is much easier to see this in action when watching a football game during a broken play or a musician in the depths of a jam session. Somehow the more experienced seem to know instinctively what to do. Even though this has nothing to do with the original game plan, it has everything to do with the cumulative experience of playing football or the saxophone. As Picasso once said, “Painting can’t be taught, only found.” In tennis, basketball, and Jazz, these instinctive reactions from the subconscious can sometimes dominate the play, and often prove to be some of the greatest matches or the greatest of art.

According to Sigmund Freud “the unconscious mind stored a lot of mental content which needs to be repressed. The term adaptive unconscious reflects the idea that much of what the unconscious does is beneficial to the organism; that its various processes have been streamlined by evolution to quickly evaluate and respond to patterns in an organism’s environment.” So in reality decisions made from intuition are anything but snap and irresponsible and actually have more empirical support than computer driven suggestions.

Perhaps a more thorough approach to trading would be to rely on statistical back testing and computer generated suggestions to a point, but also keep an open mind that these suggestions have limitations and need to be monitored constantly in the real world. Good instincts and intuitions are a great way of recognizing red flags. The trick is to sharpen those tools and act on them.

Malcolm Gladwell reveals in his book Blink, that “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.” A good reliable set of statistics that back a trading methodology is a great way of filtering a few factors that matter from an overwhelming number of variables. In addition a heightened awareness toward our instincts and intuitions will help us monitor our more quantified game plan for possible failures.

The famous painter Jackson Pollock once said, “It is only when I lose contact with the painting that the result is a mess. Otherwise there is pure harmony, an easy give and take, and the painting comes out well.”

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I think most of us will agree in order to be successful trading we need some kind of an edge. A good friend or relative who is willing to give us inside information where he is employed always works well, but most of us have to rely on something more fundamental or technical. I realize there are gifted people out there who have the ability to disseminate large amounts of information and draw accurate conclusions based on fundamental analysis, but I have always used technical analysis to gain my edge.

We use a model that is comprised of multiple trading systems, money management strategies and psychological disciplines, each of which give us an independent edge in that respective area. The combination of the three however is what really adds up to very playable over all edge.

When building an edge one must first consider what will drive the performance. Is it volatility, overbought and oversold counter trend conditions, or trends? Also how will you protect the capital when these conditions are not dominant?

Let’s examine one of the models that we use which is dependent on trends. It was developed in a joint effort between Angus Jackson, Inc. and Traders Tech., Inc. For all intent and purpose it is a trend capturing approach.  The first basic concept that needs to be understood is we need trends to succeed and a way of protecting the capital when markets are not trending.

Dean Hoffman, system developer and president of Traders Tech said “When you think about it, trends can be seen everywhere. Temperatures gradually trend from warm to cold as winter approaches. The demand for gasoline gradually trends higher during the summer driving months. Ground moisture trends from moist to dry when a drought approaches, and interest rates trend from high to low or low to high over time, and so on. All these events, whether seemingly natural or unnatural, can create sustained price trends in the futures market, and it is from these trends that we can try to profit.”

The real difference among traders is how they determine the beginning and end of a trend. A trader may define the starting point of a trend as something as basic as a change in the direction of a moving average. Counter-trend traders, on the other hand, might use this same indicator as a sign that the market is overbought and getting ready to head lower. Both are potentially correct depending on their exits. The real question is how can we quantify these trading approaches and code them into profitable trading systems.

Along with entry and exit methods, a trader must also have a position sizing and money management plan. Even if his entry and exit points are 90% accurate, if a trader risks it all on every trade, at some point the odds are substantially in favor of him losing all his money. By the same token, a system that is only accurate 10% of the time but has proper money management could do well. The bottom line is that traders need to know precisely how much of their account to put at risk in any given trade. It is also necessary to know how many positions to buy or sell whenever there is a signal. An expert system should provide traders with all this information and therefore an edge.

The final piece of the puzzle is proper trading psychology. It does not matter how brilliant a trader’s systems are, if he is unable to take the heat during the inevitable drawdown periods, he will fail. By the same token, if he gets too ecstatic during winning periods, he will also tend to fail. The key is emotional consistency. A trader must have complete confidence in his approach. This is where extensive (and proper) testing can help. Testing can help to build up solid proof that what a trader is doing works over the long run.

The more small edges a trader can build, the greater the probability of success. The small edges built into each system combined with those built into the money management and the psychological discipline will add up to enough total edge to trade with success.

In our model we use 5 different systems simultaneously, that will give a trader an advantage over only trading one. All these systems are essentially trend capturing, yet they also incorporate features that signal counter-trend following.  These different systems also communicate with one another and trade together as one integrated unit. For example, if one system has already invested heavily in Japanese Yen, the other four systems know not to take any more trades in that market. Doing so would not help to diversify but only raise the risk in the same trading idea.

Another unique edge that we have built is called “dynamic portfolio logic.” Unlike most systems that predefine a smaller portfolio to trade, our model trades almost every liquid commodity. The reason is because the systems rank the markets into percentiles on a daily basis. It then narrows the list down to only those few markets that have the highest relative trending potential. The net result of this filter is an edge that shows us where the best opportunities lie. It also guards us against the possibility that the best trends may surface in markets that are not in a static portfolio we may have chosen.

We have also paid close attention to position sizing and money management. It specifically manages how many contracts to enter when a trader gets a trading signal. This is essential because different futures contracts have different volatilities and trading them all in equal numbers would not be properly diversifying. If a contract, for example, tends to have high-volatility, a trader should trade fewer of those than another whose volatility is lower. We use a trader’s account size to determine the proper position size for each trade he makes.

Frequently the right position size is simply zero, and there are four reasons for this:

First, if the trade occurs in a market that is not strong enough in rank to be in the dynamic portfolio. Second, if, given the account size, the risk in the trade is just too high. Third, if there is already enough risk held in that given sector. And finally, if there is already enough risk across all the current positions in the portfolio.

The model does not risk more than 1.5% of a traders account size in any given trade. It will also not risk more than 5% of his account in any given sector. Let’s suppose, for example, that a trader purchases crude oil for his account. If the risk in that trade amounts to 5% or more, the model will not take new trades in any markets that are highly correlated such as unleaded gasoline.

The model will not risk more than 15% of a trader’s entire account at any given time. Meaning, if every trade a trader is in were to hit its stop price simultaneously, the total should represent no more than about 15% of the entire equity of the trader’s account. Once the risk level either reaches or goes past this 15% level, it will reject all new trades and return a position size of zero.

In summary, this was our attempt to build a model of small edges in each category of method, management and psychology, so when combined, we would have a large enough edge to trade with confidence.

The goal was to capture trends in trending periods, while protecting the capital in trendless periods.

Now, as we know, no matter how much precaution a trader takes, money can be lost and therefore any model should be monitored daily for red flags. After all, in a profession of such uncertainty, anything can happen, so we have to prepare for this before putting our money on the line.  Having an edge (or a series of them) is essential.

In the movie “Rounders,” Matt Damon who plays a skilled poker player, says in the opening scene:

“Here’s the thing. If you can’t spot the sucker in your first half hour at the table, then you’re the sucker.”

So don’t get taken. Ask yourself “what is my edge and how will I be protected when my edge is not working.”

If you would like to receive a detailed research report on our model please email me at charles@viewpointsofacommoditytrader.com or call (800) 858-2340 Toll Free.
 
 

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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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The problem with assumptions is that we believe them to be true. Once we believe something to be true, we are not even considering the alternative. Perhaps your boss is actually planning to give additional responsibilities to a co-worker since you can’t get your routine work finished between 9AM and 5PM. Maybe your wife has just called a lawyer.

In essence, when we assume, instead of inquire, we invite problems.

One of the most generic assumptions in the trading / investing world is that “highly educated” people actually know what they are doing. We assume that if this guy graduated from the Harvard Business School, and has now written a book, or appears on CNBC, that he knows what he is talking about. I’m sure people thought in 1927 that H.M. Warner of Warner Brothers might be correct when he said “Who the hell wants to hear actors talk?

There are many smart people in the financial community whose opinions should demand respect. Keep in mind however, that in a profession where prediction is the dominant component, all we really have is educated guesses. King George III had many believers in 1773 when he went on and on about how the American colonies had little stomach for revolution. Oh, and let’s not forget that the Titanic was unsinkable.

Then of course there are the “highly educated” entertainers whom we should give less respect. Jim Cramer for example has openly bragged that he keeps 2000 stocks in his head.

Think about that for a moment. I have trouble following a handful.

I think it is a lot easier to become an expert in some fields as opposed to others. As I wrote in a previous post if you are an auto mechanic, you most likely know more about fixing cars than you don’t know about fixing cars. Also, errors are easily rectified. In this light, a good mechanic is an expert.

If you are a psychologist or an economist, I don’t think so. In fact, it’s practically impossible that your knowledge of the human condition would exceed your lack of knowledge of the human condition. Not to mention that mistakes can be catastrophic in these “big system” type professions. Plumbers don’t kill people but doctors do. Mistakes when predicting the weather, the economy, or the financial markets can and do ruin our lives.

So, are there really experts in professions that require prediction? Well, I guess some people are more expert than others in highly unpredictable professions, but I would be careful equating their expertise with that of the expert mechanic.   

It also seems to me that academic arrogance has escalated lately, particularly in our own government. It’s ironic how the policy makers, mostly academics, politicians and lawyers, have no real business experience, yet seem drunk on the delusion that they can fix things through more and more regulation.

I guess they can afford these risks more than the “real world” businessman, because in their world ideas don’t really have to work. In academia and government the solution for “bad ideas” is more research and more regulation. When you think about it, they stay in business whether they propose good ideas or bad ideas. How nice for them.

So what is a constructive way of dealing with all this?

Vincent Ryan Ruggiero in his book Critical Thinker points out that one way of avoiding assumption is to question. He says to train yourself to think in terms of exception. Once the “case” has been made, begin to run through your mind the exceptions that could upset the case. One exercise that I use all the time is to think in reverse. Whenever I feel very strong about a scenario, and find myself assuming I’m right, I take the exact opposite posture to see if there is a case there. The more exceptions that I can find, the less impact the original case has, and therefore the more cautious I am about my position. In the end it’s always about controlling the risk, so whatever it takes to keep us cognizant of risk, I am a fan.

So, the next time you want to assume that the expert’s opinion is correct consider that Lee de Forest who invented the cathode ray tube in 1926 said, “Theoretically, television may be feasible, but I consider it impossibility–a development which we should waste little time dreaming about.” Thomas J. Watson who was the Chairman of the Board at IBM in 1943 said “I think there is a world market for maybe five computers.”

The list goes on and on. In 1895 Albert Einstein’s teacher told his father “It doesn’t matter what he does, he will never amount to anything.” And my personal favorite was when Decca Recording Company rejected the Beatles in 1962 saying “We don’t like their sound, and guitar music is on the way out.”
 

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Ask not that the journey be easy, ask instead that it be worth it  – Author unknown

I was having lunch with my partner and a client yesterday when the conversation turned to trading (imagine that), and in particular what keeps a trader from being consistently profitable. There are countless reasons why most people who attempt trading commodities fail, but why is it that fairly seasoned guys who have been around a while still struggle? 

I have had this conversation many times with clients over the years and the feedback has always been interesting. Mostly, people think it’s because they did not follow a definitive game plan, they were over leveraged or overtraded, or let a few large losses take them out. Although these errors certainly exist, I think the culprits that get in the way of the more seasoned guy are different. Usually, when a trader has survived a good 5-10 years or more, he is quite aware of the basic concepts of a having a trading plan and using proper leverage. He knows he must control risk through stops and other money management techniques and stay disciplined to his approach. 

So what happens? What are some of his demons? Here are my views on the subject, I’m sure there are others. 

I think one of the biggest concepts (virtues) that we need to really metabolize is patience. 

Very few people have the patience for a long term outlook these days. I know so many situations where fairly seasoned guys were trading good reliable methodologies, controlling their risk and leverage, yet threw in the towel because “The program was doing nothing.” The boredom or the lure of a better “grass is greener” strategy begins to dominate the mind. We have to be careful not to talk ourselves out of something that is doing its job, just because we would like more from it. Don’t fix what is not broken. 

The more knowledgeable we are, the greater the tendency we have to take ourselves too seriously. What we think we know get’s glorified at the expense of what we don’t know. When we’ve convinced ourselves that there is a problem when in fact the problem may be our own impatience, we try and fix it. We try to make it what we would like it to be, as opposed to what it is. It’s only human nature and that’s why it is such a powerful problem. 

The second obstacle is expectation. 

This problem of attaching ourselves to an outcome is a problem in investing in general. Expectations of higher and higher returns have become commonplace in an environment of lower opportunity to do so. Generally speaking most people have no idea how to even gage expectation. Very few consider the rate of return on riskless investment (90 day T- Bills) as the benchmark for their current expectation.  

Doesn’t it stand to reason that if the 90 day bill rate is 15%, like it was in the early eighties, one should have a higher expectation for returns than when the 90 day bill rate is less than 1% like it is now? I think so, yet most people have an arbitrary number usually based on what they need, or would like, or heard you’re entitled to in commodities. After all, commodities are risky business, I deserve a higher return. More nonsense. 

Investors seem to recognize this when buying yield (bonds or CD’s), but not necessarily when dealing with other asset classes like stocks or commodities. For instance, the Ten Year Treasury Note will pay 3.71% per year for the next ten years, principal returned. We accept this or we would not buy the instrument. However, it’s not that simple when faced with other Investments. 

For example, earnings per share (EPS) in the stock market have historically grown two percentage points above inflation. So let’s say annual inflation runs at 0%, we are talking about 2% earnings growth. Assuming share prices rise with earnings, you will get 2% annual gains. With The Dividend Yield around 1.88% right now, that is a forecasted total return of around 3.88%. Inflation at 2% would forecast 5.88% etc. Now, do you think that the average person has invested in the stock market for a 4% to 5% return?  

I would guess they are looking for much more, and this opens the door for surprises. When the outcome is different than the expectation, we usually react emotionally, something that hardly ever works out.  

When I ask a prospective client what he expects these days trading commodities, I routinely get answers that hover around 30%. The reality is we are entitled to a riskless 0.16% return (90 day T- Bill). That’s $160.00 on an investment of $100,000.00. It appears to me that our expectation for returns in other asset classes needs to be more realistic or you will make impatient mistakes. 

The third concept I don’t think we give enough thought to is the power of compounding positive returns in the long run. 

I have discussed with so many traders that have no real understanding of what compounding can do for them over the long term. If you suggest that perhaps a 15% return in a reliable managed futures program might be the current expectation, you get silence. 

15%, that’s not that exciting. Well I think it is, right now anyway. 

Let’s look at an example of having patience and reasonable expectation over the long run. 

If a forty five year old investor were to invest $75,000.00 in a program that compounded at 15%, and added $10,000 to the account per year, he would be able to write a check for $2,241,000.00 upon retirement (assuming a 65 year old retirement date). 

How many 65 year olds do you know that can write a check for $2,241,000.00 from one account.? 

So, there’s my PEP talk.  PATIENCE, EXPECTATION AND THE POWER OF COMPOUNDING.   

Whenever you are feeling impatient or a little greedy give yourself a PEP talk.
 

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Game Theory is basically the mathematics of strategy, where the primary theory says that if all the players of a game play the best, most rational strategy, the resulting outcome of the game is predictable. There are plenty of economists, portfolio managers and financial advisors that employ a variation of the Game Theory model to trade and invest.

This started me thinking about the role Game Theory plays when trading the markets. Can we really say that all the players play the best, most rational strategy? Is “playing to win” really the way to go? If we play “not to lose,” do we have a greater chance of winning in the end?

I think that the players in the “Market Game” are not always rational, and this really throws off the accuracy of prediction. Attempts to use rational strategy to predict outcomes in an irrational game, tends to work until Mr. irrational behavior sits down at the table to play. Then the modeled prediction can change dramatically.

A good example of this may very well be going on right now.

It seems to me that we have arrived at the conclusion that the risk of not being “in the market” is greater than the risk of actually being in the market.  Now, think about that. If you are not involved you have no risk, so how can it be greater than the real risk of being involved? This is academic drivel. This implies that you “need” the perceived gains to keep up with inflation and the Jones’s.

As I mentioned in a previous post, Mark Hulbert at market watch was quoted as saying “Based on the several hundred investment advisers I track, I’d have to say that bullish sentiment is approaching dangerously high levels. Consider the Hulbert Stock Newsletter Sentiment Index (HSNSI), which represents the average recommended stock market exposure among a subset of short term stock market timers tracked by the Hulbert Financial Digest. 

The Hulbert Index currently stands at 62.8%, up from 13.8% just one month ago. That’s an awfully big jump for so short a period of time, suggesting that equity managers in general are more fearful of “missing out” than they are of a reasonable correction. This is evidence of overconfidence in the outcome, and although sometimes irrational behavior pays off in the markets, it usually results in a mistake.

As Shakespeare said, “To be, or not to be: that is the question: Whether ’tis nobler in the mind to suffer the slings and arrows of outrageous fortune, Or to take arms against a sea of troubles”

Peter Bernstein talks about this behavior in his book Against The gods. He says that in the early 70’s “portfolio managers became so enamored with the idea of growth in general, and the so-called Nifty Fifty growth stocks in particular, that they were willing to pay any price at all for the privilege of owning shares in companies like Xerox, Coca-Cola, IBM and Polaroid. These investment managers defined the risk in the Nifty Fifty, not as the risk of overpaying, but as the risk of not owning them.” In January 1973, the Nifty Fifty slipped into the biggest stock market decline since the Great Depression.

The point here is not to judge the current market valuations as much as it is to keep us cognizant of why we are involved in this stock market. Are we in because we think not being in is a greater risk? To me this is the ultimate “playing to win” mentality and has a tendency to blindside us if we’re wrong. The stock market is not grossly overvalued but it is not a great buying (or holding) opportunity either.

When “not being in” is a reason to own, it’s basically saying that we’re sure of the outcome. It’s the “new risk”, a destructive impulse that re-defines risk as the chance you take when you fail to bet on a sure thing. Playing to win may be the way to go in some games but not trading. I think in games like poker and trading “playing not to lose” makes better sense. Wait for the right hand so to speak, based on the cards at hand and not any other reason. When we make decisions based on emotion, when worry and caution become a vice instead of a virtue, trouble is about to pay us a visit.

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Mike Tyson knew how having your plan challenged can be rather upsetting, and could perhaps change your entire pre-conceived expectation. Surprises, whether expected or not, can drain the confidence right of out you, and cause you to make irrational decisions.

Most good traders know the essentials to successful trading. We know we need an effective system or some methodology which has demonstrated a history of success through all types of markets. We need definitive, objective, operational rules. We need a risk management overlay which takes you out of losing trades and keeps you in wining trades. We need to manage exposures in various groups and in the overall account. Finally, we need discipline, which includes trader psychology, self control, persistence, positive attitude, and more.

Geez, I’m exhausted, Is that all?  No, unfortunately there’s more.

The markets are a cruel mistress and have the annoying ability to keep us in constant skepticism. I think there is a little more to being successful than the traditional “have a plan, manage the plan, and to stay with the plan.” It is just not that simple or at least not that easy.

I think we sometimes confuse having a plan with understanding our plan, and more important, understanding the limitations of our plan. You can adopt a methodology (or system) and not really know why it works, or in what environments it should work well or struggle.

A trend following approach for example can not be expected to perform in periods where there are no trends. It also may have limitations with respect to volatility. Even if markets are trending, but volatility is so high that trades are being filtered out as part of the risk management program, it won’t perform up to expectations.

If we don’t understand this before hand, we could conclude “something’s gone wrong”, when in fact it has not. This is a limitation to the trend following approach that has to be expected from time to time if we want to fight the entire fifteen rounds.

We need to actually work to ensure we understand our approach, and its potential limitations, to minimize the surprises. I’m sure a punch in the face was not a surprise to Mike Tyson. After all he is a prize fighter, and that’s part of the sport. On the other hand if he has underestimated his opponent, or over estimated his skills, he may find himself on the mat looking up.

We will never be able to understand everything about ourselves or our approach, but we can make an effort to at least understand at the basic level what is “normal” trading as opposed to something abnormal. Randomness plays a much stronger role than we think, and not fully understanding our approach may lead us to overestimate, or underestimate what the randomness actually means.

At the end of the day trading is an art form, and we can only use the sciences to a point. Socrates once said that “likeness to the truth is not the same thing as truth.” The science of employing quantified models exclusively is not the truth so to speak. It is a likeness to the truth with future surprises for which we must be prepared.

Unfortunately we can not quantify the future to the point that we can sit back and become spectators. We must fight in each round if we want to win in the end and the more we understand the strengths and weaknesses of ourselves and our approach, the greater the probability we’ll stay in the ring.

The markets can surprise us and come to think of it, so can Mike Tyson. Apart from being a great fighter, most of us think of Tyson’s impoverished childhood, rocky marriages and his rape conviction. Oh yea, and trying to bite off Holyfield’s ear…… twice.

I’ll bet you didn’t know Mike is soothed by the cooing of his collection of pigeons, or that he is a big fan of the Irish Playwright Oscar Wilde. Apparently, he relates to his self destructive flamboyance. He also finds solace in German philosophy which helps him to deal with his irrational pull toward living life to extremes, something that has caused him nothing but pain.

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