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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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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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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A set of statistics that suggest a positive expectation (a system) is quite helpful when sailing the seas of uncertainty. In fact I believe most traders need a definitive plan to assure discipline. 

We need to look at the various measurements of risk and reward. We look at average winners, average losers, returns and draw-downs. We examine the numbers further to calculate Kelly Expectations (bet size), MAR Ratios and Monte Carlo distributions.

These are the tools that help us understand the system. On the other hand no matter how many numbers we crunch we cannot replace randomness with systematic probability. We can not quantify the future.  

Socrates once said that “likeness to the truth is not the same thing as truth.” Truth to the Greeks was basically law, something that had to be proved. All the back-testing in the world does not prove anything. 

These past statistics do not remove future randomness. At best they will give us some likeness to the back-test (or what we think is the truth) and we must manage the risk to make sure we are on that path. 

What is potentially more dangerous than the information which makes up the numbers, is how we feel about the accuracy of the numbers. In the real world, randomness plays a much stronger role than we would care to believe. Arrogance about potential accuracy can lead us to overestimate what we think we know and underestimate future randomness. This is how you blow up. 

The markets are constantly changing. There are new markets available to trade. Markets dry up in liquidity. There are shifts in volatility and correlation. Sometimes a combination of these things can happen at the same time. A system without a risk management component will not be able to properly identify these changes and unfortunately most vendors have not built any risk management into the equation. I think that is potentially dangerous. 

When you choose a number of these systems you will still be faced with how they will interact with each other. You have the risk of volatility and correlation shifts in the markets that you will be trading but you will also have the risk of correlation between the systems. 

This is what destroys most approaches, not the systems, but the way the systems were managed. A system that holds up in a rigorous back-test is at best “The One-Eyed King.” An approach that can see, but does not see everything we would like it to see. The good news is if we are aware of that fact we will be forced to manage that fact. 

I strongly believe we need a platform to monitor what is going on when we are in trades. The volatility of a market upon entry can be quite different than the volatility of that market one week or one month later. This holds true of correlation between markets, as well as correlation between systems.

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It continues to amaze me to watch the Wall Street Gurus apply scientific and fundamental logic to an illogical game. Not only does this cause traders, who buy into these scenarios, to underestimate risks, it also draws a crowd into the scenario, increasing risk further. As John Train said in his book Dance of the Money Bees, “The herd instinct seems to be the strongest human emotion, one that the race is constantly breeding off as the mavericks are liquidated. Happiness is running with the crowd.” 

If we place too much emphasis on the “quantifiable”, we run the risk of being blindsided by a changing world and changing markets. This upsets the balance between left brained analysis and the right brain instincts, both of which we should employ to be good traders. When we get sold on sophisticated models, that tell the future from past data, by very qualified and believable scholars, we underestimate what can go wrong. 

Bennett Goodspeed in his book The Tao Jones Averages points out, “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.” 

“On Wall Street what is known tends to get glorified at the expense of the unknown. We have become so caught up in our scientific methodology, that if something cannot be measured or counted, it will not be believed. As a result, we tend to adapt the world to our belief systems, rather than try to understand as it is.” 

This is not to say that one should underestimate their trading plan. It means don’t buy into it. Stay flexible, and always think in terms of what can go wrong. This is especially true these days, where momentum trades and “bubbles” have become commonplace. And when the crowd shifts, be assured that the controlled logic will give way to uncontrolled emotion. 

I think it pays to assume this can, and at some point, will happen. Your approach should have a “worst case” scenario, no matter how right you think you are. What if all my trades correlate and go bad all at once? What will happen to my account? 

Paul Tudor Jones in Market Wizards said “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.” 

“Don’t be a hero, don’t have an ego. Always question yourself and your ability. Don’t ever feel that you are very good. The second you do, you are dead.”  Read Related post

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