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What is the difference between stock trading and gambling in a casino?

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MonteCarloAnswer by Laurent Bernut:

I’ll give You the same answer I gave two CIOs of Fidelity. The common point between professional poker players, star fund managers and street hookers is that they go to work: it is not meant to be fun.
Excellent question. Beyond taxes and manufactured negative gain expectancy, there is much market participants could learn from professional gamblers:
  1. Gambler’s serenity prayer: grant me the serenity to accept folding a losing hand, the courage to take calculated risk and the wisdom to know the difference
  2. Cut losses and run winners: in poker, money is made by folding a lot and be aggressive a few times. Successful fund managers spend their time cutting losses. The paradox is that the way to win the war is to accept losing small battles
  3. Position sizing: Black jack is a game where You play against the house. It is manufactured to have You lose. Yet, Edwin Thorpe, whose track record towers Warren Buffet’s, beat the dealer. His method forced casinos to adapt. His secret sauce was position sizing, a fraction of Kelly criterion
  4. Position sizing algorithms: Gambling is a far more mature industry than investing in the sense that a lot of position sizing algorithms used in finance come from game theory. Martingale, reverse-martingale, drawdown/run-up of bankroll, Kelly Criterion
  5. Gambling is boring: hookers, poker players and star managers go to work. It is not meant to be fun. They leave their emotions at the door. Treat gambling and markets as a job so that You can fleece the emotional players
  6. Gamblers have a system: gamblers are not smarter, they have smarter gambling habits. Adherence to a system takes discipline. Reinforced discipline is called habit
  7. Gambling as trading is not a zero sum game: one of the most common myths about the market is the zero sum game. Slippage, commissions erode however slightly the account. Take every trade as if You put a chip on the table
  8. Quantified risk: the notion of calculated risk has unfortunately been perverted by those who do not understand it. Risk is not an abstract dissertation at the end of an investment thesis. Risk is a hard cold probabilistic number
  9. Odds and win rates: one of the fallacies of market participants is the belief they need above 50% win rate to be successful. 2 things here: 1. trading edge or gain expectancy shows that low win rate can be compensated by big payouts. 2, Distributions of P&L of most traders (excluding mean reversion and market making) show aggregate win rates over the cycle of 30-45%. Winners compensate for losers. The important lesson here is that traders walk into a trade expecting it to win, when they should be mentally prepared  for a loss. Pre-packaging grief (see my post: The view from the short-side: how we process emotions and the market signature of the 5 stages of grief Kubler-Ross by Laurent Bernut on Alpha Secure ) . This means that throughout the cycle, styles come and go. Making money means knowing when your style is out of favour and betting small and then when in fvaour take risks. Back to the serenity prayer
Conclusion
Investors usually look down on gamblers. Yet, there is much to learn from gamblers. How come a few of them become successful despite built-in unfavorable odds ?
Beginners in both markets and gambling believe they are on to something when they double down after each loss. They believe that their luck is about to turn, so they use martingale (it comes from the French for winning streak). They just forget two things: dice have no memory so each run is independent from the previous one. More importantly, the maximum expected value is break-even. This means that any outcome other than the best one carries an interesting probabilistic property called “certainty of ruin”.
In other words, there is a reason why casinos have gold, marble columns, master paintings and rookie gamblers go broke…

What is the difference between stock trading and gambling in a casino?

Has anybody gotten rich through automated trading?

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Happy New Year from Alpha Secure Capital. This was an answer to a question on Quora. It has been read by more than 16,000 people.

Now, I am a digital nomad investor: Viet Nam, Singapore, Tokyo, KL, Venezia, Palermo, Reikjavik. Rents get paid in our sleep, balance gets bigger by 1-3% every week. Dream life, hey (*) ? Well, it came at great sacrifices.

Autotrade sub 30 mn is the tallest order in the trading industry. On the one hand, there are HFT shops, with whom there is no point competing. They already do a wondeful job at killing each other not so softly. On the other hand, point and click prop shops ecking penny after penny. Then, there are Delta one and deriv desks arbitraging small corners away. All those guys have the money, the resources, the access, the info, the programmers You will never have. You are outgunned, outnumbered and let’s face it: outside. Now, let the race begin.

It took me 15 years to mature the concepts, 3,694 hours to code, 3 2/3 years to run  and a lifetime to refine them. This has consumed my life, my waking hours, my sleep. Ever woke up breathless and feverishly write equations ? I nearly burned the house not once, but twice, because i forgot that there was something on the stove, while i was wrestling with some C#. Once, my wife came yelling at me for not taking care of our screaming baby. I just did not hear our daughter crying… on my lap. Well, code would not compile…

Sisyphus stones
Then, there is the sheer frustration of never being enough. Then there are bugs. One rule of thumb, never add, always subtract, always come to simplicity when solving bugs. Then, there are “100 year flood”, perfectly rhyming with the late “100 nights of solitude”. Then, there are platform issues. They are not meant to do scale-out/scale-in and adaptive position sizing. Then, there are those small issues that You will have to face one after the other.  There will be times where You wander and meander like Ulysses, “what if this, what if that ?” But there also those immensely gratifying days when You wake up with light and equations flowing through like when I found my personal holy grail of position sizing

After the Daedalus of development, one day the end will be in sight; it will be there, almost, just a few modules away. But then, there are those shortcuts You took 10 iterations ago that will come back and bite You. They stand between You and the finish line. And You know that tackling them means overhauling the entire architecture.
This is the realm of frustration. The last mile is always the hardest. Please remember this though: autotrade is like watch-making. Until the last cog fits in the right place, your clock will always be off, so don’t give up, never give up.

Then, You run your own money, face drawdowns, go back to fix the last few bugs. Then, You run it on small amounts. The best moments are not when You make your previous monthly salary in a week while kitesurfing or going wine tasting. The most beautiful moments are when You make those few hundred dollars week after week and when You finally know it is viable. It feels like watching a flower blossom. This is the best sleep You will have in your lifetime, well at least for 3 months …

Here are the lessons I learned. A viable trading system is built backward:

  1. Focus on the short side: the short side is notoriously harder. If Your system works on the short side, it will work on the Long side. Any 3 star Michelin chef can flip burgers. Now how many Burger king employees can do 3 star meals ?
  2. Focus on the exit first: a race is never won until the finish line is crossed. Some of your positions are marathonians, some are sprinters. You never know until You see them on the field.
  3. Stop loss: it is the only variable that has a direct influence on 3 out of 4 variables of your trading hedge
  4. Money management is key: how to preserve capital when your system won’t work and how to take calculated risk when it does ? This is where the heavy mathematical artillery should be concentrated, not on the entry. Think about it: everyone owns Apple. The difference that makes the difference is how big You are
  5. Simplicity: complexity is a form of laziness. If your solution is still complex, it means You have not worked hard enough to find a simple one. There is no exception to this truth
  6. Symmetry: once the short side delivers, translate it to the long side. You will have unambiguous signals, unified risk management
  7. Watch Star Trek and the original Kardashians, they were not as villains as the newer ones, breaking bad, desperate house wives etc
  8. Then, last and very least, but first take the dogs out. And then finally, sorry don’t forget to water the plants first. And then finally, oops have You called your mother yet ? And then finally, take the trash out and after a good night of sleep, You may think about entry. Entry is at the very bottom pile of the priority list of an autotrade strategy, long after labeling priorities on multiple positions

In the end, You will realise that the goal was never about money. It was first about the freedom from a paycheck and the long term uncertainty of retirement. Rich and wealthy are not synonymous. Rich should be the experiences You accumulate over your life. Now, we live out of our suitcases, frugally as usual, but what a life! Speaking of which, time for a Prosecco with our neighbours, our landlord the architect and his buddy the last Gondola maker in Venezia

(*) Now, the highlights of our week is to hunt for consecutive stop losses. We have excess capacity. We have suffered a great deal coming up with our strategy on MT4. Most modules had to be built from the ground up. We  genuinely want to spare this Sisyphean ordeal to aspiring autotraders.
So, we will choose 2 or 3 people and help them build their strategy.
I can help anyone formalise their own strategy through a thorough guided discovery process. This is not pleasant.
Then on the MT4 coding side, the person I work with is a senior programmer for the US Department of Defense (be nice to him or he will bring democracy to your computer…). I can code alright, but his stuff is military grade… Reach out if You are interested, or if You like what You read

Has anybody gotten rich through automated trading?

What the great Chinese philosopher Bruce Lee can teach Fund managers about mastery

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Answer by Laurent Bernut: This was originally a question on QUORA: which investment method is the best ?

As the Great Chinese philosopher Bruce Lee said: “have the style of no style, be water my friend”Game of death

There are two games of trading: outer and inner game of trading

Stage 0: Dunning Kruger effect
The Dunning Kruger effect is a cognitive bias where unskilled individuals believe in their illusory superiority. It is often found in senior management of old listed companies such as Volkswagen, Kodak, Sony etc. When Bruce Lees did not know anything about Wing Tsun, he thought a punch was merely a punch. After he had internalised his craft, a punch became just a punch.
In the beginning, anyone thinks the stock market is easy. Then they lose

Stage 1: Exploration
Bruce Lee not only explored Wing Tsun, but also English boxing, karate.
At this stage, market students embark on an exploratory phase to build a syncretism of what they think is best.

Stage 2: Perfection
This is the most common mistake of all outer game centered practice. Students perfect their craft and believe their style beats any other style out there. MMA is better than Brazilian Jiu Jitsu. Kyokushinkai is more resilient among karate etc.
Still, students myopically concentrate on their microscopic universe and fail to embrace diversity. They may be outwardly good, but they are still trapped in the outer game.

Stage 3: Acceptance
Responding to a challenge from other Kung Fu teachers, Bruce Lee defeated his opponent in a  whooping 3 minutes. In doing so, he injured himself and pestered about how long it took. He then proceeded to enrich his repertoire.
This is the first stage of inner game. This is where internalization and deep learning starts.
This is the essence of the “10,000 hours”. This is where “flow state” happens. Students redefine their identity. They free themselves from the confine of the style they used to practice.

Stage 4: Mastery “Be water my friend”
At this stage, students redefine the game. They bend reality. It becomes effortless. Master traders and investors have redefined their game. They have a congruent universe governed by a simple set of rules.

So, in conclusion, there is no superior method: fundamental, quantitative, technical, HFT, etc. There is a better method for You that suits your personality. It is incumbent upon You to find your path on the markets. Believing that fundamental or technical analysis is the way to succeed, just because everyone else around is doing it, will not work. They are also struggling. A long journey on the markets begins in stillness

Which investment method is the best?

A powerful two step process to deal with the endowment effect: The game of two thirds, or how to deal with free loaders in your portfolio

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Would You allow tenants to stay rent-free ?

Would You allow tenants to stay rent-free ?

If You were the owner of an apartment building, would You allow tenants to stay rent-free forever ? You would probably do everything in your power to either collect or evict free loaders. In the investment realm however, one of the main reasons managers fail to accomplish their goals is that they allow free-loaders to stay rent-free in their portfolios. The difficulty then is how to identify and deal with free loaders.

They don’t really stand out enough on an individual basis. Yet, as an aggregate free-loaders put a drag on performance.

  • Endowment effect: once in the portfolio positions are sticky.
  • How to identify and effectively deal with free loaders
  • The 3 main benefits of the game of two thirds
Once upon a time, i used to place thematic small positions across the portfolio like pawns on a chessboard. They were supposedly hedges for China, precious metals, oil, monetary intervention etc. They were all tiny positions that were supposed to kick in if any of these themes were to gain traction. Six months went by and I could not understand why performance was so pedestrian. Meanwhile, none of those stocks had worked. Then, it dawned upon me that even though they were tiny individual positions, they totaled 10% of the portfolio as an aggregate.
The endowment effect (Thaler 1980)
Endowment effect is the hypothesis that people value more what they own than what they could buy. It is hard for positions to dribble their way into our portfolios, but once in they become sticky. It is difficult to get rid of them, even though they do not contribute. Some managers would hold on to losers just because they do not know what to buy next.
Our lives, our desks, our houses are filled with clutter. Unless we actively create and enforce rules to get rid of it, clutter creeps up on us. Our inner saboteur will always find good reasons to hoard junk. To illustrate its potency, let’s look at a simple example: in your wardrobe, isolate the clothes You have not worn for over a year. Think about all the excuses to keep them, but then ask yourself: “If i did not have it, would i buy it now ?” If not, then bye bye, fashion moves on and so should You.
The game of two thirds: A simple two-step process to deal with free loaders
Free loaders neither detract nor contribute enough to be visible. They don’t stand out enough to be dealt with. Since it is not possible to deal with them on the y-axis (price), the solution is to introduce time x-axis. Rationale is simple, if stocks have been there for some time, but still fail to contribute, then their weight should be reduced.
  1. Calculate portfolio turnover, divide it by three: first 1/3. Add 1/3 turnover to the entry date of each position. For example, a stock entered on January 5th and a turnover of 1 would yield a cut-off date of April 5th
  2. Divide performance in 4 quartiles, concentrate on the third quartile: second 1/3. For all stocks in the third quartile past their anniversary date, cut weight in half
 Special mention for long-term winners
Apple (AAPL) or Softbank (9984:JT) are long-term winners. They sometimes go through extended periods of under-performance. Because there is so much embedded profit, it is difficult to realise that they have not contributed for some time. The idea then is to reset contribution on a rolling basis.
The idea then is to apply the same rules as above on a rolling basis. Instead of cutting positions to half, taking a portion the size of the out-performance from the previous haircut. For example, if Apple went up by 10% from previous haircut, then shave 10% off the current size.
The rationale is
  1. if it starts to underperform, it will be dealt with, and this profit taking will have cushioned the blow. This demonstrates stewardship
  2. If it continues to go nowehere, resources are re-allocated to a potentially more productive asset. If non-performance persists over 2/3 of portfolio turnover, then a more drastic reduction is in order
  3. if outperformance resumes, then it will be dealt with
It is important to periodically reset contribution. When stocks have been in the portfolio for a long time and substantially contributed, we become attached. Failure to reset contribution is one of the reasons why some managers escort their positions on the way up and then all the way back down. It doesn’t show until it is too late.
The three benefits of the game of two thirds

The game of two thirds may appear simplistic. It has however powerful psychological implications. It is a simple, powerful and objective way to short-circuit the endowment effect for three reasons:

  1. Simplicity: math is beyond dispute. Simple rules are elegant, easier to implement and harder to challenge
  2. Stewardship: great investors are not smarter, they have smarter trading habits. Getting rid free loaders builds the habit of dealing with difficult stocks
  3. The quality of our excuses determines the quality of our performance: one of the most frequent excuses is “what do i buy next ?” Constant re-examination of positions forces managers into action.
Discussion
Once in a portfolio, positions are often sticky. Asking ourselves “would you buy it again today ?” is too subjective to deal with positions that have overstayed their welcome. Our inner saboteur will find good reasons to procrastinate until the next review. Our natural instinct to hoard junk “endowment effect”. The game of two thirds is an elegant way to identify and deal with free loaders.

 

Amygdala and the neurophysiology of Greed and Fear

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Going into a combat mission without an exit plan is suicide. In fact, the only soldiers who nevamyg400er bother with exit plans are kamikaze. On the other hand, market participants routinely enter positions without a clear exit plan. The problem is that as soon as we enter a position, our emotions impair our ability to make rational decisions. Greed and fear have a chemical signature. This is the first article of a series of four about exits and emotional mastery.

Dopamine and cortisol: the chemical brothers of Greed and Fear
When there is no exit plan, there is uncertainty about what to do next. A mild level of uncertainty can be exciting. A region of the brain Nucleus Accumbens (NAc) gets activated. This triggers the mesolimbic reward circuitry, often referred to as the dopamine reward circuitry. Dopamine is released. People take on more risk. By the way, cocaine, opiates and nicotine activate dopamine transmission. This is why just watching the portfolio feels a bit addictive sometimes. As Kuhnen and Knutson showed, risk seeking behaviors are often associated with NAc activation and high level of dopamine. In other words, Dopamine is the chemical signature of greed.
When a few positions “go against us”, uncertainty turns from thrill to mild discomfort. We are more vigilant and come back to reality. When performance starts to suffer, uncertainty morphs into stress. Stress triggers the amygdala, located in a primitive part of the brain called the limbic brain. Its primary function is to keep us alive at all times at any cost.  It is always on. The problem with the amygdala is that it cannot discern between real danger and an imagined threat, between a saber tooth tiger and a -1% dent in the portfolio. At higher levels of stress, the amygdala activates the pituitary gland that releases cortisol. When cortisol is released, the neo-cortex or thinking brain is hijacked, game over.
In his latest research, Daniel Goleman, author of Emotional Intelligence and focus, goes one step further. He describes a state of prolonged high stress as neurobiological frazzle: the thinking brain shuts down and physical health deteriorates. This is what we call burn-out. Bottom line, uncertainty has a destructive physiological signature.
Uncertainty: get comfortable with discomfort
Uncertainty cannot be eliminated whether in life or in the markets. We can learn to 1) manage it and 2) reduce it.
1) Getting comfortable with discomfort literally determines the quality of our lives. This is the subject of a future article
2) Reducing uncertainty simply comes down to  having plans and rituals or habits. One of the most important plans is the exit plan.
The three questions that will notably reduce stress:
When everyone else is stressed out, every bit of clarity counts. Unfortunately, every decision is an additional stressor. Every bit of stress reduces the mental bandwidth. This depletes the thinking rain of its capacity to make good decisions. This is called decision fatigue. Willpower is a muscle.
An interesting study was done in Israel about parole decisions made by judges. Convicts examined before lunch were 2/3 more likely to be denied parole than after lunch break.
Bottom line: if we do not want to look like deers in the headlights, we must plan our exits before entry. Experienced traders often say that the best time to put on a stop loss is 5 minutes before entry.
There are only three possibilities after entry: either a stock goes up, down or nowhere. So, an exit strategy must answer those three questions
  1. Price goes down, there is a loss: at what price do we reduce risk ? How much do we need to exit ?
  2. Profit goes up, there is profit: At what price do we take risk/money off the table ?  How much do we need to exit ?
  3. Price goes nowhere: how many days after entry ? How much do we need to exit ?
Note also that exits do not have to be binary 0-100%. This is the subject of the next two articles.
Note that there is no room for interpretation. This is not the time for abstract debates on valuations, long-term prospects, or any other rationalization that our amygdala fueled inner idiot will throw at us. It has to be an unambiguous IF…THEN sequence.
The good news is that unless any stock triggers any of those landmines, there is no need for action. It helps achieve three things:
  1. It reduces the need for constant monitoring: market participants often stay glued in front of their monitors expecting the markets to telegraph a compelling call to action
  2. It helps navigate volatility. Volatility often tempts us into action. Having a plan and sticking to it helps reduce the urge
  3. It frees up mental space that can be used for higher cognitive functions: research and planning.
Everyone knows that the key to success is to cut losers and ride winners. The problem is that no-one has ever come up with a formula. If You want a clear method to accomplish this, while maintaining your conviction, then the game of two halves is for you.
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The view from the short-side: how we process emotions and the market signature of the 5 stages of grief

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Market participants are constantly asked to defend their conviction. The moment they have to justify their positions is the moment they lose impartiality. They become attached to whatever they have to defend. Being right is no longer about the process (taking calculated risks), but about the outcome (making money). A losing position is an attack on the ego. For this reason, market participants process emotions through a 5 stage cycle defined by Elizabeth Kubler Ross as the psychology of grief. Each phase has a distinctive market signature and even a specific language.

Summary:
  • Short sellers have a unique perspective on how market participants process emotions
  • The 5 phases described: market regime, market signature, language and profitable course of action

 I have been a professional short seller for almost a decade. For 8 years, my mandate was to under-perform the longest bear market in modern history: Japan equities. I have always searched for a way to identify the signature of human emotions across markets. Many respected market gurus have come up with charts plotted with emotions ranging from euphoria to despondency. Yet, they never really resonated with the short seller in me. Those were written by market participants with a natural Long bias. The short side offers a unique perspective on how investors process emotions. We, short sellers, never sell against buyers. We ride the tails of those who were once holders and now have to “accept” losses and “let go” of attachment.
There are three market regimes: bull, bear and sideways. Each regime can be subdivided into two categories: quiet or choppy. Bear markets usually start in sideways choppy markets: an epic battle between bears and bulls. They usually end in indifference: sideways quiet or bull quiet. Everyone has thrown the towel and no-one cares anymore.
The psychology of grief has five phases: denial, anger, bargaining, depression and acceptance. We will examine each phase looking at the market regime, the market signature, the language and a profitable course of action.
Phase 1: Denial
  • Market regime is usually sideways choppy. Stocks stop making new highs. They are trapped in a volatile range. Short interest is low. Bulls fight bears.
  • Market signature is the compression of estimates. Optimistic and pessimistic analysts have fairly close estimates. All available information has been “baked in” the estimates. The decisive factor is a sudden penetration through support level.
At this stage, analysts jump in and say two things:
  1. This is a “one-off”, “inventory adjustment”, “seasonal adjustment” etc
  2. This is a “Buy on Weakness opportunity”: Analysts are usually quite vocal as they appeal to market participants who were waiting for a pullback to enter a position
If a stop loss was not triggered, it is best to wait until the ensuing rebound is over to make a decision. If the new peak is below the previous high, then start trimming. When in doubt, reduce position size.
Phase 2: Anger
  • Market regime has morphed into a choppy bear. Stocks make lower highs and lower lows. Volatility remains elevated. Short interest start to tick up. Professional short sellers, such as myself, put a chip on the table just to see. Fast money, those who bought the dips and lost money, turn around and engage in some revenge short selling.
  • Market signature is characterized by institutional reducing their weight. Initial sellers are Long Onlys trimming their weights. Mutual funds may well keep their bets over the index, but they still trim their weights so as to reflect under-performance.
At this stage, analysts express their frustration:
  1. “…But the market does not understand …”: that is always an interesting argument, particularly after years of out-performance, institutional participation. Market probably knows something analysts refuse to accept yet
  2. “Short-sellers and speculators are taking the stocks down…”: ignorant analysts and market commentators blame us for stocks tanking, yet facts are stubborn: short interest is low. Secondly, in order to sell short, we need to locate borrow. Borrow availability represents a tiny fraction of the free float. Simply said, we just do not have the might to take anything down.
At this stage, it is prudent to aggressively reduce bet size for two reasons: 1) Volatility remains high and 2) performance does not justify a big position anyway. For market participants with a Long/Short mandate, this is a good time to anchor a small short bet. Position sizing is crucial as volatility remains elevated. Those anchors become invaluable when stocks move into the next phase as they embed substantial profits.
Phase 3: Bargaining
Me: “Doctor, if I eat my vegetables, stop drinking, smoking, eating poorly and exercise more, will I live longer ?”
Doctor: “I don’t know, but it will feel much longer anyway”
  • Market regime shifts from bear choppy to bear quiet. Bears have won the battle.
  • Market signature is a softening of a leading indicator that triggers a downgrade of estimates. Negative earnings momentum attracts short-sellers. Short interest start to rise.
At this stage analysts bargain with their conviction:
  1. “We take our estimates down, we revise our target price, we extend our investment horizon, but…”: Since analysts were ardent supporters, they believe they cannot change their mind at once
  2. “… We keep our Buy rating, because the long-term story is still intact”: the softening is not perceived as the symptom of a disease but a temporary setback
Analysts devote their existence to a few stocks. They know something is wrong but they cannot publicly admit that it is time to let go, but market participants can read through the lines and sell. Price action has already shown some weakness, but quantitative short sellers see negative earnings momentum as the sign to build positions. Short interest rises and so does the cost of borrow. This is when anchoring a small position in the previous phase becomes invaluable: borrow was secured at a cheap cost.
 
Phase 4: Depression
  • Market regime is bear quiet to bear volatile because of short squeezes
  • Market signature is 1) deterioration of newsflow , 2) radio-silence from the analyst community and 3) rapid increase in short interest
At this stage analysts:
  • crawl under their desks: they hardly contact companies or market participants
  • “this is a stock for long-term investors”: to which there is only one retort: “then it should be matched by long-term commissions”. If they frown, sell short…
Short interest rises quickly. The quality of borrow deteriorates (callable stocks, usury borrowing rate etc). It becomes costly and difficult to sell short. As a rule of thumb, do not sell short when short utilization (shares borrowed/shares available) rises above 51%. Volume is thin so any tiny event can trigger a short squeeze. Amateur short sellers are forced to cover, which trigger a cascade of short cover.
Phase 5: Acceptance
When the inexorability of reality sets in, there is a sort of euphoric relief.
  • Market regime is either quiet bull (small higher highs, higher lows) or sideways quiet
  • Market signature is terrible news-flow, massive downgrade from the analyst community, elevated short interest (crowded short). It is also muted price action: stocks do not react to a torrent of bad news anymore
At this stage, analysts are frustrated and no longer afraid to tarnish their standing with companies. They downgrade ratings, estimates and publish some vitriolic content such as:
  1. “Structural short”, “flawed business model…”, “…mismanaged”: it sometimes becomes personal, because analysts had a rough inner journey being champions of a lost cause
When all the negativity, particularly the words “structural words”, does not move share price anymore, it is a sign that the worse is over. There is one logical thing left to do: cover the short and go long.
Discussion
Markets are the ultimate mental sports. As much as we would like to think we are rational, the moment we are asked to defend our opinions is the moment we lose impartiality. The irony is that we intuitively know when something is not quite right. Still, we feel obligated to defend our stance. We refuse to admit reality, so we go through a painful process that eventually leads to acceptance. Pain is inevitable, suffering is optional. Making money in the markets is not about trying to be right, it is about accepting to be wrong and move on. Would You like to learn simple powerful techniques designed to reconcile the need for conviction and the reality of losses ?
Please leave a comment and share if You care:

 

Is Stock Picking Overrated ?

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Summary

  • If 80% of managers underperform their benchmark, we probably focus on the wrong thing. How about focusing on gain expectancy instead of stock picking ?
  • Signal module: how often we win (hit ratio) is not a function of what we enter (stock picking) but how we exit.
  • Money is made in the money management module: how much we win is a function of how much we bet (position sizing).
  • Psychology module: Great traders are not smarter, they have smarter trading habits

The finance industry is built on the cult of the stock picker. We have been conditioned to believe that entering the right stocks is the recipe to beat the markets. Year after year, we spare no effort, expenses, technology and time just to find that golden nugget. We never stop and ask ourselves whether it works in the first place. SPIVA gives an unapologetic report on active versus index investing. Every year, about 80% of managers underperform the market by a few percentage points, the equivalent of fees plus transaction costs of one time turnover. There are probably two reasons for this.

Firstly, Charles Ellis explained in his book “winning the losers game” that markets are dominated by institutional investors. The index is therefore the average of highly educated, intelligent, hard working and ferociously competitive people. So, outperforming the index comes down to beating a very high average.

Secondly, if , year after year, we try the same old “better sameness” just a little bit harder and expect different results, only to be humbled each time, we may have been focusing on the wrong thing in the first place. The answer may lie in an equation so simple it is often overlooked: Gain Expectancy.

But first, please understand that our objective is not to throw stones at active management from our modest glass house. We are committed to helping market participants build smarter trading habits. We provide simple yet powerful tools to nudge performance: resources, research, links, Excel files.

Enter Gain expectancy

Gain expectancy is just another fancy word for average profit. All strategies without exception boil down to this formula:

Gain Expectancy = Win rate% * Avg Win% – Loss rate% * |Avg Loss%|

Using this equation, we will examine what we believe to be the four components of any strategy in increasing order of importance: entry, exit, money management and psychology.

Entry Accounts for 5% of performance

Jesse-Owens-007

Finance is the only sport that hands out medals before the race

Finance is the only competitive sport where we expect medals to be handed out before the race. Market participants focus their energy on picking the right securities, but stock picking is the process that leads to entry. When we focus on stock picking, we just care about getting the best stocks to the starting blocks and assume they will do well thereafter. We overlook critical questions such as 1) what if they do not perform as expected, 2) how big we should be and more importantly 3) will we have the fortitude to stomach the ride ?

Stock picking is not irrelevant, it is overrated. There is no doubt that picking the right stocks increases our chance of success. The treasure hunt of stock picking is the most exciting aspect of the job. Ironically, entry is also the part that has the lowest impact on performance. Looking back at the gain expectancy formula, entry is just an ingredient of the win rate%, not the happy meal. After all, even the best ingredients will not necessarily turn into a succulent meal if there is no recipe. When everyone else is fixated on entry, paying a little more attention to other components may give us a critical edge.

In the coming articles, we will examine different types of entry techniques, common pitfalls and remedies. Everybody likes to buy on weakness and sell short on strength. But sometimes weakness is a symptom of a bigger problem and vice-versa on the short side, strength turns into bullishness.

Exit Accounts For 20% of Performance

jesse-owens

It’s not what we pick but how we exit that determines the hir ratio

We all have been shaken out of a position and then watched it rally without participating. The hit ratio is not determined by what we enter, but how we leave. Exit is a binary event: a trade is either profitable or not. The only time when win rate% can be calculated with absolute certainty is after positions are closed. Anytime before that is just paper profit. The quality of our exits determines the shape of our P&L distribution.

Before I embraced the sophistication of simplicity, I used to believe that a certain combination of factors would generate optimal performance. I was looking for a holy grail of some sort. The first epiphany came after a Monte Carlo optimization. One of the combinations made money 19 years out of 20, despite a win rate of 34%. Meanwhile, the highest win rate (67%) lost money 17 out of 20 years. The lesson was clear: “making money in the markets is not about trying to be right. It is about accepting one is wrong and move on”. There is one class of individuals to whom it should come easy: married men.

Would You drive a car without brakes ? Then, would You trust a strategy without a stop loss ? Market participants are often refractory to the idea of a stop loss. It is however the second most important component in any strategy. It has direct impact on 3 out of 4 variables of the gain expectancy: win rate%, loss rate%, Avg loss%. In addition, it has a direct impact on trading frequency and bet sizing. Profits look big only to the extent that losses are kept small.

Entry and exit constitute the signal module. They only determine the win rate. A trading system is like a car. The signal module is the engine. The money management is the transmission and psychology is the driver.

In the coming articles, we will examine the various types of exits and their influence on the P&L distribution.

Money management accounts for 25% of performance

Different Weight simulations SPX - Excel 2015-03-10

Same strategy, different bet sizing algorithms generate different outcomes

Money is made in the money management module. There is rampant confusion in our industry that associates alpha generation capability with high win rate. LTCM used to boast a win rate above 70%. Yet, their demise nearly took down the modern financial system. By contrast, William Eckhardt, the father of the Turtle Traders, claims a modest win rate of 35%. He has however achieved a remarkable annualized performance of 18% over a 36 year career. It is not how often we win but how much we make that ultimately determines our performance.

In a previous job, I used to run my algorithm across various portfolios. The objective was to help other managers better trade their positions 5bps at a time. Compound this over a year and this is the difference between 2nd quartile and top decile performance. The same stocks kept on reappearing in top ten bets. Managers exchange ideas and have access to the same research. There was a low dispersion of holdings, but there was a high disparity of performance. So, the difference that made the difference was obviously not stock picking: everybody owned the same stocks. The primary determinant of performance was bet sizing.

Looking back at the gain expectancy formula, bet sizing is the component that tells how much we make. It helps us achieve our investment objectives. It is also the most important component for market participants engaged in short selling activities.

In the coming articles, we will look at various position size algorithms, risk management tools so as to help You extract more alpha out of your ideas. We will look at specific techniques designed to help You clarify your objectives and achieve your goals.

Psychology Accounts For 50% of Performance

“If You don’t know who You are, this [markets] is an expensive place to find out”, Adam Smith

Habits

Great traders are not smarter, they have smarter trading habits

Unfortunately, bull markets have never boosted anybody’s IQ. We simply get overconfident during winning streaks and start gambling away. Then, during the ensuing losing streaks, we get depressed and take too little risk. In any case, we tend to abandon our discipline. Even systematic traders tend to tweak their models during losing streaks.

We have been conditioned to believe that willpower is the key to success. Unfortunately, willpower is a muscle that tires quickly, particularly under stress. For example, we all know that the key to performance is to cut losers and ride winners. So, we promise ourselves that we will reevaluate positions once stories change. Unfortunately, no plan has ever survived its collision with reality. If we leave this process to our willpower, it invariably turns into an internal debate, where our inner saboteur often convinces us to keep losers in the portfolio.  Inertia creeps in and the next thing we know, our portfolio has turned into a toxic waste junkyard. The problem is: every time we say “Yes” to a loser, we say “No” to a potential winner.

Market psychology is comprised of two parts. It is the ability to execute a trading plan through winning and losing streaks alike. It is also the inner game of investing: the inner alignment from deep subconscious beliefs to daily unconscious routines. “Watch your thoughts, they become words. Watch your words, they become actions. Watch your actions, they become habits. Watch your habits, they become character. Watch your character, for it becomes your destiny”, Mohandas Gandhi

There is a simple, but not easy, solution to change our psychological make-up. According to a 2002 research paper by Wendy Wood, we spend between 45% and 60% of waking time in habitual mode.  Interestingly enough, the study was conducted on young undergraduates, a segment of the population where habits are still highly malleable. Imagine how habitual our behavior can be after 10 years on the job. We probably learned for the first 2 years and then pushed the repeat button ever since.

Great traders are not smarter, they have smarter trading habits. They have developed and practiced profitable behaviors that have turned into trading rituals. The beauty of habits is that they bypass conscious decision process. They become effortless and emotionless over time. Under stress, we ditch elaborate plans and fall back to our habits. This is why installing smarter habits is critical: success is a habit and unfortunately, so is failure.

Fortunately, executing stop losses can be as emotionally intense as brushing teeth. This is a gradual process that starts, not with ruthlessly cutting losers, but with keeping a portion in the portfolio…  It starts small but the compounded effects are immense. The difference between sending a golf ball off course or close to the hole is one millimeter when hitting the ball. If smarter trading habits resulted in a gain as small as 0.02% per trade, the compounded effect over 100 trades would put us in the rare company of market gurus.

At ASC, We are committed to help You build healthier trading habits. In the coming articles, we will provide You with research from the fields of finance and medical sciences, resources exercises, links that will help You change your habits.

Conclusion

“We are what we repeatedly do. Excellence, then, is not an act, but a habit.”, Aristotle

If we want different results, then doing something different is probably a good start. Stock picking is not irrelevant, it is overrated. All it takes to nudge gain expectancy (i-e performance) is to redirect a small portion of our focus to the other components of the success formula.

Great traders are not smarter, they have smarter trading habits. We are committed to helping market participants form healthier trading habits. We will provide You with resources, links, exercises and an App on the Bloomberg portal.

Preview of the next article

  • In the next article, we will introduce a powerful visual representation of gain expectancy
  • Using this tool, we will reclassify strategies across all asset classes in two types
  • We will provide You with suitable risk measures risk for either type of strategy
  • We will introduce a new risk measure: Common Sense Ratio
  • We will provide You with a simple technique that dramatically improve your win rate %