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I have just come back from vacation, it is the start of a new year, I have a brand new fund that needs to be invested, I am sitting in my study watching the markets and I haven't a clue as what to do.
The greatest minds in the world tell us that the US is sick, and by sick I don't mean the flu. The US is infected with a terminal disease that can only be cured with painfull surgery, and strict observance of a health programme, anything else will lead to death.
Let us not blame this on the Americans alone, a culture of spending all of tomorrows earnings today has pervaded most of the western world, and this increases the chance of major "illness" spreading across the globe in an epidemic the like the world has never seen before.
It is against this backdrop that I ponder the weightings and directional balance of the virgin fund I have been blessed to consumate.
I will end tonights session by saying that I have maintained a bearish view on the markets for over 3 years in the face of a bear market rally, the "pain" has been severe and the error humbling. However, I stand tall and steadfast in my view that we are indeed in a bear market rally, and the time is nigh for a monumental correction in the markets that although painfull and devestating for the world should provide bountiful profits for our new fund.
"Stay the Course"
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13 comments:
Amazing what a good night sleep and productive working day can do for your confidence and clarity of vision.
I can see the markets gently shaping into the way I had anticipated and with a little bit of patients I should be able to setup a really strong platform to produce superior returns.
The current theme running through my head at the moment is whether I am a trader or a hedge fund manager.
This will need to be explored in greater detail in a future post.
It has been a really long day, and I am exhausted. Busy putting the kids to sleep, and still need to do some work going through my WealthLab trading systems.
This is an excellent piece from John Mauldin it says it all, and is exactly the way I like to trade. Perhaps there is a bit of a masochist in me, will need to check it out with my therapist on my next visit.
On the Contrary: Why It Pays To Be Different
Whilst the consensus may sometimes be right, it is unlikely you will make money from investing in it. As Keynes put it, investors should "go contrary to the general opinion, on the grounds that if everyone agreed about its merits, the investment is inevitably too dear". So going against the crowd is still likely to be the best recipe for consistently adding value. But where are the big consensus trades now?
>> In a world in which everyone is trying to outperform each other, doing what everyone else is doing is unlikely to work as a viable source of long term alpha. As the quotation from Maynard Keynes makes clear, equity prices should reflect the consensus view. So betting with the consensus is unlikely to generate significant outperformance.
>> New research by Lehavy and Sloan shows the stocks that institutional fund managers are busy buying are outperformed by the stocks the fund managers are busy selling. In the three years after portfolios were formed, those stocks that had seen the lowest level of interest from institutional investors outperformed those stocks with the highest attraction by over 4.5% p.a. (using data from 1982-2004).
>> Of course, going against the crowd is not painless. Neuropsychologists have found that social pain (the pain of going against the crowd, or being excluded) is felt in the same parts of the brain as real physical pain. So contrarian investing is a little bit like having your arm broken on a regular basis.
>> The returns to bearing this discomfort can be sizeable. For instance, a model relating the PE people are willing to pay to measures of underlying volatility shows that as volatility declines so people will pay more, but of course, they end up earning less. For instance, buying the market when it is in the comfort zone (i.e. volatility is low) results in very low real returns over the long run (an average of 1.3% p.a.). In contrast, buying equities when it feels absolutely awful to do so can generate high returns. When the market is in the "you must be mad to buy equities" mode, the real return over ten years is 15% p.a.!
>> So, where are big consensus trades at the moment? Many investors seem to have itchy trigger fingers when it comes to getting into growth styles. The logic seems to be that after five years of value outperformance, surely growth is due a bounce back. Japanese equities continue to attract a vast amount of support from overseas investors, and surveys consistently show Japan is one the most favoured regions this year. Long US/ Short Europe is becoming another highly consensus trade. After a couple of years of US underperformance, investors seem to think it is time for catch up. However, this ignores valuations. Across a gamut of valuation measures the US is on average 56% overvalued, whilst Europe is around 'only' 27% overvalued. Small caps also stand out as an expensive consensus bet.
>> Our value-orientated country screen suggests buying Belgium, Norway, Netherlands, the UK and France. Amongst emerging markets Venezuela, Thailand, Indonesia, Peru, Korea and Brazil stand out as cheap. Of course, buying any of these is likely to result in accusations of insanity and calls for your internment in an institution. Such are the joys of being a contrarian.
The following rules of trading are desinged by the well known, economist and trader - Dennis Gartman of The Gartman Letter fame.
It is amazing how simple and brilliant these rules are, my only point of debate is reconciling these principles with a contrarian approach to trading.
If I have understood these rules correctly, Dennis is saying that you cannot trade contrarian profitably. You can have contrarian views, however, it seems according to him you need to wait for the new trend to take effect.
I need to give this more thought, however, those rules aside I think the rest make for a must when trading.
The "Not-So-Simple" (But Really Utterly So) Rules of Trading
The world of investing/treading, even at the very highest levels, where we are supposed to believe that wisdom prevails and profits abound, is littered with the wreckage of wealth that has hit the various myriad rocks that exist just beneath the tranquil surface of the global economy. It matters not what level of supposed wisdom, or education, that the money managers or individuals in question have. We can make a list of wondrously large financial failures that have come to flounder upon these rocks for the very same reasons. Let us, for a bit, have a moment of collective silence for Long Term Capital Management; for Baring's Brothers; for Sumitomo Copper... and for the tens of thousands of individuals each year who follow their lead into financial oblivion.
I've been in the business of trading since the early 1970s as a bank trader, as a member of the Chicago Board of Trade, as a private investor, and as the writer of The Gartman Letter, a daily newsletter I've been producing for primarily institutional clientele since the middle 1980s. I've survived, but often just barely. I've made preposterous errors of judgment. I've made wondrously insightful "plays." I've understood, from time to time, basis economic fundamentals that should drive prices--and then don't. I've misunderstood other economic fundamentals that, in retrospect, were 180 degrees out of logic and yet prevailed profitably. I've prospered; I've almost failed utterly. I've won, I've lost, and I've broken even.
As I get older, and in my mid-50s, having seen so much of the game--for a game it is, with bad players who get lucky; great players who get unlucky; mediocre players who find their slot in the lineup and produce nice, steady results over long periods of time; "streak-y" players who score big for a while and lose big at other times--I have distilled what it is that we do to survive into a series of "Not-So-Simple" Rules of Trading that I try my best to live by every day ... every week ... every month. When I do stand by my rules, I prosper; when I don't, I don't. I am convinced that had Long Term Capital Management not listened to its myriad Nobel Laureates in Economics and had instead followed these rules, it would not only still be extant, it would be enormously larger, preposterously profitable and an example to everyone. I am convinced that had Nick Leeson and Barings Brothers adhered to these rules, Barings too would be alive and functioning. Perhaps the same might even be said for Mr. Hamanaka and Sumitomo Copper.
Now, onto the Rules:
NEVER ADD TO A LOSING POSITION
R U L E # 1
Never, ever, under any circumstance, should one add to a losing position ... not EVER!
Averaging down into a losing trade is the only thing that will assuredly take you out of the investment business. This is what took LTCM out. This is what took Barings Brothers out; this is what took Sumitomo Copper out, and this is what takes most losing investors out. The only thing that can happen to you when you average down into a long position (or up into a short position) is that your net worth must decline. Oh, it may turn around eventually and your decision to average down may be proven fortuitous, but for every example of fortune shining we can give an example of fortune turning bleak and deadly.
By contrast, if you buy a stock or a commodity or a currency at progressively higher prices, the only thing that can happen to your net worth is that it shall rise. Eventually, all prices tumble. Eventually, the last position you buy, at progressively higher prices, shall prove to be a loser, and it is at that point that you will have to exit your position. However, as long as you buy at higher prices, the market is telling you that you are correct in your analysis and you should continue to trade accordingly.
R U L E # 2
Never, ever, under any circumstance, should one add to a losing position ... not EVER!
We trust our point is made. If "location, location, location" are the first three rules of investing in real estate, then the first two rules of trading equities, debt, commodities, currencies, and so on are these: never add to a losing position.
INVEST ON THE SIDE THAT IS WINNING
R U L E # 3
Learn to trade like a mercenary guerrilla.
The great Jesse Livermore once said that it is not our duty to trade upon the bullish side, nor the bearish side, but upon the winning side. This is brilliance of the first order. We must indeed learn to fight/invest on the winning side, and we must be willing to change sides immediately when one side has gained the upper hand.
Once, when Lord Keynes was appearing at a conference he had spoken to the year previous, at which he had suggested an investment in a particular stock that he was now suggesting should be shorted, a gentleman in the audience took him to task for having changed his view. This gentleman wondered how it was possible that Lord Keynes could shift in this manner and thought that Keynes was a charlatan for having changed his opinion. Lord Keynes responded in a wonderfully prescient manner when he said, "Sir, the facts have changed regarding this company, and when the facts change, I change. What do you do, Sir?" Lord Keynes understood the rationality of trading as a mercenary guerrilla, choosing to invest/fight upon the winning side. When the facts change, we must change. It is illogical to do otherwise.
DON'T HOLD ON TO LOSING POSITIONS
R U L E # 4
Capital is in two varieties: Mental and Real, and, of the two, the mental capital is the most important.
Holding on to losing positions costs real capital as one's account balance is depleted, but it can exhaust one's mental capital even more seriously as one holds to the losing trade, becoming more and more fearful with each passing minute, day and week, avoiding potentially profitable trades while one nurtures the losing position.
GO WHERE THE STRENGTH IS
R U L E # 5
The objective of what we are after is not to buy low and to sell high, but to buy high and to sell higher, or to sell short low and to buy lower.
We can never know what price is really "low," nor what price is really "high." We can, however, have a modest chance at knowing what the trend is and acting on that trend. We can buy higher and we can sell higher still if the trend is up. Conversely, we can sell short at low prices and we can cover at lower prices if the trend is still down. However, we've no idea how high high is, nor how low low is.
Nortel went from approximately the split-adjusted price of $1 share back in the early 1980s, to just under $90/share in early 2000 and back to near $1 share by 2002 (where it has hovered ever since). On the way up, it looked expensive at $20, at $30, at $70, and at $85, and on the way down it may have looked inexpensive at $70, and $30, and $20--and even at $10 and $5. The lesson here is that we really cannot tell what is high and/or what is low, but when the trend becomes established, it can run far farther than the most optimistic or most pessimistic among us can foresee.
R U L E # 6
Sell markets that show the greatest weakness; buy markets that show the greatest strength.
Metaphorically, when bearish we need to throw our rocks into the wettest paper sack for it will break the most readily, while in bull markets we need to ride the strongest wind for it shall carry us farther than others.
Those in the women's apparel business understand this rule better than others, for when they carry an inventory of various dresses and designers they watch which designer's work moves off the shelf most readily and which do not. They instinctively mark down the work of those designers who sell poorly, recovering what capital then can as swiftly as they can, and use that capital to buy more works by the successful designer. To do otherwise is counterintuitive. They instinctively buy the "strongest" designers and sell the "weakest." Investors in stocks all too often and by contrast, watch their portfolio shift over time and sell out the best stocks, often deploying this capital into the shares that have lagged. They are, in essence, selling the best designers while buying more of the worst. A clothing shop owner would never do this; stock investors do it all the time and think they are wise for doing so!
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MAKING "LOGICAL" PLAYS IS COSTLY
R U L E # 7
In a Bull Market we can only be long or neutral; in a bear market we can only be bearish or neutral.
Rule 6 addresses what might seem like a logical play: selling out of a long position after a sharp rush higher or covering a short position after a sharp break lower--and then trying to play the market from the other direction, hoping to profit from the supposedly inevitable correction, only to see the market continue on in the original direction that we had gotten ourselves exposed to. At this point, we are not only losing real capital, we are losing mental capital at an explosive rate, and we are bound to make more and more errors of judgment along the way.
Actually, in a bull market we can be neutral, modestly long, or aggressively long--getting into the last position after a protracted bull run into which we've added to our winning position all along the way. Conversely, in a bear market we can be neutral, modestly short, or aggressively short, but never, ever can we--or should we--be the opposite way even so slightly.
Many years ago I was standing on the top step of the CBOT bond-trading pit with an old friend Bradley Rotter, looking down into the tumult below in awe. When asked what he thought, Brad replied, "I'm flat ... and I'm nervous." That, we think, says it all...that the markets are often so terrifying that no position is a position of consequence.
R U L E # 8
"Markets can remain illogical far longer than you or I can remain solvent."
I understand that it was Lord Keynes who said this first, but the first time I heard it was one morning many years ago when talking with a very good friend, and mentor, Dr. A. Gary Shilling, as he worried over a position in U.S. debt that was going against him and seemed to go against the most obvious economic fundamentals at the time. Worried about his losing position and obviously dismayed by it, Gary said over the phone, "Dennis, the markets are illogical at times, and they can remain illogical far longer than you or I can remain solvent." The University of Chicago "boys" have argued for decades that the markets are rational, but we in the markets every day know otherwise. We must learn to accept that irrationality, deal with it, and move on. There is not much else one can say. (Dr. Shilling's position shortly thereafter proved to have been wise and profitable, but not before further "mental" capital was expended.)
R U L E # 9
Trading runs in cycles; some are good, some are bad, and there is nothing we can do about that other than accept it and act accordingly.
The academics will never understand this, but those of us who trade for a living know that there are times when every trade we make (even the errors) is profitable and there is nothing we can do to change that. Conversely, there are times that no matter what we do--no matter how wise and considered are our insights; no matter how sophisticated our analysis--our trades will surrender nothing other than losses. Thus, when things are going well, trade often, trade large, and try to maximize the good fortune that is being bestowed upon you. However, when trading poorly, trade infrequently, trade very small, and continue to get steadily smaller until the winds have changed and the trading "gods" have chosen to smile upon you once again. The latter usually happens when we begin following the rules of trading again. Funny how that happens!
THINK LIKE A FUNDAMENTALIST;
TRADE LIKE A TECHNICIAN
R U L E # 10
To trade/invest successfully, think like a fundamentalist; trade like a technician.
It is obviously imperative that we understand the economic fundamentals that will drive a market higher or lower, but we must understand the technicals as well. When we do, then and only then can we, or should we, trade. If the market fundamentals as we understand them are bullish and the trend is down, it is illogical to buy; conversely, if the fundamentals as we understand them are bearish but the market's trend is up, it is illogical to sell that market short. Ah, but if we understand the market's fundamentals to be bullish and if the trend is up, it is even more illogical not to trade bullishly.
R U L E # 11
Keep your technical systems simple.
Over the years we have listened to inordinately bright young men and women explain the most complicated and clearly sophisticated trading systems. These are systems that they have labored over; nurtured; expended huge sums of money and time upon, but our history has shown that they rarely make money for those employing them. Complexity breeds confusion; simplicity breeds an ability to make decisions swiftly, and to admit error when wrong. Simplicity breeds elegance.
The greatest traders/investors we've had the honor to know over the years continue to employ the simplest trading schemes. They draw simple trend lines, they see and act on simple technical signals, they react swiftly, and they attribute it to their knowledge gained over the years that complexity is the home of the young and untested.
UNDERSTAND THE ENVIRONMENT
R U L E # 12
In trading/investing, an understanding of mass psychology is often more important than an understanding of economics.
Markets are, as we like to say, the sum total of the wisdom and stupidity of all who trade in them, and they are collectively given over to the most basic components of the collective psychology. The dot-com bubble was indeed a bubble, but it grew from a small group to a larger group to the largest group, collectively fed by mass mania, until it ended. The economists among us missed the bull-run entirely, but that proves only that markets can indeed remain irrational, and that economic fundamentals may eventually hold the day but in the interim, psychology holds the moment.
And finally the most important rule of all:
THE RULE THAT SUMS UP THE REST
R U L E # 13
Do more of that which is working and do less of that which is not.
This is a simple rule in writing; this is a difficult rule to act upon. However, it synthesizes all the modest wisdom we've accumulated over thirty years of watching and trading in markets. Adding to a winning trade while cutting back on losing trades is the one true rule that holds--and it holds in life as well as in trading/investing.
If you would go to the golf course to play a tournament and find at the practice tee that you are hitting the ball with a slight "left-to-right" tendency that day, it would be best to take that notion out to the course rather than attempt to re-work your swing. Doing more of what is working works on the golf course, and it works in investing.
If you find that writing thank you notes, following the niceties of life that are extended to you, gets you more niceties in the future, you should write more thank you notes. If you find that being pleasant to those around you elicits more pleasantness, then be more pleasant.
And if you find that cutting losses while letting profits run--or even more directly, that cutting losses and adding to winning trades works best of all--then that is the course of action you must take when trading/investing. Here in our offices, as we trade for our own account, we constantly ask each other, "What's working today, and what's not?" Then we try to the very best of our ability "to do more of that which is working and less of that which is not." We've no set rule on how much more or how much less we are to do, we know only that we are to do "some" more of the former and "some" less of the latter. If our long positions are up, we look at which of those long positions is doing us the most good and we do more of that. If short positions are also up, we cut back on that which is doing us the most ill. Our process is simple.
We are certain that great--even vast--holes can and will be proven in our rules by doctoral candidates in business and economics, but we care not a whit, for they work. They've proven so through time and under pressure. We try our best to adhere to them.
This is what I have learned about the world of investing over three decades. I try each day to stand by my rules. I fail miserably at times, for I break them often, and when I do I lose money and mental capital, until such time as I return to my rules and try my very best to hold strongly to them. The losses incurred are the inevitable tithe I must make to the markets to atone for my trading sins. I accept them, and I move on, but only after vowing that "I'll never do that again."
I fell for the classic sucker play with my RYL short. I was making good money and the position was working, and then I suddenly developed uncertainty over my wave count.
I was making money and having so many times being in a profitable position and then giving it all back chasing the big one, i decided to cash in.
Needless to say it has collapsed and my profits have been curtailed.
I need to stay the course the road down is going to be violent and bumpy, this is the time to strap in tight, not pull out at the first sign of turbulence.
The ride will be frightening but enjoyable, with great results to show for itself. This is what i need to focus on when the going gets tough.
Exhibit 11 spells an ominous time ahead. We have reached the same level as in 1997, which preceded the biggest bear market in REIT history.
I foresee something similar as the market just does not price in risk today. To amplify my comments look at exhibit 12, we are in un-chartered territory vs corporate debt.
My opponents will tell me that this time is different, we are in a new type of environment, they will say the same in SA because of the political/demographic change, I say nonsense.
The principles that drive a market almost never change; it is all the same just cloaked in a different disguise. In the end common sense always prevails. Watch this space, as the US yield curve continues to invert and the market pays no attention to risk, I sense this time I may be right.
Mike
This is a long overdue post.
The REIT market has been steadily climbing this year with the market already being up a total return of 11.5% which outstrips what even the most bullish analysts had for the full years return.
My bearish outlook in the broader markets along with the real estate markets has been growing at an alarming rate over the last 2 weeks with my firm view that the major indices having topped.
The alignment for the majors to have topped in a grand super cycle wave 2 with the emerging markets SA and Aussie, etc also putting in tops, is perfect.
Everything from an Elliott Wave point of view points to a massive top. The fundamentals can easily be used as an appendix to these views although the market is tending to a more bullish stance.
I have been positioning myself over the last few weeks and now feel I have the appropriate position size on the US REIT market, S&P 500 Futures, EURO, ALSi, SA PROPERTY and GOLD.
Now I am in the uncomfortable positon of waiting for my trades to pan out as expected. The trades are on the scope to get bigger is not necessary as the positions are at their appropriate size.
The comfort of selling into strength is now gone, all that is left is a stop loss and a fantastic profit objective.
With all my strength I am fighting the fear that comes with the fact that I have been here before, with only bruises of late to show for my analysis.
There was a moment yesterday when I watched South Africa do the impossible while chasing a world record score to post a world record themselves. As we entered the last over it seemed like it was a slam dunk to win when we struck a 4 and needed only 3 runs of 4 balls. |Then bang a wicket and all the self doubt the Aussies have inflicted on us over the years by beating us in the dying moments started flooding in, and it seemed that once again victory was going to be snatched right out from underneath us.
The SA team never allowed their doubts paralyze a truly remarkable performance.
The same applies to my situation I know that I have done my homework and that from a % point of view my luck must turn and that the setup is perfect for a collapse and to use an incorrect term achieve - VICTORY.
I know what I have to do and a healthy dose of nerves in this situation is appropriate, but now is not the time to be scared. Now is the time to be bold and back myself to trade brilliantly.
WATCH THIS SPACE!!!
I am itching to write so more personal philosophy by due to certain time constraints placed by work and academic deadlines I am going to have to skip the pearls and maybe post a couple of thoughts as to how I see the markets at present.
Let me start by recounting that the proprietary funds I currently manage (3) have been doing pretty well. In fact 2 have done exceptionally and 1 has essentially broken square after 6 months.
I believe that the markets are finally starting to reflect the kind of risk premium I have been preaching is due for so long. A number of markets (emerging and SA property markets) have had a torrid time this last month, although the South African All Share Index has been stubbornly repairing its sharp losses on the back of stronger commodity prices and a weak rand.
In short I see trouble ahead on all fronts and the market is starting to sense there is something ominious afoot.
As per my fund management methodology and my views on where to for the business. I stress this business is about designing a system and sticking to it.
The longer I manage to stay in the game the more I learn in terms of how to stay solvent and ride with the ups and downs.
I have also realised that putting oneself in a strong financial position is the key to trading my style. I am a contrarian so there are often times I need to back myself and will go through a period of underperformance, my ability to stay in the game is the ability to withstand the temptation of running with the pack which will enivetably be my undoing.
So to stress a life lesson, the key to being a success in this business is learning from books, and people what their secret of success is, and trying to bring as many of their qualities into your business.
Finally, no matter how well the market moves in your favour the true fund managers is always cautious and concerned that things are about to change and upset the apple cart. Never be complacent, always be enquiring.
Last point I met with a banker at Investec the other day, and he was the typical arrogant stereotype investment banker (Investec brand), and his arrogance made me want to be sick. I will try to remain humble whatever my circumstances may be going forward.
Mike
I really want to get into more of a habit of recording my musings on the market.
The US has held up much longer than we all expected with the S&P and DOW I think having topped out of their respective wave 2 of 3 waves, this should spell selling fever going forward.
Suprisingly the REIT market has recovered to make new highs, this has been an impossible top to call and I have learnt many lessons over the last 4 years in my effort to call multiple tops (unsuccessfully I might add).
I feel reasonably calm, I have a nice position on the US markets should a selloff ensue. However, I have a very large short position on the SA Top 40 index, should the US top out and the gold which i believe is poised to correct at this point I should have a really nice pay day.
My new account should be setup with IG this week and in line with the bounce in bonds we forecast a selling opportunity should present itself, and who knows we may actually catch the top this time. My objective is to be really aggressive should a selloff of substance materialise.
On the SA listed property scene, I am getting the bounce I wanted with most importantly the occumpanying bullish sentiment. I will once again be in the minority shortly which is exciting, but I know there will be some severe discomfort ahead, which I will need to get my head around in preparation.
What is quite nice is that a free call option has resulted as we do not yet have to elect what to do with our Spearhead shares so we are in a good position should a bounce materialise.
I might have my new tablet pc by the end of the week and i look forward to some nice blogging.
I want to go on record and say that ApexHi has probably put in a major top. The confusion that will surround the C units will keep investors away.
Feature
Tharp's Thoughts
PERFECTIONISM and SYSTEM DEVELOPMENT
By
Van K. Tharp
My research suggests that the problems people have in developing a trading system fall into five different categories.
The first three areas prevent traders from ever starting (or finishing) the development of a trading system. These include computer/technology phobia, procrastination, and being overwhelmed by the whole process. The last two problems tend to prevent the trader from coming up with a workable system: perfectionism and judgmental biases in your thinking.
In earlier articles we’ve covered procrastination and the feeling of being overwhelmed. This week let’s look at perfectionism.
PERFECTIONISM
Perfectionism, in contrast to what some might expect, has an extremely negative impact on performance. People often strive to be perfect in what they do because their parents demanded they be perfect as children. Unfortunately, these lofty standards sometimes keep them from ever coming close to achieving them. Perfectionists waste time with unnecessary tasks. Businessmen make less effective decisions, traders make less money, and athletes perform poorly—all because of the high standards they set for themselves.
But the vicious problem perfectionists have is not just created by lofty standards. You can have lofty standards without being a perfectionist. Instead, perfectionism means those standards are tied into your self-esteem. If you don’t achieve those standards (and for most perfectionists, those standards are all‑or‑none), then you feel like less of a person. The perfectionist has trouble tolerating a mistake or handling a distraction. Perfectionists tend to have all‑or‑none thinking; so everyday little setbacks lead them into a world of despair.
Here is how the perfectionist mind- set can create lowered performance—the opposite of the desired result. The likelihood of a person achieving any outcome depends on two primary beliefs: 1) the belief that the behavior attempted will produce the outcome and 2) a belief that you are capable of producing the necessary behavior. The perfectionist has extremely high standards, by definition, which suggests their outcome may not be directly obtainable as a result of the behavior. More importantly, the perfectionist tends to be his or her own worst critic when these high standards are not achieved. At first, the perfectionist’s criticism drives him forward towards his goals. But as he repeatedly fails to achieve them, the self‑criticism gets much stronger and the person begins to create a wall around himself making the task impossible. As a result, the desired result of nearly impossible standards frequently creates below‑average performance.
Let’s take a look at Elmer:
Elmer was a perfectionist who was trying to develop a trading system that would win in nine out of ten trades and would make five times as much money as he was risking on any given trade. When he first tried to develop the system, it was just profitable after commissions and slippage. But when he saw the results—only a 2% gain each year—he wanted to beat his head into the wall. “How could you be so stupid to think that an approach like that would work?” he wailed. After three failed attempts, he was beside himself. His family found him hard to live with—he was uncivil and didn’t spend any time with them. He just locked himself in his computer room doing more testing and feeling more and more unsatisfied with himself. Normally, Elmer would have just given up after about six months. But in trading, he was exceptionally committed to find something that would meet his standards. He’d abandon a lot of good ideas before testing them because of his self‑criticism. Those he did test, no matter how well they turned out, would not meet his criteria for acceptance. Eventually, Elmer’s wife left him and Elmer found himself broke, without a family, or even a trading system that met his standards.
Poor performance among perfectionists is well documented in many fields. Psychologist David Burns, for example, found that perfectionist insurance agents, those who linked their achievement to their self‑worth, earned on the average $15,000 a year less than their non-perfectionistic counterparts.
Similarly, highly successful athletes tend to show a lack of perfectionist tendencies. For example, elite male gymnasts who qualified for Olympic competition tended to give much less importance to past poor performance than did a group of highly talented gymnasts who failed to qualify. The latter group, in fact, would rouse themselves into near panic states by dwelling on the images of past failure and turning those failures into excessive self-doubt and thoughts of impending tragedy. Think about it—the best baseball hitter in any given year will only get a hit about 3.5 times out of ten. If that player dwelled on the 6.5 times he didn’t get a hit, his chances of getting exceptional performance would be slim.
Perfectionists tend to find themselves under a great deal of emotional stress. They drive themselves hard, while at the same time, being their own worst critic. For example, when a perfectionist falls short of a goal, he or she is probably screaming criticisms at themselves for not meeting his/her own lofty standards.
Joe was a trader on a diet. One day he ate a tablespoon of ice cream and scolded himself by saying, “I shouldn’t have done that. I’m a pig.” His self-critique so upset him that he went on to eat the entire quart of ice cream. And, of course, by the time the quart was finished, he’d berated himself so much that the whole idea of a diet seemed hopeless.
How does this cycle of lofty standards tie into a person’s self esteem development? One theory holds that perfectionism develops when a child is regularly rewarded with love and approval for outstanding performance, but severely criticized for substandard performance. The child, in order to gain parental acceptance, begins to take on the parent’s high standards. And, in order to avoid criticism from the parents, the child begins to criticize him/herself. Soon the young child begins to anticipate mistakes that will lead to a loss of acceptance and starts criticizing himself for the slightest mistake. The logic is, “If I criticize myself, I’ll do better and then my parents will love me more”. But, of course, self‑criticism leads to feeling bad and then even poorer performance. And suddenly, the vicious cycle of high standards leading to poor performance, common to almost all people with this trait, ensues. A perfectionist has started down the road to ruin.
Getting out of the perfectionist trap. The best solution to getting out of perfectionism is probably to seek professional help to get rid of the perfectionist decisions that you made some time in the past. However, there is a five-step program you can do on your own to help you make progress.
First, make a list of the advantages and disadvantages of being perfectionist with respect to your trading (or in anything for that matter). Once you have the list, notice how the advantages may not be as great as the disadvantages. This should give you some insights about your standards and what you are doing to yourself.
Second, since your perfectionism comes from all‑or‑none standards, spend a day investigating how well the world can be evaluated by such all‑or‑none standards. For example, notice what happens when you decide that food must either be terrific or awful. What happens when you decide that a room is either totally clean or totally messy? What happens when you decide that a person is either beautiful or ugly? Intelligent or stupid? Or fat or thin? And, of course, as you are doing this notice how distorted all-or-none thinking is and then think about your perfectionist standards.
Third, keep a daily written record of self-critical statements you make. You might notice how irrational some of these thoughts are, even though they may seem quite plausible when you think them. Give yourself a reward for being able to write down at least 50 such thoughts in a day. Your reward, of course, is for your self‑awareness—not the negative thoughts. At the end of the day, examine what you’ve written down and notice the distortions in the thinking.
Fourth, for several days keep a record of the activities you do. Before you undertake each activity, estimate how satisfying you think the activity will be. When you finish the activity, record how satisfying you felt it actually was and how effectively you performed. What will happen is that you will notice your personal satisfaction is not necessarily correlated with superior performance. When you learn to move toward what gives you satisfaction, rather than superior performance, you will be on the road toward making your life work. And quite often-superior performance will follow.
Lastly, each day while you are developing a trading system, set behavioral standards that are about 10% of what you would normally expect of yourself. When you accomplish those new standards, agree to be proud of your performance and congratulate yourself. If you achieve more than that, fine! But always celebrate when you achieve your new standards. If necessary, get help from someone close who is not a perfectionist in setting your standards. Most people, when doing this exercise, find that the lower they set their standards, the higher their productivity suddenly becomes.
About Van Tharp: Trading coach, and author Dr. Van K Tharp, is widely recognized for his best-selling book Trade Your Way to Financial Fre-edom and his outstanding Peak Performance Home Study program - a highly regarded classic that is suitable for all levels of traders and investors. You can learn more about Van Tharp at www.iitm.com.
How Change Happens
"To trace something unknown back to something known is alleviating, soothing, gratifying, and gives moreover a feeling of power. Danger, disquiet, anxiety attend the unknown - the first instinct is to eliminate these distressing states. First principle: any explanation is better than none... The cause-creating drive is thus conditioned and excited by the feeling of fear ...." Friedrich Nietzsche
"Any explanation is better than none." And the simpler, it seems in the investment game, the better. "The markets went up because oil went down," we are told. Then the next day the opposite relationship occurs. Then there is another reason for the movement of the markets. But we all intuitively know that things are far more complicated than that. As Nietzsche noted, dealing with the unknown can be disturbing, so we look for the simple explanation.
"Ah," we tell ourselves. "I know why that happened." With an explanation firmly in hand, we now feel we know something. And the behavioral psychologists note that this state actually releases chemicals in our brain which make us feel good. We become literally addicted to the simple explanation. The fact that what we "know" (the explanation for the unknowable) is irrelevant or even wrong is not important to the chemical release. And thus we look for reasons.
And that is why some people get so angry when you challenge their beliefs. You are literally taking away the source of their good feeling, like drugs from a junkie, or a boyfriend from a teenage girl.
Thus we reason the NASDAQ bubble happened because of Greenspan. Or a collective mania. Or any number of things. Just like the proverbial butterfly flapping its wings in the Amazon that triggers a storm in Europe, maybe an investor in St. Louis triggered the NASDAQ crash.
Crazy? Maybe not. Today we will look at what complexity theory tells us about the reasons for earthquakes, disasters, and the movement of markets. Then we look at how New Zealand, Fed policy, gold, oil, and that investor in St. Louis are all tied together in a critical state. Of course, how critical and what state are the issues.
Ubiquity, Complexity Theory, and Sandpiles
We are going to start our explorations with excerpts from a very important book by Mark Buchanan called Ubiquity, Why Catastrophes Happen. I HIGHLY recommend it to those of you who, like me, are trying to understand the complexity of the markets. Not directly about investing, although he touches on it, it is about chaos theory, complexity theory, and critical states. It is written in a manner any layman can understand. There are no equations, just easy to grasp well-written stories and analogies. www.amazon.com.
We have all had the fun as kids of going to the beach and playing in the sand. Remember taking your plastic buckets and making sand piles? Slowly pouring the sand into ever bigger piles, until one side of the pile started an avalanche?
Imagine, Buchanan says, dropping one grain of sand after another onto a table. A pile soon develops. Eventually, just one grain starts an avalanche. Most of the time it is a small one, but sometimes it builds up and it seems like one whole side of the pile slides down to the bottom.
Well, in 1987, three physicists named Per Bak, Chao Tang, and Kurt Weisenfeld began to play the sandpile game in their lab at Brookhaven National Laboratory in New York. Now, actually piling up one grain of sand at a time is a slow process, so they wrote a computer program to do it. Not as much fun, but a whole lot faster. Not that they really cared about sandpiles. They were more interested in what are called nonequilibrium systems.
They learned some interesting things. What is the typical size of an avalanche? After a huge number of tests with millions of grains of sand, they found out that there is no typical number. "Some involved a single grain; others, ten, a hundred or a thousand. Still others were pile-wide cataclysms involving millions that brought nearly the whole mountain down. At any time, literally anything, it seemed, might be just about to occur."
It was indeed completely chaotic in its unpredictability. Now, let's read this next paragraph slowly. It is important, as it creates a mental image that may help us understand the organization of the financial markets and the world economy. (Emphasis mine.)
"To find out why [such unpredictability] should show up in their sandpile game, Bak and colleagues next played a trick with their computer. Imagine peering down on the pile from above, and coloring it in according to its steepness. Where it is relatively flat and stable, color it green; where steep and, in avalanche terms, 'ready to go,' color it red. What do you see? They found that at the outset the pile looked mostly green, but that, as the pile grew, the green became infiltrated with ever more red. With more grains, the scattering of red danger spots grew until a dense skeleton of instability ran through the pile. Here then was a clue to its peculiar behavior: a grain falling on a red spot can, by domino-like action, cause sliding at other nearby red spots. If the red network was sparse, and all trouble spots were well isolated one from the other, then a single grain could have only limited repercussions. But when the red spots come to riddle the pile, the consequences of the next grain become fiendishly unpredictable. It might trigger only a few tumblings, or it might instead set off a cataclysmic chain reaction involving millions. The sandpile seemed to have configured itself into a hypersensitive and peculiarly unstable condition in which the next falling grain could trigger a response of any size whatsoever."
Something only a math nerd could love? Scientists refer to this as a critical state. The term critical state can mean the point at which water would go to ice or steam, or the moment that critical mass induces a nuclear reaction, etc. It is the point at which something triggers a change in the basic nature or character of the object or group. Thus, (and very casually for all you physicists) we refer to something being in a critical state (or the term critical mass) when there is the opportunity for significant change.
"But to physicists, [the critical state] has always been seen as a kind of theoretical freak and sideshow, a devilishly unstable and unusual condition that arises only under the most exceptional circumstances [in highly controlled experiments]... In the sandpile game, however, a critical state seemed to arise naturally through the mindless sprinkling of grains."
Thus, they asked themselves, could this phenomenon show up elsewhere? In the earth's crust triggering earthquakes, wholesale changes in an ecosystem, or a stock market crash? "Could the special organization of the critical state explain why the world at large seems so susceptible to unpredictable upheavals?" Could it help us understand not just earthquakes, but why cartoons in a third-rate paper in Denmark could cause worldwide riots?
He concludes in his opening chapter: "There are many subtleties and twists in the story ... but the basic message, roughly speaking, is simple: The peculiar and exceptionally unstable organization of the critical state does indeed seem to ubiquitous in our world. Researchers in the past few years have found its mathematical fingerprints in the workings of all the upheavals I've mentioned so far [earthquakes, eco-disasters, market crashes], as well as in the spreading of epidemics, the flaring of traffic jams, the patterns by which instructions trickle down from managers to workers in the office, and in many other things. At the heart of our story, then, lies the discovery that networks of things of all kinds - atoms, molecules, species, people, and even ideas - have a marked tendency to organize themselves along similar lines. On the basis of this insight, scientists are finally beginning to fathom what lies behind tumultuous events of all sorts, and to see patterns at work where they have never seen them before."
Now, let's think about this for a moment. Going back to the sandpile game, you find that as you double the number of grains of sand involved in an avalanche, the probability of an avalanche is 2.14 times as unlikely. We find something similar in earthquakes. In terms of energy, the data indicate that earthquakes simply become four times less likely each time you double the energy they release. Mathematicians refer to this as a "power law" or a special mathematical pattern that stands out in contrast to the overall complexity of the earthquake process.
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Fingers of Instability
So what happens in our game? "...after the pile evolves into a critical state, many grains rest just on the verge of tumbling, and these grains link up into 'fingers of instability' of all possible lengths. While many are short, others slice through the pile from one end to the other. So the chain reaction triggered by a single grain might lead to an avalanche of any size whatsoever, depending on whether that grain fell on a short, intermediate or long finger of instability."
Now, we come to a critical point in our discussion of the critical state. Again, read this with the markets in mind (again, emphasis mine):
"In this simplified setting of the sandpile, the power law also points to something else: the surprising conclusion that even the greatest of events have no special or exceptional causes. After all, every avalanche large or small starts out the same way, when a single grain falls and makes the pile just slightly too steep at one point. What makes one avalanche much larger than another has nothing to do with its original cause, and nothing to do with some special situation in the pile just before it starts. Rather, it has to do with the perpetually unstable organization of the critical state, which makes it always possible for the next grain to trigger an avalanche of any size."
Now, let's couple this idea with a few other concepts. First, Nobel Laureate Hyman Minsky points out that stability leads to instability. The more comfortable we get with a given condition or trend, the longer it will persist; and then when the trend fails, the more dramatic is the correction. The problem with long-term macroeconomic stability is that it tends to produce unstable financial arrangements. If we believe that tomorrow and next year will be the same as last week and last year, we are more willing to add debt or postpone savings for current consumption. Thus, says Minsky, the longer the period of stability, the higher the potential risk for even greater instability when market participants must change their behavior.
Relating this to our sandpile, the longer that a critical state builds up in an economy, or in other words, the more "fingers of instability" that are allowed to develop a connection to other fingers of instability, the greater the potential for a serious "avalanche."
We Are Managing Uncertainty
Or, maybe a series of smaller shocks lessens the long reach of the fingers of instability, paradoxically giving rise to even more apparent stability. As the late Hunt Taylor wrote:
"Let us start with what we know. First, these markets look nothing like anything I've ever encountered before. Their stunning complexity, the staggering number of tradable instruments and their interconnectedness, the light-speed at which information moves, the degree to which the movement of one instrument triggers nonlinear reactions along chains of related derivatives, and the requisite level of mathematics necessary to price them speak to the reality that we are now sailing in uncharted waters.
"Next, we know things have been getting less, not more, turbulent, and that the tendency towards market serenity (complacency?) has been increasing. This is counterintuitive. It's not as though the 21st century has been lacking in liquidity shocking events. Since the bursting of the tech bubble, we've had a disputed Presidential election, 9/11, the collapse of Enron and Worldcom, the invasion of Afghanistan, the war in Iraq, US$70 oil, the largest debt downgrade in history and the failure of Refco, to name just a few. There seems to be an inverse correlation between market complexity and market stability, for now anyway....
"I've had 30-plus years of learning experiences in markets, all of which tell me that technology and telecommunications will not do away with human greed and ignorance. I think we will drive the car faster and faster until something bad happens. And I think it will come, like a comet, from that part of the night sky where we least expect it. This is something old.
"But I have learned to trust my eyes and ears and overrule my heart, when I have to. Everywhere I look, technology is making things faster, more efficient, safer. I cannot find the law of physics or economics that says it cannot happen in financial markets as well. I think, because risk will be lower, return will be as well. And savvy investors may have to seek additional risk, and manage it well, in order to earn an excess return. This is something new.
"I think shocks will come, but they will be shallower, shorter. They will be harder to predict, because we are not really managing risk anymore. We are managing uncertainty - too many new variables, plus leverage on a scale we have never encountered (something borrowed). And, when the inevitable occurs, the buying opportunities that result will be won by the technologically enabled swift."
As I read through this again, I think I have an insight. It is one of the reasons we get "fat tails." In theory, returns on investment should look like a smooth bell curve, with the ends tapering off into nothing. According to the theoretical distribution, events that deviate from the mean by five or more standard deviations ('5-sigma event') are extremely rare, with 10 or more sigma being practically impossible, at least in theory. However, under many applications, such events are more common than expected; 15 or more sigma events have happened in the world of investments. Examples of such unlikely events would be Long Term Capital or any of a dozen bubbles in history. Because the real-world commonality of high-sigma events is much greater than in theory, the distribution is "fatter" at the extremes ("tails") than a truly normal one.
Thus, the build-up of critical states, those fingers of instability, is perpetuated even as, and precisely because, we hedge risks. We try to "stabilize" the risks we see, shoring them up with derivatives, emergency plans, insurance, and all manner of risk-control procedures. And by doing so, the economic system can absorb more body blows which would have been severe only a few decades ago. We distribute the risks and the effects of the risk throughout the system.
Yet as we reduce the known risks we see, we lay the seeds for the next 10 sigma event. It is the improbable risks that we do not yet see which will create the next real crisis. It is not that the fingers of instability have been removed from the equation. It is that they are in different places and are not yet seen.
A second related concept is from game theory. The Nash equilibrium (named after John Nash) is a kind of optimal strategy for games involving two or more players, whereby the players reach an outcome to mutual advantage. If there is a set of strategies for a game with the property that no player can benefit by changing his strategy while (if) the other players keep their strategies unchanged, then that set of strategies and the corresponding payoffs constitute a Nash equilibrium.
A Stable Disequilibrium
So we end up in a critical state of what Paul McCulley calls a "stable disequilibrium." We have "players" of this game from all over the world tied inextricably together in a vast dance through investment, debt, derivatives, trade, globalization, international business, and finance. Each player works hard to maximize his own personal outcome and to reduce his exposure to "fingers of instability."
But the longer we go, asserts Minsky, the more likely and violent an "avalanche" is. The more the fingers of instability can build. The more that state of stable disequilibrium can go critical on us.
Go back to 1997. Thailand began to experience trouble. The debt explosion in Asia began to unravel. Russia was defaulting on its bonds. (Astounding. Was it less than ten years ago? Now Russian is awash in capital. Who could anticipate such a dramatic turn of events?) Things on the periphery, small fingers of instability, began to impinge on fault lines in the major world economies. Something that had not been seen before happened. The historically sound and logical relationship between 29- and 30-year bonds broke down. Then country after country suddenly and inexplicably saw that relationship in their bonds begin to correlate, an unheard-of event. A diversified pool of debt was suddenly no longer diversified.
The fingers of instability reached into Long Term Capital Management and nearly brought the financial world to its knees.
And now we manage for that risk. If (when) General Motors defaults on its bonds, the risk is now spread through thousands of funds and investors. Yes, they will lose, but that is the known risk they are taking. They take the risk for the equivalent of an insurance premium.
And yet, back to our opening theme, even as investors can hedge the potential collapse of the sub-prime mortgage markets and the slowing of the housing markets, it is more difficult to hedge the risks of a serious slowdown in consumer spending that would result. You just try and see what the results will be and avoid the oncoming train.
I am reading through some of my old postings and to be frank I am amazed that I am still in the game, seeing how out of time my major calls have been.
Perhaps it is a good time to give this blog some perspective.
The first thing that is important to realize is that I manage a number of different funds as well as strategies.
The good thing is that from a trading perspective this year has been a tremendous success with profits for 2 out of 4 of my funds in excess of 50% y-t-d. The others are marginally under water; nothing a strong tide can't wash up. So the year remains a good one from a trading point of view.
Where 2006 has been a revelation is the growth in my trading process and methodology, and how I have come on as a "professional" hedge fund manager.
I believe I have faced almost every obstacle the industry can throw at you and I am still around and getting stronger.
So I drink a toast on this blog to my resilence and the team I have around me. That is work colleagues and family and friends.
I am looking forward to getting a lot more out this blog as I get my systems more in tune.
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